“My Preference”

Eric Wheeler, Founder and CEO of 33across, and I came up with this joke at a venture event. If you’re in the VC world and familiar with “Lord of the Rings,” you’ll immediately understand the reference.

For the rest of you, a little explanation is in order.

Pictured is Gollum, the epitome of greed. He coveted the One Ring, which possessed special powers over others. He obsessively called it “My Precious.”

Gollum kept his Precious for 500 years, largely by hiding in a cave where he transformed into a grotesque version of his former self. Then he lost his Precious and became obsessed with regaining it.

The similarities to venture land are greater than you might think.

Full disclosure: I was a venture capitalist. So I know that in general, venture capital is a well-intended market. Without it, a major part of our economy would stagnate. Unfortunately, many venture capitalists have become obsessed with what’s called a “preference,” meaning that a particular VC has preference (power) over other invested capital and, therefore, many decisions in that particular deal. It’s a provision that’s designed to protect the investor if a deal goes bad.

Many VCs fall prey to the power of preference and exploit it. Ideally, a VC gets a simple liquidation preference. That means if the company sells, the VC either gets their money back before anybody else gets a penny, or they share equally on percentage of ownership, whichever is larger. It’s a smart way to encourage investment while reducing the risk.

Unfortunately, like Gollum and his Precious, some VCs are seduced by the power in their hands. They demand a liquidation preference for multiples of their money. They also receive what is known as “participating preferred.” That means they not only get their money back first, but they also share in distributions based on their pro rata ownership.

Such overt greed is inevitably harmful. The more preferences you add on, the harder you make it for the company to bring in new investors and more capital, exacerbating risk and creating disharmony.

Gollum-like venture capitalists forget that investing is a privilege. Talented innovators and entrepreneurs are a VC’s greatest renewable asset — and you don’t abuse your renewable assets. But some VCs just can’t help themselves. Like Gollum and his Precious, once they glimpse the power, they want more, and they morph into a grotesque version of their former selves. And like Gollum, they meet an apt fate.