Fundraise Vs. Sell : The Startup Dilemma

14 June, 2010

Imagine this, you are a passionate entrepreneur who has been working hard on his/her startup for a few years. You were lucky enough to get some VC funding. You sold the investors on your “conservative” financials, which you have missed by a long shot. It’s a tough and often very frictional conversation that takes place between promoters/management teams and investors. The story goes something like this. The entrepreneur ever optimistic indicates that the company is on the cusp of greatness, if they only had another $1M-$2M to get those marquis customers, or build that souped-up mouse trap feature or module, and that a $200k contract is a slam dunk in the next 2-3 months. The company, however, is out of cash in the next 2-3 months also. The investor balks at the idea of putting in additional capital, forcing the company to either find a buyer or wind down operations.  Remember that vast majority of startups fail, and I am guessing that in most of those failed startups, only the seasoned and pragmatic entrepreneur realizes their company’s fate amicably.

 

There are usually four scenarios that play out after the series A financing:

1.       The company either hits the key milestones or comes close to it, convincing existing and new investors to fund the company and a successful series B fundraise takes place.

2.       The company is a rare breed and achieves scale/profitability without need for additional equity capital.

3.       The company doesn’t make the required progress for new VCs to invest, but the existing investors believe enough in the management and company to bridge the company until enough progress is made to be able to get a new VC to invest.

4.       The company doesn’t make the required progress, and the existing investors are also not convinced that it makes sense to bridge the company, thereby using the line that investing at that point might be commensurate with putting “good money after bad”. The result is either a distress sale or a complete wind down of operations.

 

Both scenarios 3 and 4 can be tricky conversations between management and investors. The key to making those conversations fruitful is to start having the dialog sooner rather than later, and sharing the bad news (more important than good news) with the investors as early as possible. Complete transparency is a good thing in a marriage as well as relationship with one’s investors (something honestly I have had issues with in India).

 

I have had the pleasure of being in the midst of all four of the above scenarios. The first two are a pleasure and not as commonplace as I would like. What does an entrepreneur do? You strongly believe in the prospect of the company (often driven by emotion and passion which is completely understandable), even though you have not achieved the milestones as projected.

Bottom-line is that there has to be some underlying trend, data or progress that gives the existing investor comfort and confidence that it’s not a matter of “if” but “when” the hockey stick growth will take place, and the “when” is not years but perhaps a few months away. If you are able to convince them with the existing burn/spend, then the investors are likely to bridge the company because they fundamentally believe that the timeline has shifted a little but the prospects are still very strong. But if the entrepreneur is not able to convince that investors, then one of two outcomes is likely – either the entrepreneur/management has to cut the burn and make the existing cash balance last longer until they can actually show progress to be able to convince existing and/or new investors to put in additional capital. Else, if there is time (several months till cash runs out), then one can engage a banker to find a home via M&A or if there isn’t time, then the company is forced to wind down.

 

The road to success for entrepreneur is rarely smooth. There are tough decisions to be made along the way, and many successful entrepreneurs will tell stories of mortgaging their homes to meet payroll, deferring salaries or being able to convince employees to work without pay for months. The key is to not play a game of chicken with your investors. i.e. don’t think that the investors can’t afford to shut the company down, or can’t afford not to fund the company. Usually, the entrepreneur loses that game. Instead, it’s best to tackle the tough situations through collaboration, to anticipate the tough times ahead and have a plan to get through it. All of this is driven by the fact that “cash is king”. I remember coming out of a board meeting where management was celebrating a key milestone – the company had crossed $100k/month in bookings.

Rather than celebrate, I asked two simple questions – “how much of the bookings convert to actual recognizable revenue”, and “what percentage of the revenue actually results in cash coming in the door”. It turned out that 75% of the bookings turned into revenue, and another 75% of the revenue was actually collected (with a 90 – 120 day lag to add to the agony). In other words, only 50% of what was being celebrated as bookings was actually resulting in cash coming in the door.  If the cash situation is fully understood, then a good entrepreneur can anticipate the wall approaching from far away rather than have a “oh, &*$#” moment when the wall is upon you.

