Investors in startups are often faced with the following problem: The company they backed is not generating revenue as fast as it needs to and is running out of cash.
My experience has been that most investors react to this situation in the worst possible way. Instead of thinking rationally about their options, they spend their time criticizing the founders and demanding their money back.
Before I discuss what I think are the rational choices and the factors that investors should consider to make their selections, let me start with explaining what investors should not do. Demanding, asking for, pleading for, or any other effort to get one’s money back is a waste of time. If the money was there, the founders would have used it to generate revenues.
Criticizing the founder is also a waste of time that could be spent more productively. Telling someone they are an idiot for making past decisions does nothing to improve your options going forward. Besides, it’s not like the founder is happy either. Founders do not want to lose investors’ money. They would gladly rewrite history to use the funds for more successful purposes.
What You Can Do When Things Go Bad in a Startup
When a startup in which you have invested is running out of cash, you have four options. You should choose rationally between:
• Putting more money into the company without requiring any changes to the management team,
• Reinvesting, conditional on a change in the management team,
• Refraining from further investment, but encouraging others to invest, and accepting the resulting dilution,
• Working to get an immediate exit to recoup some or all of the invested capital.
Which of these four choices you select should depend on three factors: your assessment of the cause of the problems, your belief in the future potential of the business and the residual value of your investment, and your capital reserves.
If you believe that bad luck was responsible for the problems that the company is facing, but you still believe in the future potential of the business, and still have confidence in the skills of the founders, then you should put more money into the business without requiring any changes to the management team.
But if you think that poor management is responsible for the business’s difficulties, then you probably want to put new money in only if the management team changes. Since you believe in the future potential of the company, though, you’d want to make the investment as long as the right management was in place.
If you feel that poor management is responsible for the business’s problems and you no longer believe in the future potential of the company then it probably makes sense for you to try to recoup your capital, which means working towards a low value exit.
Refraining from further investment, but encouraging others to invest and accepting dilution of your stake makes sense if you believe in the management team and the future of the company, but don’t have the cash to invest further, think that the valuation has not adjusted down sufficiently to make the new investment attractive, or have alternative investments that are a better use of your money.
When your portfolio companies are not doing well and tell you that they need additional cash to move forward, the best response is to rationally evaluate your alternatives. Criticizing the founders and asking for your money back does nothing.
If you think that’s how you will react when things go bad, do everyone a favor when you are considering investing in a startup. Buy a certificate of deposit at your local bank instead.
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