5 learnings from startup failure and success: investors.
As a startup founder, your investors can be a huge help or a major headache. Here are 5 learnings that show how managing your shareholders properly can have a dramatic impact on your business.
This is the third of three articles written for budding startup founders. If you haven't yet read the other instalments, you can find part 1 here. If you want a shortcut to the lessons, see this Twitter thread.
1. For investors, this is business.
Sure, investors and founders can be friends, but it's important to remember that you're in business together. This is a professional relationship. Investors back early-stage companies for a variety of reasons, but it's safe to say that most want to make money. Founders should not expect an investor to do anything that's not in their own best interest. And if a shareholder offers advice, help, or guidance, it's probably their way of protecting their investment. Please listen.
Having backed early-stage companies since 2012, I'm fortunate enough to have been through several exits. Some of these have not gone entirely to plan, in part because founders and investors were not aligned.
Don't expect investors to behave a certain way.
One acquisition took place in North America. It was essentially an acqui-hire. Although still functioning, the company had not grown as quickly as expected. A trade sale seemed like the best option to keep the idea alive and staff employed, albeit without delivering a positive outcome for investors. The conversation divided shareholders dramatically. Some, including me, felt that this deal was the only sensible option. Our money was lost, but at least the business could survive, and the team could remain employed. Other investors were so angry about losing their money that they attempted, unsuccessfully, to block the deal. Why should the company survive if the investors had been wiped out? I found the attitude quite surprising, but it taught me that people don't always behave as you expect them to.
I've experienced a similar phenomenon first-hand. Having run out of options and runway, I had the painful experience of closing down a startup, for which I'd raised several million dollars in funding. While most investors accepted it, some made it clear that they were upset. One demanded his money back (which amazed me, as he worked for a bank and seemed to understand finance pretty well). Others, however, were fantastic. A shutdown is a hard thing to get through, so having understanding investors helps a lot. Many of my backers remain good friends, and most have never mentioned their losses, despite them being considerable.
Another told me the following:
"I understand you feel bad, but don’t ever feel ashamed about doing your best. You had a great idea, you tried your hardest, but it wasn't to be. As I remember it, you didn't hold a gun to my head to make me invest. I did it because I'm greedy - I thought you were going to make me a lot of money, and I understood the risks. Your other investors backed you for the same reason. If they can’t take it when they lose, they shouldn’t be in this game at all.”
For you, it's your dream; for them, it's an investment.
In another sale, there were some last-minute changes that didn't work in the investors' favour. Notably, the buyer expected all shareholders, not just founders, to accept warranties. Despite it being a good deal otherwise, some people refused to sign. It was understandable. Whether or not they put pen to paper was actually immaterial. The deal had sufficient support for approval anyway. Non-signers would simply be "dragged along", enjoying the exit without any risk. It didn't impact the deal, but it created some bad feeling. The founders' view was that everyone should be "in it together". The investors who didn't sign simply did what was best for them. It was business.
Advice may not always be welcome, but listen to it anyway.
Another example showed what can happen when a founder doesn't accept advice. It was a company with some exciting IP that, in the right hands, could potentially be very valuable. As the board spoke with potential buyers, one of my fellow investors offered some excellent advice. One recommendation was an exclusivity provision. This would require any serious purchaser to pay a non-refundable deposit while they carried out due diligence. Should they proceed with the acquisition, the deposit would be deducted from the sale price. Should they not proceed, the deposit would be forfeit, compensating the company for opportunity cost during the period of exclusivity. For reasons I still don't understand, no such provision was requested. As the due diligence period drew out, the company's funds ran low. Eventually the buyer made an extremely low offer, but by that time cash was so tight that it was impossible to go back to the market. There was no choice but to approve the sale. Investors who bought in at the same time as us received 10% of their capital back. Others received considerably less. A painful lesson for all involved.
Investors care about the business, not you.
Last but by no means least, remember that many investors want influence. The obvious way to get it is by requesting a board seat. Whatever they may tell you, they don't do this in order to help you; they take board seats so they have the option to replace you. This article is well worth a read.
2. Have legal agreements.
This seems like an obvious one, but I've found that many early-stage companies have no documentation whatsoever. Whatever stage you're at, if there is more than one person involved, it's worth drawing up a shareholder agreement. There are plenty of templates online. This is particularly important where there are multiple founders, especially when they're related. Ironically these tend to be the situations where agreements are considered unnecessary.
Legal agreements are not there to govern the way you work together. They exist solely for when times get tough. You never want to find yourself in a stalemate, with literally no way forward. It's much better to agree how decisions are made before you start, when you can still think dispassionately. I've used the same documents, with a few minor changes, for multiple businesses throughout the last decade. I can't remember when I last looked at them, except when signing, but it feels good to know they're in place.
3. Avoid complex share structures.
The other benefit to having your own legal agreements is that it makes it much easier to avoid signing someone else's. As your startup grows, it's likely that you'll encounter requests for specific legal terms. You'll hear phrases like: "preference shares", "downside protection", "warrants", and "anti-dilution". Some of these things can't be avoided; others you should steer clear of.
If you have your own documentation in place, and it's good, you may be able to convince investors simply to agree to yours. If you haven't, they may offer up their own. These will almost certainly include terms that your own agreements wouldn't.
I've felt the impact, first-hand, of many different investment terms. As an early-stage investor, these mechanisms have usually worked to my disadvantage, along with other early investors and founders. The more money that's at stake, the less risk investors seem prepared to take. Later-stage VCs negotiate different methods of mitigating their downside, mostly at the cost of those who came before them. Of course, if things go completely to plan, these mechanisms don't kick in. But often they do.
