How Investors Can Cause Early Exits
There is an increasing narrative from some folks in the investor community that lazy, good-for-nothing founders are taking investors’ money and then partying and going on vacation with it. This is the latest such article I have read but there are plenty of others. Closing a seed round isn’t an excuse to take any downtime, these articles say, or even to move into your own apartment. You should be spending 12 hours a day on your business, they say, 7 days a week, as if somehow working yourself into exhaustion will make your business better or help to keep your eye on the ball.
Now, it’s admittedly true that some young founders — particularly in the Bay Area —have exhibited awfully questionable judgment. To some degree, this is expected; when there is a preference in the marketplace for young and inexperienced founders, you get all of the other headaches that go along with managing 23 year olds. Even if they happen to be CEOs. This is a problem that any industry with a reliance on young talent has to deal with, from Hollywood to Major League Baseball. But I’m not talking about that. I’m talking about founders wanting something as simple as their own apartment.
I think it’s worth pointing out just how much the goal posts have shifted to raise a first round of funding since we started Cuddli, and how this could be contributing in a very real way to founder fatigue. When we first assembled our team, it was still possible in some cases for first-time founders to raise money with an idea, a prototype and a convincingly large enough market opportunity.
In the roughly 18 months since we began (during which time we have shipped two beta releases and a full release of our product), the goal posts have repeatedly shifted. You now need to have your team together, product built and shipped, be well on the way to product-market fit and have customers and revenues before you can raise a dime. Meanwhile, valuations haven’t changed that much. The average founder — after clearing all the hurdles and finally kicking the ball through the ever-shifting goal posts before they move again —isn’t really able to raise substantially more money than before. Outside of the Bay Area, the average founding team is still raising only about $500k via a convertible note at a $2.5M-$5M cap, after clearing ever-higher hurdles. You can raise more — a lot more — if you survive to raise a seed round. But to raise the very first round of funding, the bar has gone way up and the money hasn’t. So, many founders end up burning through their savings and/or going into debt to get started. What used to be a seed round is now coming out of founders’ pockets, or if you’re lucky, you’re accepted into an accelerator. Idea-stage companies aren’t building their first product in an accelerator anymore; instead, companies with traction are scaling that traction while being extensively coached on fundraising.
How do you clear these hurdles as a founding team? Well, you save money wherever you can and you decide whether you’re going to focus on fundraising or building product. You can’t actually do both. We chose to focus on product. I live jammed in a small house with 7 other people. It beats living in my car, but only barely. About half of my diet consists of free samples from Costco. Our director of engineering moved to Zagreb, Croatia from LA. He lives in a Communist-era concrete block building. The last time I visited, there was a problem involving raw sewage pouring from the ceiling.
Now, don’t feel sorry for us. We choose to do this. After all, we all had very successful careers before Cuddli and could go back to corporate jobs whenever we want. That being said, if we do eventually raise money, we fully intend to pay ourselves salaries with part of it, and I won’t apologize for (or even feel like I should have to justify) using my salary to pay for a 1 bedroom apartment of my own. We’ll also arrange a stable place from which we can work without my co-founder’s cat jumping on the keyboard, or listening to the neighbors argue upstairs. And — just like now — we’re not going to work 12 hours every day, and we’re going to take occasional days off. Yes, startups require a lot of hard work, and often require long hours. But they shouldn’t require crazy hours all the time. If a company’s culture requires this, something is wrong. I turned 41 today, and frankly, I’m too old for that.
Investors should want this. Founders need downtime, need stable living situations, and need a stable work location to be their most productive. After a certain point, more work hours actually subtract value, they don’t add it. People make bad decisions when they’re exhausted. I’m especially cognizant of this, because poverty (I legally live below the poverty line and qualify for Medicaid) is almost equally exhausting. Lacking the few thousand dollars a month that would keep gas in my car, food on the table, my bills paid, and a roof over my head, I’m trading a huge amount of distraction and it’s translating to lost productivity. However, given the difficulty of the fundraising environment and the counter-productive expectations of many investors, this might be less bad than the alternative. Honestly, we’re not sure, but as long as we can push the ball forward without taking outside money, we’re inclined to do so. It just doesn’t feel like selling 15–25% of the company makes a great deal of sense given how little money we’d likely get.
This does mean — and I’m being perfectly candid here — that we might be more inclined to sell early. Perhaps much earlier than we would if we were venture-funded (since we just can’t get as far without any capital). OKCupid sold for $50M. It’s laughably small relative to the value that it holds today as part of the IAC portfolio, but it also created a life-changing outcome for the founders. If we had a convertible note we could just pay back before conversion by selling early, we’d be awfully tempted to do so if the money came from investors who were hassling us about wanting our own apartment and stalking our Facebook accounts to see whether we dare to post party photos. “Robert,” you might say, “That’s crazy! You could close another round and get those annoying and distracting investors out of the picture.” While that may be true, there’s no guarantee that a new set of investors wouldn’t be equally troublesome the moment the deal closes. But the cashier’s check from your would-be acquirer could be cut this afternoon. And given how much we have personally invested, the calculation necessarily changes. Our portfolio consists of one company. We invested our life’s savings. We may even end up in personal debt. So our risk tolerance will necessarily have to be different. It’s not that we don’t believe in our potential. We just need to be realistic about the significantly higher risk, and cognizant of our own personal financial situations.
To founders who don’t already have millions in the bank, 20 million or 200 million doesn’t actually make a whole lot of difference (beyond ego, and on the Cuddli team, we just don’t have outsized egos). Think about it: I couldn’t personally spend all of that money in a lifetime anyway, whichever figure above that you choose. And to an investor, this is all the difference between an anemic portfolio and a portfolio that outperforms. You need every company in your portfolio swinging for the fences. You need exits to be optimized for outsized returns, not for “the founder decided on his 41st birthday that he is tired of living with 7 roommates.” You need founding teams performing at their best— not just the largest number of hours worked. And if you need all of this, you also need to respect the founders in your portfolio. Encourage them, don’t beat up on them. Add value, don’t subtract it. Let them have downtime, and for heaven’s sake, let them have a stable living situation. Otherwise, your founders may quietly optimize for an early exit, and leave you wondering what happened.