Guest post: The madness stops here – don’t pay a VC any fees

This is a guest post written by a London-based VC. For the purposes of them being able to speak plainly without jeopardising their fund or their career, I’ve allowed them to post anonymously. Why are we doing this? Well, while the startup eco-system is long in the tooth and highly developed in the US, the European scene is still a spotty, shy teenager, sometimes making a few mistakes. And as a result startups need educating. Make no mistake, LondonVC is a genuine VC and TechCrunch Europe has met them face to face. Over the next few weeks they are going to offer a unique insight into the VC and startup world in Europe. I hope it’s enlightening for European startups. Read and learn.

One reason I started this column is because I see a lot of “injustices” in the VC-start-up universe, and while I’m obviously aware that we don’t work in the charity sector and that business is business — and we’re here to maximise investment returns! — I do think we should let market forces determine what’s reasonable or not for business practices and deal terms. However, this works only if entrepreneurs actually have access to experience and insight into what really has been “standard” or acceptable in the past.

Unfortunately, a lot of things that I witness as an active member of this scene take place because entrepreneurs let them – simply because they don’t know any better. And how could they? It’s not like a VC is motivated to let them in on it… And since not many entrepreneurs brag or complain about the terms they get from VC term sheets, I realise that it’s difficult to know what’s standard or not. I’d like to be one small source of “truth”, and hopefully over time we can bring a bit of balance back into this business. First up: For early stage companies and start-ups: Don’t pay your VCs any fees.

This means:

Do not pay your VC a transaction or arrangement fee [for doing the deal]: They should pay for their own costs of doing business.

Do not pay your VC’s legal fees: If you absolutely have to, cap it so it doesn’t become unwieldy.

Do not pay your VC any non-executive directors’, advisory or consultancy fees for serving on your board or giving you advice:

Unless you’re bringing in strong revenues and turning a profit, this is just plain daylight robbery.

Aside from the fact that it just doesn’t make sense to put money into a business only to take it back out again (like, WTF?!), these fees will also be distasteful to other prospective co-investors who might otherwise take an interest in your financing round. In other words, no investor happily tags along on a deal if the lead investor is lining their own pockets with the cash.

For an early stage pre-profitable company, it doesn’t make sense to pay fees. You should choose your VC investors for the value they bring (over and beyond a bank or other sources of “dumb financing”), so it doesn’t make sense to pay “extra” for that value.

Ask The VC has a great Q&A post on this from July 2008. (And by the way, Ask The VC should be a must-read for any entrepreneur, but I’m realising that it doesn’t get as much of an audience here in the UK/Europe.) Paying fees to your VCs is clearly a distasteful practise in the US, so why is it still popping up in term sheets circulating around London? Can we please not be the “seedy side of VC”-?

One reason I guess these are cropping up more and more is because of the rise of new smaller VC funds. There’s been a lot of public discussion over the past 6 months or year that the VC industry is “broken” from VCs living (fatly) off their fixed non-performance based management fees and being subsequently incented to simply raise larger and larger funds. Some examples of this discussion and ranting is here, here, here, here and here plus a nice aggregated listing here (handy!)

Obviously this is a simplified view – since a VC can’t possibly raise a new fund (of any size) unless it has a track record or performance to boast of. But either way, there has been a clear response to all of this fodder and we’re seeing new smaller funds emerge on the scene. And while that’s very good news, the bad news is that *some of* these smaller funds (not all, of course) – in compensating for their smaller management fees (or none at all if they are private funds) – are nickel and diming their portfolio companies instead.

I say let’s not replace one inefficient model with another.