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March, 2010:

VCs passing for “soft” vs. “hard” reasons

I recently made the choice (mistake?) of telling an entrepreneur, whose business I actually liked and respected, the real reason why I was passing on investing at the time.

In this case, there was a new CEO recently signed up to work with a technical founder, there were some family relationships on the team and board, and there were some international complexities (overseas offices). I also believed that there were some cultural issues in the company that needed work (especially around customer service / customer experience issues).

Now, compare these things to the usual, “hard,” “objective” issues that VCs take: market size, defensibility / patents, growth rate, capital requirements — things that can generally be reduced to numbers. My concerns looked pretty “soft” in comparison: seasoning of the team working together, culture of customer satisfaction, family dynamics. I took a risk and laid it out there, adding that I would be happy to check in in a few months to see how things were shaping up on these “soft” issues (but I acknowledged the risk of losing the deal to a faster moving investor).

The entrepreneur’s reaction was mixed. At first he told me he appreciated the candor, but then, in a follow up email, objected pretty strongly and negatively contrasted our communication with other VC “passes” he’d received, each of which had a “hard” reason (like raising too much / too little, outside of geography, etc.). I thought about this for a bit.

If you were pitching, and the VC declined to proceed at that time, would you rather get a “hard” or “soft” reason for a pass?

I’d say “soft.”

If a VC tells you, “ah, you’re raising 10-12 million from two VCs, but my fund size will only let me put in 2-4,” or conversely, “you’re raising 2-3 but I have to put 4-6 to work in each investment,” what have you actually learned? With due respect, you’ve been told that your would-be date has to wash her hair on Friday. Perhaps, in fact, she is going to wash her hair, but if she was really attracted to you, she’d rearrange her shampoo schedule.

Likewise, total market size, IP, or the elusive “traction” are all “hard” reasons for a pass. They’re likewise convenient: they are impersonal / objective, deficient to some extent in all startups, and theoretically required for success. Each is a seed crystal around which a swirl of “soft” reasons can easily and apparently crystallize. And they all sound good, well-reasoned, prudent — things we can easily feel OK about mentioning to our partnerships or to you, the entrepreneur.

(Not that this is disingenuous or untruthful in any way on the VC’s part; since we must reject literally 99% of deals we look at, sometimes one reason is as good as another.)

BUT: if you can find someone willing to take a risk and share the “soft” reasons with you, have a close listen. Soft items include team dynamics, opinions about “direction” or “strategy,” or “pattern recognition” stuff. Sometimes it’s about a “smell factor” or something else that just makes a VC uncomfortable. Always, it’s a complex cocktail of different perceptions, judgments, and opinions (from the discounted cash flows to Lord Keynes’ “animal spirits”), and the true contents are much more varied and harder to describe than a single crystallized hard reason that’s dropped out of solution.

These things are risky for an investor to try and describe. They can be personal or interpersonal, and talking (or listening!) directly about one’s own self is hard. They often include a personal value or judgment call on the investor’s part, and those calls can prove wrong. However, in fundraising as in so much of startup work, perception is (or at the very least strongly feeds back into) reality. Getting an honest assessment of what one investor really, truly thinks at the “soft” and complex level is likely to be more helpful in shaping the business and the pitch than a pat “hard” answer.

Sometimes, things just don’t align and the real answer is: no fit, let’s both shake hands and move on quickly. And sometimes, there’s a complex swirl of doubt but the time and effort of dissecting and parsing it isn’t worth the likely yield: crystallizing on a “hard” rationale for a pass is fine. But if an investor takes the time to dig in, to do the “mass spectrometry” on the trace elements of his doubt, please listen. He’s taking a risk, and though the soft observations may be wrong, the mere fact of their existence and elicitation, as well as their details, should be valuable to the entrepreneur.

(The next step is getting VCs to solicit, appreciate, and iterate/improve based upon “soft” feedback from entrepreneurs. Which I am trying, the reader may have concluded in surmise, myself to do. The entrepreneur I describe is real and gave permission for me to mention him anonymously.)