5 Ways Investment Can Kill Your Startup
This is part seven of my big ol’ nine-part series, exploring every imaginable aspect of startup funding. From funding rounds to valuation methodologies, get ready for a complete crash-course in funding.
Click to read all nine parts as a complete post, or download as a PDF.
From signalling risk to the startup graveyard, fundraising is a perilous path for startup founders to walk. But with high risk comes high reward.
Securing investment can provide the resources you need to scale, and many of the biggest pitfalls faced by founders are well understood. With a bit of preparation prior to seeking investment, these can even be side-stepped.
1) SIGNALLING RISK
Being a seed investor grants privileged access to a startup’s inner workings.
So, when the time comes to raise a Series A, if your investor chooses to lead the round, that sends a powerful signal to the market: something good is happening behind the scenes of Startup X, and it’d be a smart move to get involved.
But what happens if your investor doesn’t follow on?
Regardless of their specific motivations, the market gets the same message: the people with the best insight into Startup X’s performance haven’t lead their Series A, so we need to stay away. If they won’t put their capital at risk, why should we?
The average VC-backed seed company raises a Series A 35% of the time, or 51% of the time if it’s a smart money VC (a VC that provides strategic guidance, and not just capital). But if that smart money VC doesn’t follow-on, the chances of raising a Series A round plummet to 27%. This is the signalling risk of VC seed funding.
2) BECOMING AN “OPTION”
If we look at the biggest macro-trends in startup funding, it quickly becomes apparent that:
- More startups are founded each year.
- Investors are willing to invest more than ever before.
This is creating a real problem for investment-hungry startups: VCs are increasingly happy to make small, speculative investments on the off-chance they’ll succeed, allowing the VC to lead a much more lucrative Series A.
These speculative investments bring with them two kinds of risk: signalling risk if the VC then declines your Series A, and the opportunity cost of taking capital from someone unwilling to advise your startup, instead of an investor who would be more hands-on.
3) LOSS OF CONTROL
Capital comes at a cost: equity.
Even if you start out looking for modest amounts of capital, many startups find that the more investment they raise, the more future investment they need, as their burn rate increases and their swelling panel of investors demand ever-faster growth.
This makes it extremely likely that come the latter stages of fundraising, you, the startup founder, will no longer be the majority shareholder of your business. Even if you’re happy sacrificing your majority stakehold for the good of the company, the loss of board control can leave you powerless to veto the issuing of further shares, diluting your stake even further.
- At their time of IPO, Box CEO Aaron Levie owned just 5.7% of the company he founded.
- After losing control over the company, Sandy Lerner, co-founder of Cisco, was fired by one of the company’s early investors.
- When Groupon reported a larger-than-expected quarterly loss, founder Andrew Mason found himself out of a job, issuing a memo that read: “After 4 1/2 intense and wonderful years as CEO of Groupon, I’ve decided that I’d like to spend more time with my family. Just kidding — I was fired today.”
4) THE STARTUP GRAVEYARD
Investors (particularly VCs and financial institutions) will perform rigorous due diligence, and scrutinise every aspect of your business model prior to investing. Securing investment could even be considered a vote of confidence, suggesting that your business is in good shape. But, crucially, investors are fallible, and investment doesn’t always increase your chances of success.
Only 41% of Y Combinator’s portfolio companies are still funded and in operation — greater than the 90% failure rate predicted for startups as a whole, but far from ideal.
If we stretch our definition of success even further, and look at only those companies that have gone on to exit, that success rate drops down to 13% (and just 4% for 500 Startups). VCs will be more discerning with their investments, but high failure rates are still part-and-parcel of their portfolio.
5) THE FORCED EXIT
But what happens if you don’t fail?
VCs, angels and almost every other type of equity investor need an exit to make money from their investment: an opportunity to cash-in their shares at a profit.
VC funds also have a shelf-life: most are designed to offer returns over a ten year period. As that deadline looms, your investor needs to steer your company towards an exit.
This is fine for long-time founders that set-out to scale and sell their company. But what if you don’t want to go public or sell your company? And what if you joined the VC fund towards the end of their ten year cycle? Even though you don’t want to sell or IPO, your investors will.
When combined with the loss of control almost all founders experience, that can mean full steam ahead for an exit, even if you’d rather stay the course.
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