3 Things That Will Make Your Startup Un-investable
It was 2008, pre-crisis. My startup was the world leader in mobile travel apps, and Sequoia were interested. Interested enough to go through successful partner meetings, market due diligence and a green light at a partnership meeting. Then they asked for the Cap Table.
A few days later I was called to a meeting with the partner, where he said very simply “I’m sorry, we are not going to invest. We looked at your cap table and enquired about the angel investors. We can’t make money here.”
I shrugged and moved on.
I ended up raising that C Round the next year from corporate VCs. In late 2009 my new board had me relocate my family and my executive team from Israel to Palo Alto. A couple of months later, sensing an imminent acquisition offer from Blackberry, those angel investors took over the company, installed a stooge as CEO (“think of him as an investment banker who’s come in to negotiate a better deal… in 6 months time the company will be sold and you will be the only one remembered”), sowed discord within the exec team, and took over strategic discussions. Over the next two years, they destroyed two thirds of the company value offered in that deal, and that’s after raising a few more million dollars in debt, leading to a 1x return to investors and roughly 0 to everyone else.
More importantly, those investors caused me and my family significant duress, emotional hardship and financial loss — after working a decade on a company that was by all other measures a success.
So what did Sequoia know that I didn’t, back in 2008?
Is Your Company Investable?
Rational investing is based on projected returns. To produce returns, your company’s potential to increase in valuation by being a good business / having a good product / technology is not enough. It also needs to be exited at the right point in time at a reasonable amount of risk. Venture investing is risky by definition, and investors’ job is to pick the right companies and back them through their trials and tribulations. There’s selection risk, market risk, execution risk — all of these are part of the venture model. But there are also unacceptable kinds of risk:
- Early investor have too much control and are prone to meddling.
- Management / team fatigue.
- Legal / financial skeletons rising to haunt the company.
These risks are the subject of most legal and financial Due Diligence, but can often be detected by experienced investors even before that stage, which normally starts after a term sheet was signed. No one likes to yank a deal away after signing a term sheet — there is reputation cost and financial cost. Therefore savvy investors ask not only whether a company can be successful, but also whether it is “investable”.
Your investability is as important as your scalability
Early Investors vs. New Investors or VCs vs. Angels
In early to mid-stage companies, a new investor coming in expects to invest and wait — “nurture” the company for 3–7 years, double down on the investment when things go well, and eventually get > 10x return. That is the financial model on which a VC portfolio is built. There are two considerations here:
- One or two outsize returns “make” the fund. It’s OK that most companies will go to zero as long as a couple return a huge multiple. You have to wait to figure out who they are and double-down on them. You don’t want to sell them while they still go up.
- Money should be put to work for the long term— if a VC invests a dollar in your company, even if you return 2x in one year — that dollar was “used up”. If you return only 1.5x per year over 4 years — that’s a 5x return. If there’s an opportunity to double down as you go up — fund-level returns are further increased. Raising a fund takes a lot of time and effort, and they want to put the money to work long-term.
However — if your existing investors are interested in a quick exit and have enough control over the company (voting share, board seats, sway over management), it means that the new investor might not reach that goal — even if the company is successful and positioned for growth .
On the existing investors side, your angels might be concerned about the dilution (loss of control) and growing liquidation preferences which increase the likelihood that there will be no exit or that they will not even get their money back at a low exit. Therefore they may try to dissuade you from taking on large investments / high valuations, in effect limiting your growth. The longer it’s been since their investments, the more anxious they probably are about getting their money back — and the bigger the potential conflict between them and new investors who are coming in with deep pockets and lots of patience. From the perspective of the new investors, that’s unacceptable risk.
It’s important to note that there are no “bad guys” here necessarily. There is simply a misalignment of investment goals leading to a conflict of interests. Everyone is right, but you don’t get the money.
