Venture Hacks

“Trust, but verify.”

– Ronald Reagan

Summary: Investors trust the entrepreneurs they back. But they verify their expectations with contracts and control. You should do the same—with the same tools investors use: contracts and control.

Why do investors want to control their investments through board seats and protective provisions? Shouldn’t they just give entrepreneurs bags of money and trust them to do the right thing?

David Hornik has the answer in Venture Capital in China:

“One investor with whom I met on my [China] trip described a recent situation in which he funded an entrepreneur, only to have that entrepreneur turn around and leave for business school months later. The entrepreneur assured the investor that he would be better situated to make the business a success after the two years of school. The investor had no recourse as his money left the country with the entrepreneur.

“In another instance, an investor backed an entrepreneur in a business that thereafter appeared to be failing. However, a couple years later when the same company started thriving, the entrepreneur informed the investor that it was not the company he had backed. The investor was incredulous. He told the entrepreneur that it was the very same company with the same team and even the same name. The entrepreneur assured the investor that it was, in fact, a different company and that he had not invested in this successful company, his investment was in the previous failed venture. Despite the obvious deception, the investor told me that he again had no legal recourse.

“…the legal structures needed to support a vibrant startup economy [in China] are, at best, embryonic. Neither entrepreneurs nor investors are particularly well protected by the Chinese legal system.”

Investors trust, but verify.

Investors trust the entrepreneurs they back. They wouldn’t invest if they didn’t. Their trust is an expectation that entrepreneurs will:

1. Do what they say they’re going to do in anticipated situations.
2. Consider the investor’s interests in unanticipated situations.

Investors have been playing this game long enough to anticipate certain situations. So they use contracts and courts to enforce their expectations in those situations:

Investors trust entrepreneurs to stay at the company for 4 years, and they verify it with a vesting schedule.

Investors trust entrepreneurs to pay the investors first when the company exits, and they verify it with a liquidation preference.

Investors trust entrepreneurs to consider their interests in an acquisition, and they verify it with protective provisions and board seats.

Investors have been playing this game long enough to also know that you can’t anticipate every situation. So they use control to dispose the company towards the investor’s interests in unanticipated situations.

Verify your expectations.

China doesn’t seem to have a legal system that lets investors and entrepreneurs verify their expectations. They have trust, but no verification.

But U.S. investors can trust and verify. And you should do the same—with the same tools investors use: contracts and control.

If you trust your investors to let you stick around long enough to vest all your shares, accelerate your vesting upon termination.

If you trust your investors to let the board make the call on acquisition offers, automatically suspend protective provisions when the offer is big enough (e.g. a 3x return).

If you trust your investors to let the founders run the company, control the board.

Writing a contract doesn’t mean you don’t trust the other guy. It just means you want to document and verify your trust.