I remember one experience vividly. The company in question was closing and was due to return its remaining funds to its shareholders. It turned out that the early investors were not entitled to any money at all, because the holders of preference shares were owed more than the company had in the bank. One of the early investors said to me:
“I know we accepted this VC money, but this doesn't seem right. Frankly, I don’t care if the founders take the remaining cash to the casino. That would give me a better chance of a return than simply shutting down.”
Issuing different shares to different investors can create tension and stress, but this is usually nobody's fault. Early investors are often friends and family, who don't understand cap tables and wouldn't expect any preferential treatment anyway. It's only when things unravel that they start to seem unfair.
I have a view on this, which I know certain other people share. What could make this issue a lot less complicated is if all investors were to receive preference shares over the founders. As I wrote in an earlier post, if founders think of equity investment like a loan, it's money they should focus on paying back anyway. In that vein, giving all investors a liquidity preference over founders makes perfect sense. In its simplest form, it would ensure that every investor gets his or her money back, at least, before founders themselves participate in an exit. Doing this would also give founders a much stronger position when negotiating against harsher preference terms later on. If all investors already have a preference, why should a new investor request another one? It's not fool-proof, but it could work!
I've illustrated this below. In each case, the founder has raised $1m from his investors at a $4m pre-money valuation (so $5m post-money), giving those investors a 20% stake in the business. Soon after, the business falters and is sold for $2m. It's not a complete disaster, but having injected $1m of their children's inheritance into the business, the investors feel justified in expecting a share of the proceeds. But, how much should the investors get back? With no liquidity preference, they get 40% of their money back, but is that enough?
| Preference Shares | Investors Receive | Founders Receive |
|---|---|---|
| None | $400K | $1.6m |
| All Investors (non-participating) | $1m | $1m |
| All Investors (1x-participating) | $1.2m | $800K |
If you were the founder, which approach would feel right to you? [1]
4. Be transparent with your shareholders.
This is a lesson I’ve learned from being an investor as well as a founder.
Once you've landed your investors, you'll need to update them on your progress. Don't go overboard, and don't write War and Peace, but as an investor I expect an update at least once-per-quarter.
Despite the temptation just to share the good news, it is far better to be open with your investors about all aspects of the business, especially the challenges. Early-stage investors are invariably successful, well-connected, knowledgeable people. They often enjoy helping others and adding value to the businesses they fund. If you don’t share your problems with them, how can they possibly help you? What’s more, if things ultimately don’t work out, you don't want the news to come as a shock. Investors know things can go wrong, but they generally don’t appreciate nasty surprises.
With literally only one or two exceptions, every founder I have backed makes a poor job of this. It’s ironic. Founders spend half their lives trying to win over new investors, but once they have them, they leave them largely alone, especially when they need them the most. Some of the founders I've backed are ex-VCs, but even with them, I'm lucky if I get an occasional investor update. (You know who you are!)
One of the founders I've backed stands out to me. Chris Howard of The Rattle (sorry Chris, I’m going to embarrass you here) communicates often and with what feels like absolute transparency. He shares the good, the bad, and the potentially disastrous. Chris understands that investors don’t expect him and his team to have all the answers. We're not going to rebuke him when something goes off-plan. We know it will! Instead, he knows that we're a valuable resource. He can gain advice and introductions, he can share his concerns, and he can ask for help. (Chris is something of an expert when it comes to investors. Check out this YouTube video for a sample.)
Treat them as trusted advisors and your investors can feel like business partners. It may seem logical to treat them as such, but my experience as a founder tells me this doesn't necessarily come naturally. It’s hard not to be “always raising”. Sadly, the majority of founders don’t give bad news until it's impossible for them to “shield their investors” any longer. By that time, it may be too late.
I would like to think that, as a founder, my shareholder communications have always been decent. I've strived to keep them regular, thorough, and balanced, and I've learned a lot about what (not) to do from the founders I've backed myself. There were times, however, when I too felt the temptation to paint a rosy picture. I've also had a tendency to send less frequent updates as things became more difficult, hoping to create some good news that would offset the bad. This was a failing. At times it also raised questions, even suspicions, among certain investors. I've had several unpleasant investor conversations I should never have needed to have.
It’s true that founders are always thinking about the next funding round. However, with existing shareholders, I have absolutely no doubt that total transparency and regular communication are the best tactics, particularly in times of adversity. This is a learning I’ve brought to DQventures, where I send a private investor update quarterly, followed by a public one.
5. Failed founders have to work twice as hard to impress investors.
At various times throughout my startup journey, different investors have told me that I'm doing a good job. Several said that, whether they made money or not from the current venture, they would be happy to invest in me in the future. The words were welcome, and I believe they were heartfelt.
The thing is, I did go again, but not one of my former investors backed me the next time around. Once bitten, twice shy. Now, this is hardly surprising, and I would never expect people to invest in my businesses. My point is simply this: having failed (and having acquired all the learnings that came with that failure) I had to work three times harder the next time I tried to raise money.
If you think about it, it's logical. If your first startup succeeded, you and your investors received an influx of money that you could throw at something else. If you failed, you’re all worse-off. Not only have you suffered a painful lesson in how easy it is to lose your capital, you also have less capital than you started off with, making you even more circumspect about going again. For investors, this is why the number one golden rule is to diversify at the very beginning of your angel investing journey.
As a founder, although I genuinely believe you become a lot more likely to succeed second time around, you should be under no illusion that it will become easier. Nevertheless, as this wonderful image Tweeted by Blake Emal shows, failure is just part of the journey, not the destination.
I wish you the very best of luck.
If you have failed, or know someone who has, I would love to hear the story. Please share this article, and encourage the founders you know to get in touch with me. Thank you!
Photo and illustration credits:
– Mohamed Hassan on Pixabay
– Chris Howard of The Rattle by dot.LA