Team Fatigue
Similar to investors who’ve lost their patience, founders and other key members are subject to fatigue and post-trauma stress. When a company has been around for a long time, the assumption is that management gets tired, sees more of the risk and less of the upside, and may easily be tempted by an early exit. As explained — that goes counter to the VC model.
Similarly, a team with that mindset may not be able to weather the next downturn, failure or disappointment. A new investor has to assume that there will be hard challenges, good and bad times. A team that has taken a long time to see some success, and is facing more hardships may be more likely to give up. Lower motivation and more attrition drive undue execution risk.
Investors have many terms for this — “old DNA”, “zombie company”, “management PTSD”. One way or the other, at the team level, accumulative scar tissue drives low exits at the best case and fragility at the worst case. Both are bad news for investors.
Worms In The Woodwork
Remember the Winklevoss Bros. in The Social Network?
It is virtually impossible to run a startup company and not collect some individuals / companies / governments that believe, or at least claim that you owe them something.
Some such loose ends I’ve encountered during my career:
- Ex-founders, “self appointed founders” and executives with claims over equity and / or intellectual property (IP).
- Disgruntled employees and advisors who were promised / granted equity that’s not showing anywhere.
- Unpaid debt to employees, vendors and lenders.
- Clients with significant financial or legal complaints.
- Shareholders who’ve been “over-diluted” or otherwise sidelined with claims of oppression of minority.
Right or wrong, if these people are smart, they wait until you are worth something and are vulnerable. For instance — when you’re about to be acquired, or negotiating a strategic deal. And that’s when they are drop a legal or financial threat. When this happens, you will most likely be advised to settle with them in order not to lose the deal — costing your shareholders some percentage of their proceeds (typically in excess of what these claimants are actually owed). In worst-case scenarios, this will end with the deal going away, because the buyer or investor is spooked of the legal exposure, concerned about how this reflects about your governance broadly (“we know that we don’t know what we don’t know”), or simply not interested enough to warrant a complicated due diligence and cleanup work. This could manifest itself in lots of different ways — from walking away from a deal, to requiring indemnification terms or escrow terms that kill its attractiveness. I have personally had an acquisition scuppered at the last moment over final definitive documents due to an excessive indemnification clause.
“As a VC, I’m not in the business of cleaning up companies before I invest in them.”
From an investor’s perspective — each such vulnerability represents a small chance that even though you built a good company, they will not be able to exit profitably. And if you have many such loose ends — these risks compound, and again represent an unacceptable risk level.
How To Stay Investable
Startups are hard, and s*#t happens. But you do have some control over your future.
- Don’t rack up too much convertible debt and don’t get too much control in the hands of non-professional investors.
- Understand that your startup has an “expiry date” and beyond that date you’re better off starting afresh. As you approach it — try to sell, and if needed — walk away.
- Don’t leave loose ends. When you reach an agreement — sign a document. When you end a relationship — negotiate a written separation.
- Avoid unnecessary drama. End toxic relationships, settle and document. Shun erratic investors and business partners.
In real life, this advice is hard to implement. You are always hustling and scrambling for cash. There are always differing interests and points of view, and success has many fathers (and mothers!). But if you’re undisciplined in your management style, it typically comes back to bite you in the a$$. You must institute discipline in your decision making and in your handling of legal and administrative issues. Know when to say “no” and when to walk away. The cost of not doing so may be too high. And you may only feel that pain years later, after investing even more blood, sweat and tears — and by then it may be too late to fix.
Life-time is the one thing no one can give you back. There’s no other way to say it — wasting years of your life working on something that can’t succeed is stupid and painful. Some mistakes can’t be avoided, and luck always plays the key role. But planting the seeds for your eventual demise is a shame, and beating a dead horse is going to be more painful for you than for the carcass.
Nadav Gur is a serial entrepreneur who founded, ran and exited several companies in the AI, automotive and travel space. He is the principal at NG Vanguard Enterprises where he works with founding teams and investors to make them 21% better.
