The Series A crunch and the 38 studios debacle have lots of parallels even though the money raised by 38 was huge. Because it barely got a first product out, it parallels many of the challenges that seed companies currently face. I have had this post in my drafts folder for quite a long time and almost tossed it, but hearing the noise about seed companies struggling to get future rounds of investment, I thought it remained pertinent. btw: The crunch is not a change in VC behavior — just a radical expansion of seed companies vying for the same # of Series A deals done every year. VC bonanza!!
Who do you want in your lifeboat?
For anyone raising money and evaluating investor partners, there is no better expression to capture the ups and down of investor relations in startups. When the going is good e.g. “rising tide lifts all boats” — everyone is happy. Perhaps greedy, but generally happy. And investors at times can be more interchangeable during heady times. The term “dumb money” was coined to illustrate indistinguishable money. Money with no added value. During a storm, who do you want in your lifeboat?
Series A Crunch: When the Going Gets Tough:
But when times are tough for the startup, it really matters who your partner is. That’s because interests are rarely aligned when things aren’t going well. Here’s a list of misalignments that can absolutely kill your company, much less get you squeezed out financially or literally. Generally, there are three stages of misalignment between the entrepreneur and the investor in tough times.
Stage 1 — Protect the Value of the Investment
- When times beging to get tough, many investors will want to preserve their value at all costs. There are a number of ways that they can force the entrepreneur’s hand. They are:
- Drastically curtail cash expenses. Few if any investors like the double down principle. It magnifies the risk that they have already taken and limits the amount of time they have to search for alternatives. When times get tough, expect investors to use a magnifying glass on our income statement and budget. They will get very nosy and interested in people and functions that they ignored for months if not years before. They will evaluate your admins for you and weigh in when they have not bothered to meet them. They will make you entirely second guess yourself asking probing questions “Do you really need x or y?” Are you sure you need thus and so?
The Sequoia powerpoint from 2008 was a great illustration of a very valid wake up call that entrepreneurs needed to heed. Unfortunately, the many in the market acted like the tail of the dog and thrashed quite a bit. - Prevent you from slashing expenses
There are those investors who don’t like massive pivots or retrenchments. “Stay the course. Don’t give up. Be single minded” are phrases entrepreneurs will often hear from the board. And often they are signs of encouragement, where investors bring forward their trials as proof that the future can be brighter. I will never forget in the fall of 2008. I had $3+million in the bank 25 team members and a very uncertain future. I proposed three scenarios to the board (1), as is; (2) trim but stay the course; (3) slash to 1/3 the size retrench and re-think. I had a strong inkling that our virtual world property would not scale because of customer acquisition costs and our retention curves. But I was not forceful enough to say “Re-start” and allowed option 2 to kick in which just meant a slow death. - Overanalyze your pipeline. Investors will wave at your pipeline and stats when the going is good, but when things start to go south, they become experts in your customer acquisition process. They will weigh in on your approaches, your deal flow, the quality of your pipe, the size of your top of funnel. You name it, they wil analyze it. Its natural but it can be really inconsistent and very annoying.
- Recommend consultants. For months, they trusted your judgement, but now they are questioning every decision and statement you are making. To arbitrate and get perspective, they will often recommend a consultant paid for on the company’s dime (wait, I thought we were cutting cash expenses?”). Note, I said consultant and not advisor! Advisors can bring huge value add to the startup as they figure out product or market or customer acquisition strategy. But when the consultants are called in, expect a renal exam! Everything you do will be questioned and result in one of two outcomes – (1) no change to the business; (2) firings of various people, including yourself. The recommendation will come in the form of benefits, but in reality, the investors are questioning your decision-making or domain knowledge or both, and from this they are hoping for silver bullets to get the company on the right footing.
- Drastically curtail cash expenses. Few if any investors like the double down principle. It magnifies the risk that they have already taken and limits the amount of time they have to search for alternatives. When times get tough, expect investors to use a magnifying glass on our income statement and budget. They will get very nosy and interested in people and functions that they ignored for months if not years before. They will evaluate your admins for you and weigh in when they have not bothered to meet them. They will make you entirely second guess yourself asking probing questions “Do you really need x or y?” Are you sure you need thus and so?
Stage 2A — Get more in tough times
Stage 1 will normally result in one of two outcomes — making the investors feel better or worse. Neutral is not a feeling they will be experiencing. In this scenario, investors are optimistic about the business and may often seek to increase their stake at the entrepreneur’s expense. The classic term sheet item here is “Anti-dilution protection”, which hopefully, most entrepreneurs do not have to go through. The terms of Anti-dilution essentially mean that the % of ownership of the company is maintained by the original investors regardless of the final valuation in the new round. The math works out that as new money comes in, the normal “everyone gets diluted” process is thrown out and instead the common stock holders are the only ones really diluted. A full explanation can be found here; its ugly.
Stage 2B — Cut Your Losses — Sell
The flip side of getting more is for investors to cut their losses and sell as fast as possible. Protect their value is a very logical reaction when investors move from optimism to downright pessimism. Unfortunately, their reaction becomes a tell-tale to every would-be buyer and drastically reduces your negotiating leverage. These situations rarely end well and terms like aqhire are pleasant ways of describing a fire sale of product and talent. Usually, the acquirer is just buying teams, more quickly than they could in any sort of traditional recruiting process.
Stage 3 – Abandon Ship
If an aqhire is not in the cards (team is on the wrong coast, technology is the wrong type or there are no other alternatives, investors will look to shut the company down fast in order to minimize liabilities and litigation. If they are asking you to make sure that vacation time has been paid up and that wage taxes are paid, its a good sign that the outcome is not going to be pleasant.
Read the Stages
Hopefully, any of you reading this will never get to Stage 3. If you see signs of Stage 2B, overcommunicate the facts and prepare your own exit as an entrepreneur. Don’t feel like you have to be the last person in the ship. Realize that there is very little upside for you sticking around since whatever notion of loyalty described in earlier stages has been abandoned by the investors by this point in time.
Curt had no business raising money from an investor like Rhode Island. The lawsuit just filed demonstrates their institutional inflexibility. Compared to VC’s, there is no room for failure with governmental capital.
Final Notes on CEO Communication – How much do you share?
Curt Shilling did not have this option since he had over invested his own capital in the company, picked a very rigid investor (State of Rhode Island) and did not overcommunicate. This last point is a tough one for CEO’s. If you over communicate, you risk the potential loss of great team members. But if you don’t, you risk creating havoc in their personal lives and causing irreparable damage in your relationships with them. Let them make the choice. Family is always first and we as CEO’s need to respect that.
