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Startups that got screwed by venture capital

Investopedia logoInvestopedia 03-11-2015 Zaw Thiha Tun
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For most startups, reaching the first round of venture capital funding (also known as series A funding) is a major milestone. Reaching series A means  that the fledgling company is part of the elite 10 percent that has managed to survive the tumultuous initial years when the business was run on bootstrapping or angel capital and is now ramping up towards going public or getting bought out. Though venture capitalists offer the allure of large cash infusions, nothing is free. In return for their risky investment, venture capital (VC) firms gain varying levels of control over the company and its future profits.

There can be large disconnect between the founding vision for the company and the venture capital firms' expectations for return on investment. This schism between the visionaries and capitalists can ultimately lead to the failure of companies, as was in the case of pioneering web development company ArsDigita. On the other hand, if the startup is wildly successful, venture capital firms are well positioned to reel in the profits--sometimes at the expense of the company’s founders.

1. ArsDigita: How VC Meddling Led a Trailblazer to its Ruin

The pioneering web development company ArsDigita was founded in 1993 with just a $10,000 investment. Based on a candid account of its rise and fall by company founder Phillip Greenspun, the company eventually grew to an impressive $20 million in annual revenue during the dot-com boom of the late 90s. In its heyday, ArsDigita, which had ties to the M.I.T. academic community, ran a free, one-year online course in computer science (a revolutionary idea at the time), and rewarded Ferraris to any employee who could recruit 10 programmers into the team. With orders pouring in, ArsDigita decided to expand and secured $38 million in venture capital funding from the firms Greylock Partners and General Atlantic. The first thing the venture capital firms did was install a new CEO who had little experience in software sales. The VCs and the new CEO oversaw an erosion of ArsDigita’s company culture, ballooning costs, higher customer churn and the loss of a buy-out offer from Microsoft Corp (MSFT). Eventually, managerial incompetence and the dot-com crash led to the firm’s collapse. ArsDigita's founders later sued the venture capitalists (the lawsuit was settled out of court for an undisclosed sum).

2. Bloodhound Technologies: A Hard Lesson In Dilution

A company does not even have to be run into the ground for the founders to lose everything. Venture capital firms would prefer to see a company thrive, if only to maximize their own profits. And reducing the founders' share through deals involving preferred stock is one way to maximize the VC's cut. Founded in the mid-1990s, Bloodhound Technologies offered software for detecting healthcare fraud. The company rode the dot-com boom through two series of venture capital funding. After the Internet bubble burst, Bloodhound ran into troubled times. Fearing for their investment, the venture capital firms exerted control and ousted the company founders. Eventually, Bloodhound recovered, and by April 2011 the company was sold by for $82.5 million to Verisk Health Inc (VRSK). Unfortunately for the founders, due the capital structure of the further rounds of VC funding, the founders' shares were now heavily diluted. Long story short, the venture capitalists managed to receive almost the entirety of the sales price, while the original founders were paid out less than $36,000. One founder received just $99.

3. Get Satisfaction: Additional Funding Comes With Its Own Costs

But even $99 is a windfall payment compared to what the cofounder of the customer engagement platform, Get Satisfaction, received. According to Business Insider, when company cofounder Lane Becker saw the paperwork for his company’s buyout by social media software management firm, Sprinklr, in April 2015, he vomited. Sprinklr wrote a check for $50 million for the company, but Becker received nothing. Much like the Bloodhound Technologies case, Get Satisfaction's founders succumbed to the temptation of VC money to grow the business. During the second round of funding in 2010, the venture capitalists took control and forced out the original management. Five-years later, Becker had no idea an acquisition deal was even in the works.

The Bottom Line

While securing venture capital funding is an important milestone towards a buyout or going public, startups should be wary of the potential pitfalls that come with the money. As in the case of ArsDigita, Bloodhound Technologies and Get Satisfaction, entrepreneurs should make sure that the venture capitalists have interests that align with the vision and culture of the company. Furthermore, startup founders should familiarize themselves with the proposed capital structure of the funding to ensure they are not cut out of future profits.

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