Key recommendations to avoiding that “fundraise vs. sell”:

1. Never in my history of working with startups for the past 15 years, has a company beaten the plan it presented during the Series A fundraise. So understand that, and work with the assumption that revenues will take longer, costs will be higher and collections will be a challenge. That will help make the team more frugal yet productive from the get go. By the way, a VC’s rule of thumb is to halve the revenue and double the expenses projected in a pitch by an entrepreneur.

2. Do a monthly cash flow water fall analysis. Basically, understand your “cash out” position month by month. That cash-out position will move (usually further up) due to unanticipated events along the way.

3. Assume that a successful fundraise will take 6 months, so you want to have at least that much runway in the bank (preferably more) when you go out fundraising. By the way, VCs can smell if you are running out cash and options, and therefore have tremendous leverage during valuation negotiation. That can obviously be reduced or nullified if you have multiple term sheets on the table.

4. Be nimble to change the business or business model if conditions or market shift or take longer to materialize. That could mean going from a licensing to SAAS model, morphing from a product to service or simply going into a consulting mode to last longer until conditions improve.

5. Raise more than you think you need (i.e. more than your initial “conservative” estimate would dictate). Things are likely to go wrong and key milestones usually shift out, not in. Another way to think of it is point number 6.

6. When offered cash, take it. Don’t get hung up on valuations. In the long run, the impact of valuation is not as big as one anticipates. For example, taking a little more earlier, and diluting may lead to the company making more progress and raising the next round later at a higher valuation; vs. taking less capital up front avoiding dilution, but having to hit the fundraising trail soon thereafter without key milestones having been hit, and being diluted.

7. Learn to detach the emotional from the rational or pragmatic. Know that as an entrepreneur, especially one who has taken investment from others, you have an obligation to create shareholder value. And if things don’t go well, that may well happen through a sale.

8. Do realize up front when you take VC money, that VC’s are portfolio managers, and they have their LPs to answer to. So, even though you as an entrepreneur may be in love with your baby, if the investee company is not doing well, or has struggled to hit milestones, then VCs are compensated by their LPs to cut their losses and move on to other investments.

From a portfolio manager perspective, the harsh reality is that VCs are supposed to “double down” on the winners, and let go of those companies that don’t show significant signs of progress. Often friction occurs between entrepreneurs and investors when the entrepreneur feels that the company is making real progress and needs further investment from the existing investor(s), and the investor(s) feels otherwise.

9.  I often call venture investing “science enabled art”. That really plays out when the discussion around bullet point 8 is taking place. The existing investor has to rely partially on the data (financial performance, milestone achievement, key metrics etc) but primarily on gut feel that the company is going to make it, and that the team is passionate, driven and committed to making it happen. Often it takes strong gestures like the management team coming to the investors and the Board indicating that they are willing to work with little or no salary. That kind of act can sway an investor that is on the fence.

10. Remember that companies “should be bought, not sold”. In other words, you want to be in a position that institutions are tripping over themselves trying to acquire you, rather than you trying to get bought, in which case there isn’t much leverage. Given the risks involved with startups, chances are that an entrepreneur will more likely fail than turn into a roaring success. But do keep in mind, as hard as it is to do, that you have to do what’s right for all shareholders, and do whatever you can to maximize shareholder value, even if that means embarking on an M&A path when you personally would rather not. Doing what is fiduciarily right will also get you significant brownie points within the investment community making it easier for you to raise money next time. The investment and startup community is relatively small, especially in India. When you do something that is considered inappropriate or irrational, word gets around. If, on the other hand, you do some righteous, that too pays dividends.

Bottom line: Most startups fail. Of those that succeed, most are acquired and very few actually provide an exit for investors via a public offering. Of the acquisitions, some are actually “bought” but most are “sold”.  From an entrepreneur’s standpoint, he/she agrees to sell the company because he/she has to, not because he/she wants to. The sooner an entrepreneur realizes that, the more rational and logical he/she will be as and when he/she is put in the position to make that decision.


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Fundraise Vs. Sell : The Startup Dilemma

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