To help recover from our current economic crisis, Canada needs to develop the next generation of world-leading technology corporations.
The venture capital (VC) industry is seeking more government support, including direct funding, for early-stage technology corporations. Unfortunately, any potential increased financing will not help the vast majority of entrepreneurs.
That’s because most entrepreneurs don’t understand how to structure their corporations to attract VC financing. This is partly due to a lack of respect for the needs of investors, and an associated weak understanding about corporate governance matters.
VC frustrations
Venture capitalists are specialized intermediaries who raise money from institutions to invest in technology-oriented corporations. VCs become frustrated when entrepreneurs do not put in the time required to learn about, and implement, effective governance practices before launching their startups.
They complain that entrepreneurs often expect them to spend multiple hours learning about their business before making an investment, even though the entrepreneurs have neglected to take the time to learn about investor needs. Investors in early-stage corporations are active, and want to be heavily involved when key decisions are being made.
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VCs, and other startup investors, review hundreds of potential companies a year in order to make a handful of investments. Early-stage investors will spend an average of under five minutes reviewing an entrepreneur’s pitch deck, and will use that time to see if there are any critical flaws in the startup’s plans.
In a specialized program at the Haskayne School of Business at the University of Calgary, we’ve noticed that when investors identify a potentially interesting opportunity, the entrepreneur will be asked to provide two sets of detailed corporate information: a list of all shareholders and key governance documents.
If entrepreneurs have been too generous, or too miserly, in the distribution of shares, this will lessen their ability to grow a strong leadership team, will reflect poorly on the entrepreneur’s skills and is a big red flag for investors.
Complex governance challenges
Most entrepreneurs don’t appreciate that the governance challenges of a startup are in many ways more complex than those of an established corporation. The type of securities used to raise financing, for example, and the arrangements negotiated between entrepreneurs and investors can be quite complicated.
That means specialized governance mechanisms are needed that can be put into place at a relatively low cost during the early years of a startup. Once a corporation has developed past a certain point, any governance deficiencies may be impossible to correct or may require too much time and money, scaring away potential investors.
An investor’s time is valuable and is better spent helping a startup move forward as opposed to helping an entrepreneur clean up past mistakes. Taken together, the failure to attract investors and to build a strong management team have been identified as the second and third most important reasons for startup failure — and together they add up to a higher value than the first reason: no market need for the startup’s product or service.
There is information available that can help entrepreneurs learn how to work with investors. Canadian sources include the National Angel Capital Organization (NACO) and the Canadian Venture Capital Association (CVCA).
Unfortunately, however, much of the governance information on these types of sites is highly technical and it takes experience to understand which governance practices are reasonable. An entrepreneur is encouraged to seek out experienced practitioners to assist in making this determination.
Since this is such a specialized area, the number of such practitioners is limited. Even seasoned lawyers and directors who have spent their careers working with large publicly traded firms can struggle when dealing with the governance issues faced by startups.
Written by Michael Robinson, professor and Chen Fong Fellow in Entrepreneurial Finance, University of Calgary, for The Conversation
