The novel coronavirus has been devastating for many people, families and communities — and the consequences are still being calculated. The tech world has seen wave after wave of layoffs, sometimes multiple waves at one company only weeks apart. Some startups have lost nearly all their revenue, and depending on their cash reserves, have little hope of recovering.
For VCs, the last two months have been an exercise in triage.
Partners have gone through their entire investment portfolios to identify the winners, what’s salvageable and what (at least in their minds) has no hope of resuscitation. If you are in the first two groups, it’s back to whatever normal looks like in the midst of a global pandemic and a deep economic recession.
But what if you suddenly get a call informing you that your investor — perhaps your biggest champion to date — is going to cut the rope and write you off entirely?
That’s what we are going to talk about today.
Before we go anywhere, be thankful if you even know how your investors are judging your startup. Most, unfortunately, will couch the terms they use (“we will be engaging less” or perhaps “we are unlikely to do our pro rata going forward”) rather than just saying directly, “we are writing you off; don’t call us — we’ll call you.” That’s polite and face-saving for all parties, but the lack of transparency can make decisions down the road much harder. It’s better to know where you stand, even if the news is hard.
Finding your bearings
The first step to approaching this situation is to get your bearings. Much like during a fundraise process, it’s not uncommon for different investors on your cap table to reach different conclusions about your startup’s potential. One investor may write you off, while another has you marked at a more neutral valuation or even positively. This can absolutely be frustrating, and given the emotion of this situation, it can be hard to rationally accept that an investor who once believed in you no longer does so.
The best way to work through this thicket of feeling is to realize that a “write-off” is really an accounting mechanism and has less to do with your relationship with an individual investor and more to do with how that investor portrays individual portfolio companies to limited partners. Different firms and their heads of finance may have different views on what is acceptable to mark a valuation. Don’t just assume that any decision to write-off your company was the province of your investor in the first place.
So go through your investor base and take a pulse check. Who else has come to the same conclusion? Who is neutral on your startup? Who is bullish on the future? It’s important to get as much objective information here as possible, so don’t accuse or negotiate; instead, collect data so that you can properly assess it later.
One key aspect of these discussions is to ascertain what will happen in a couple different contingencies.
Go through your investor base and take a pulse check. Who else has come to the same conclusion? Who is neutral on your startup? Who is bullish on the future?
The most important question to get clarity on is pro ratas. The challenges plaguing startups these days means that the signal of an investor putting in or not putting in their pro rata is going to be strengthened for a while. Potential investors are going to look for signs on how existing investors perceive your company, and the strongest sign of a lack of confidence is that an investor doesn’t want to put in any more money into your business.
Again though, there is a spectrum here. Will they fund nothing no matter what? Will they put in some capital, but not their entire pro rata? Will they put in the full amount no matter who the new investor that leads your next round will be? You want to understand the different points of view here, particularly for your largest investors who have the most pro rata (smaller investors don’t send nearly the same signal no matter what their decision is).
Beyond pro rata, the next questions should be around governance. If the investor is on the board of directors, are they intending to continue to hold that role if they have written off the stock, or do they want to leave to transition their time to other projects? If they have voting power over key decisions of the company like hiring and M&A, you need to work out how they are going to remain responsive to your requests as decisions come up.
At some firms, it’s not uncommon to give junior investors some of these special situation roles as a learning opportunity — up to and including switching them in as the board member. I’ll be blunt: it’s far better to have an enthusiastic and engaged champion who is more junior than an absentee senior partner. If an investor discusses this option, certainly meet with their proposed replacement to gauge their interest, but I would bias myself toward accepting the new arrangement.
Finally, you need to determine the language that you and the investor are going to use to describe what has taken place. Both you and your investor are going to be discussing this news with different parties including LPs, other investors and employees, so it is vital to coordinate on the language used to describe the situation.
Talking to your team and moving forward
Now, let’s say you have collected your information and have a full 360-degree view of how your investors are going to approach the next phase of your startup’s life. The next step is to figure out your own financial context and begin to work through the ramifications of all that you have just learned. Frankly, this means being realistic about burn rates, cash on hand and hiring plans — the normal logistics of running a startup.
For instance, if several of your most important investors are stepping back, it’s time to reassess your ability to fundraise another venture round, at least in the short-to-medium term. It’s practically impossible to fundraise if most of the insiders are not going to put in their pro ratas, are leaving the board, or are seemingly unengaged with your startup. That means it might be time to hit cash flow break-even much sooner than you ever anticipated. That can be a hard decision, but a necessary one.
Let’s be clear: no one wants to work for a zombie company. So it is vital to couch any negative news about investor interest with a realistic and workable plan for what the next phase of the company will look like.
Once you have your own context straight, it’s time to communicate your plans with your team. This is a time for transparency, but let’s be clear: no one wants to work for a zombie company. So it is vital to couch any negative news about investor interest with a realistic and workable plan for what the next phase of the company will look like.
Explain how they and you are going to reach your critical financial benchmarks as quickly as possible. Present plans realistically, but with enough hope that the future still has some sparkle to it.
This may well be the toughest speech and message you ever deliver. Don’t be afraid to write it out, practice it, and ask for help from mentors and fellow founders who you trust.
One thing that is critical though is precisely hope. A write-off — no matter how negative that might be sound — is not an automatic death knell for a company.
A company still exists, it still has employees, it still has customers and users, and it may even have revenues. The judgment of one of your VCs is not data to ignore, but neither does it turn your company’s future into a fait accompli. Much like how a handful of companies will be winners, a handful of written-off companies will eventually turn things around.
Now that you have figured out where everyone stands and communicated a new vision to everyone that matters — what’s next? The biggest hurdle here is that you now effectively have deadweight on your cap table, investors who are lurking but not contributing or engaging. That may be fine if they sign paperwork on time, but it’s always better to have a cap table of enthusiastic investors than equity held by folks who would rather short your stock.
So start to triangulate whether there are any buyers for that equity who might be interested in a secondary transaction. Maybe one of your investors is bullish and would be up for purchasing heavily-discounted equity from other investors on your cap table (after all, any return on a write-off is a great deal). Maybe there are family offices or strategic corporate investors who might be interested in the same setup. My colleague Connie Loizos has talked a bit about secondary transactions, and we are expecting them to pick up the next few months as valuations and discounts on price are more aligned on both sides of sales.
The other side of secondaries is just an exit itself. If a significant portion of your investor base is calling it quits, and there isn’t enthusiasm by anyone else to continue financing your company, it’s time to think about what exit opportunities look like and how to honorably end your startup’s journey. Many smaller acquisitions provide no proceeds to investors, so they may not be all that helpful to you in this process, but from your own vantage point and that of your employees, it can be critical to seek out a reasonable landing pad for all of your labors.
Ultimately, the skills that got you this far are the same ones you can use after any negative discussion with an investor. Get your unit economics right, make sure you can finance the business and be clear how your hiring, financial, product and growth road maps all work together.
It’s never easy to swallow bad news, but the silver lining is that bad news delivered promptly is always better than never receiving news at all.