My previous few blog posts have been about the ongoing funding winter, how later stage founders need to secure their company's future with a focus on cashflow and profits and more lately on how investor directors should behave esp in these tough times when new funding is hard to get.
Over the last15 mths, Ning & I have had 3 startups fold with another 4-5 in danger. The new funding climate and rerating of loss making growth stocks is finally hitting home. Our startup and VC portfolio took a small 5-10% hit last year and we expect another hit this year. Fortunately, still very much above water but its indicative of the sluggish economy and the funding winter.
So this article is focusing on what happens when startup is just burning too much cash and founders can't find new investors to join or convince existing investors to inject more capital. In very stressful times like these, it's important for both founder mgmt and investors to think clearly and ethically in order to navigate the issue well. And as i speak with more founders and investors and go thru such experiences myself, i realize there are many valid opposing views sometimes. Both have their logic. I use a few real examples to illustrate some issues.
Example 1 : Pre A business that raised 4-5M usd. Company area of business needs scale to work. So it is a classic VC funded model. However, mgmt couldn't make the traction strong enough and existing shareholders didn't have the stomach to continue funding subsequent rounds esp with no clear quality valuation being given in overseas stock markets.
Some existing like us did offer pro-rata sums if a new investor can be secured. Also, various acquirers and potential new investors all pulled out despite some initial interest. In the end, we advised founder its ok to just tell stakeholders and wind down the business. Winding down not easy too as usually there will be sizable debt. In this case, founder did it well. Communicated, said sorry it didn't work out, triggered transfer of shares to himself for ease of closing down. Still on-going but largely cleaned up. Classy.
Example 2 : Series A business that raised almost 10M sgd. Company on the ropes in 2022 and lasted till 2024. Again multiple attempts to get new money failed, founders didn't take salaries to extend cashflow and borrowed from external party who was supposed to invest but didn't in the end. Situation dragged for months and towards the end, a hail mary distressed offer was made by unknown parties. Very little communicated to investors except a "please sign this or we will need to close down company". Logic is its worth nothing anyway, so something is better than nothing.
We probed this deal more and as more was revealed the less comfortable we got. Bottom line, the deal was voted out in an all hands meeting and instead liquidation was pursued.
Example 3 : Series A+ to B business that raised >$10M usd. Company had buyout offers but board investor rejected it. Investors also wanted secondary but it was not on offer. Then funding winter came and it became distressed offer. We are not direct investors but we are vested. Bottom line, now founders blame investors for the sad situation.
I summarize some key learnings here from these and a few others.
1) Each wind down is unique. How mgmt and investors got to the point of wind down matters. What was done, communicated, promised, how it was said matter a lot. A cohesive board that communicates clearly and transparently will have agreement on the history and reasons for wind down and will have much less acrimony when going thru the process. Other shareholders will take the cue and have less suspicions and questions too.
So if your board is at odds now, both parties should take the effort mend it asap.
2) Investor Directors must remember their fiduciary duty is to the company. Not your fund or your money or the founders. So if you can block a deal, blocking at the expense of company survival is not right. Though you can resign from the board and block as a note holder or shareholder if there are such rights. Shareholders I believe have much less fiduciary duty and can vote based on what you feel. Likewise founder directors too have a similar duty. So if the distressed buyer offers you a worse deal personally but everyone is fine with it, you too are obligated to take it. This is ideal but seldom done I suspect.
3) Frequently from investor viewpoint, the founders hold the most responsibility for distress. After all, the founders are the ones who asked for the money, negotiated and agreed to terms, who ran the business daily and oversaw the falling short of projections that lead to this situation. Having been a founder too, I have to say I agree. It’s all my decisions - right or wrong that I make. So there is a greater moral responsibility for me because i am the main actor every step of the way.
Some founders do not feel this responsibility. And it shows up in their actions. For example, say the founders own 30% of company and there is a reset happening. To me, management should negotiate to allow old investors to also join the reset terms with some new cash and even if they don't join, perhaps some (10-20%) carry on any future exit can be given to incentivise them to want the deal. As for mgmt share, it should be the same 30% at most. A reset where mgmt ups their share to 40% or 50% while having existing dilute to near zero and no right to coinvest is too much. A bit of greed and opportunism is common and probably desired in founders, but there is a line where it rapidly crosses to being ungrateful & scheming against the people who backed you.
4) I have heard founders speak of their own opportunity cost and so in a reset want to up their stake. And they say new buyers only want them and hence no room for existing stakeholders. Then the issue becomes how you convince the stakeholders to back the deal. If its a note, its a debt. Noteholders can block your deal by refusing to convert or write off their debt. So the practical thing is to offer them something and say it nicely.
As for opportunity cost, i think founders really should drop this argument. No one forced you to startup and you know the market rate salaries for founders. You can pay yourself more if the company does well. But not before. That's how it always works. And don't forget you ran the company and watched the cash flow disappear monthly. Most business owners who don’t raise outside money pay themselves whatever their company can afford. We used to up our annual salaries based on what kind of profit we did. Not revenue, not fundraising - net profit. That’s the sustainable way.
5) Using cold economic logic and name calling or referencing other ecosystem norms is unhelpful when relationships are broken and there is little trust. Telling a noteholder or stakeholder to take scraps while you have chance to rebuild without them is insulting even though logically some chance of money is better than none. Similarly, referencing the capitalistic norms of the valley doesn't really help. Singapore isn't the valley and the actors are all different. Remember point 1. Its the nuances of each actor and their actions and words that determines how the wind down or distressed sale can go.
So if I were a founder that has a buyout deal on hand that reduces existing to some small upside, I would sell the goal of keeping the company running, keeping the jobs etc. I would definitely agree its shitty deal for them and perhaps if they can block, I will offer some part of my upside to them as a side deal. I will also be very clear what’s my economic deal.
Investors usually already come to terms mentally and may even have written it off in the minds. So the key thing is to not make them feel they are being shortchanged. That they not only back the wrong team and company, they also misread the ethics of the founders.
6) if the decision is to wind down. Then should appoint a proper liquidator. Esp if there are debts and assets to think about. Ideally the mgmt closes down with minimal debt and can find buyers for the assets remaining. But often there are debts to employees, govt, vendors etc. A liquidator will ensure fair process is followed and that all laws are complied with.
7) Finally existing investors need to also be empathetic. You invested frequently on the back of your read of the founders and market. Its one of out many investments. So if it fails, your pain is truly less than what the founder experiences. So some empathy and generosity of spirit is in order. Of course, I understand the unhappiness frequently appear when investors actually feel the founders misused the money and executed very incompetently. Or perhaps, ignored what was repeated advice by investors. Ning & I have a few such cases. We try to be understanding and in our minds write it off. After all, we went in eyes open on the risks. The only times we push back is if we sense a lack of ethics and that the founder is trying to pull a fast one on us. Then we prefer the company to liquidate regardless of upside. Get out of each others hair.
Tough topic to write. I am sure there will be different and opposing viewpoints. Esp my view that because founders are the main actors and have the most to lose and gain, they need to be more thoughtful, exercise more restraint, make decisions and take the ultimate responsibility for what happens.
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