On Investment Groups
We recently pitched a local angel investor group, which went disastrously. The investment group could not comprehend the way we plan to manage our company, and we couldn’t convey why our plans are what they are. This exchange can be captured in one statement:
You can’t expect to be a black swan!
My Job As a Startup Founder
Successful startup exits are rare. In fact, they’re so rare, I’d say any successful exit is inherently a black swan event.
As startup founders, our job is to optimize for this black swan event happening.
Founders must plan on being a black swan, and take all possible steps to increase the likelihood of that happening.
This means founders are going to raise money. Then they are going to use the money to grow their company. And they’re going to take the revenue from that growth and dump it into more growth. And they’re going to raise more money, and they’re going to do this again, and again, and again, until one of three things happens:
- The company goes under (statistically most likely)
- The company exits
- Growth is no longer cost effective (statistically least likely)
The Job of an Investor
The role of an investor in this startup is to help that growth happen. Money is the most obvious thing that any accredited investor can contribute. Helping founders acquire customers helps grow the company too. Helping the founders hire people who can help acquire customers grows the company.
Demanding that founders turn a profit does not help them grow the company. Profit is money that the founders are not putting into growing the company, so by demanding profit investors are actively hindering growth in their own investments.
Demanding a large portion of a company at an early stage does not help founders grow the company. The founder is going to raise more money — the less of my company that they own, the less they am incentivized to keep raising or even continue running my company. I’ve seen angel groups demand 33% to 50% of companies at the angel stage. This is ludicrous. If a founder agreed to such terms, they would never want to raise money again. This would rapidly slow company growth.
The Mutual Cease-Fire
This is fundamentally risky. Founders are spending the money, and so the money is now gone and there’s no guarantee that an investor will ever see it again. This is where a number of downside protections come into play, that protect the investor in bad to middling outcomes, without costing startup founders their potential upside.
Take a note from venture capitalists. The most common protection is simple: A liquidation preference. When a company exits, investors can opt to just get their money back. If an investor puts in $500k at $4.5m, and things go wrong and the founder ends up fire saling the company for $2m, investors can get their $500k back. Without a liquidation preference, the investor would get $200k back. But, if a founder exits for $20m, investors can instead convert into common stock and get $2m.
Investors could protect themselves for the fire sale by asking for a $1.5m valuation, but startup founders should not agree to that. It costs the founder far too much in the case that they exit for $20m. Remember, the founder is optimizing everything for a high exit.
At the End of the Day
Startups are risky, expensive things. The entire startup ecosystem collapses without founders hellbent on success, and investors making calculated risks. Unless both founders and investors in a company are pulling equally in the same direction, the startup will start drifting sideways.
As a founder, we can’t afford to have people on our cap tables that have a fundamental disconnect with the growth plan and direction of the startup. Best case, those investors are a distraction; worst case, they are materially harmful.
It’s important for investors to be able to answer, “What if they early exit; what if things go horribly wrong?” and have some downside protection for those cases. If an investor is obsessed with those concerns, it’s very difficult for them to see past them, and think like a founder with an audacious goal.
“I do not fear failure. I only fear the “slowing up” of the engine inside of me which is pounding, saying, “Keep going, someone must be on top, why not you?”” — General George S. Patton