A Case Study Of Startup Failure

Startups fail. In fact, startups often fail. Anyone who has spent any time in the startup and venture capital ecosystem will tell you that failure is the most pervasive characteristic of the ecosystem. There is no shame in that. If building a great business from a startup was easy, everyone would be an entrepreneur. If identifying a startup that would return 10x on capital was easy, everyone would be a VC.

I know a prominent VC, with multiple big hits as a founder, who had chosen the vanity plate for his first Ferrari to bear the name of his first failed startup. He told me that he learned more in that failure than he could have in any big outcome. That was an “aha” moment.

More recently, one of my startups hit the wall and shut down. In the weeks leading up to closing its doors, I experienced many other “aha” moments. I thought it might be helpful for me to share three of the biggest ones.

But first, let me put some very basic facts before you. The startup was the founders’ first. What the founders’ lacked in experience, they made up for in passion and enthusiasm. They had raised a few million dollars from a novice fund in the form of a relatively standard preferred stock financing. The investors did not have a board seat and, therefore, the founders unilaterally controlled the board without investor input.

The investors, however, did have a block on a sale of the business, unless the sale exceeded an agreed upon price. In the months preceding the company’s ultimate demise, the company had raised a bridge round in the form of a convertible note. Management sought to raise additional capital, to no avail, and ultimately reached out to a handful of competitors to explore a potential sale. Ultimately, one potential acquirer emerged that had an interest in the company’s core IP and the continuing services of the company’s founders.

Unfortunately, the price they were willing to pay for the company was less than the principal amount of the convertible notes that the company raised in its bridge financings — and far less than the thresholds that would trigger an automatic conversion of the preferred stock that would avoid the requirement that the preferred stockholders consent to the transaction.

And therein lay the quandary. To do the deal, the company needed the approval of its preferred stockholders. But the preferred stockholders had no reason to approve a deal in which all of the proceeds would go to the holders of the debt in the bridge financing, despite the fact that they had invested significantly more capital into the company, and were insistent on a pro rata distribution of the proceeds as a condition to allowing the deal to proceed.

The note holders were willing to accommodate the preferred stockholders with a small piece of the proceeds, but would not share the proceeds on a pro rata basis. As a result, a sale of the business required three disparate constituencies — the founders, the preferred stockholders and the convertible debt holders — to come together and agree to a path forward. But that never happened, and the company hit the wall. Looking back, here are some of my “aha” moments as to why.

The Rose Colored Glasses

Unbridled passion and unbounded enthusiasm are the hallmarks of any great founder. Unfortunately, however, it is all too easy for a founder to confuse his or her desire to will a good outcome with the reality that will inevitably out-will any founder.

In this particular instance, the founders simply did not want to believe that despite some successes, the business simply may not have been on a trajectory to attract additional capital. Moreover, they were reluctant to scale back their expenditures to create a longer pathway to the milestones that may have attracted additional capital.

Similarly, by focusing all their attention on emphasizing to their investors the successes they were achieving, and ignoring many of the other shortcomings of the business, they created an impression with the investors that did not jibe with the reality they faced. As a result, when reality took over events, the founders lost their credibility with their investors. And, unfortunately, there is nothing more important in difficult times than having earned credibility with your cap table.

Of course, I am not suggesting for any founder or entrepreneur to forego enthusiasm or passion in what he or she does day-to-day, or the way in which he or she presents the potential for the business. But I am suggesting that, especially in troubled waters, there is nothing more important than trying to present your investors with an objective view of the business and to balance your successes with your failures and the challenges that you face.

In this case, I tend to believe that had the founders presented a more realistic picture for their investors in the lead-up to the end, the investors may have been less surprised by the stark choices they faced and, therefore, been more willing to be accommodating.

Share, Share, Share

Again, there is a natural tendency by many founders to only share good news, to only share wins and to only highlight accomplishments. But it can be as important to share bad news, shortcomings and failings. The inclination to go into a shell in the face of problems or challenges creates an information vacuum that will be extremely difficult to bridge when you inevitably have to turn to your investors for help.

First of all, you never want to surprise your investors with bad news. Surprising them with good news is a different matter, but not bad news. Secondly, if you are not engaging with your investors about the problems that you are seeing in your business, then you are not only isolating yourself in not seeing the ideas and suggestions of others, but also are taking away the investors’ “shared ownership” of the problem. If your investors feel like they share ownership in your problem, they are going to be a lot more accommodating in helping you find a path forward than if you have not been forthcoming with them, and they view the problem as your creation.

Unfortunately, the founders in the example I shared with you had stopped sharing information with their investors because they were at odds on how to execute against the plan, and had, over time, come to the conclusion that there was no real value in sharing information and plans because it typically yielded acrimony.

That was a mistake. Acrimony may be unpleasant, but it may be necessary if you want to maintain an honest dialogue with your investors. The alternative to acrimony should never be a failure to communicate. Once the channels of communications are not functioning properly, it is really hard to ask your investors to take a leap of faith with you.

Know Your Investors

I am always surprised by how little time founders and entrepreneurs spend in really getting to know their investors. There are two really important elements to really knowing your investors. First and foremost, do your diligence before taking money from an investor. Remember that not all investors are good investors. Make sure to ask your investors about their bad outcomes. Do what you can to learn about deals that they had to write off, and try to connect with the management team at those companies to get a measure of their experience under those circumstances.

It’s easy to be a good investor when your investment is working out. But it’s really, really hard to be a good investor when your investment is not. Try to get a sense of how the investor behaved under the stress of a bad outcome. Was he or she supportive? Was he or she able to contribute in a meaningful way to trying to devise better outcomes? Was he or she rational and fair in the final analysis? Those are important questions to ask. But it is just as important to get to know your investor in your working relationship.

And that only happens if you are “working” with your investor, sharing ideas and maintaining a constant dialogue. In so doing, you can get to know your investor and you can manage your relationship in a way that will enable you to get the most out of your investor. Hindsight is always 20/20, but in the example I shared with you, the investors proved themselves to be obstinate, unyielding and irrational. These are all very bad traits in an investor, which may have been gleaned earlier with a greater degree of diligence and caution at the outset of the relationship.

But the founders also failed to do more during the course of their relationship to come to terms with their investors’ idiosyncrasies. The founders also failed to build a strong enough bridge that could offer the possibility of a path across the troubled waters that they ultimately faced.