Dr. Earl R. Smith II

Dr. Earl R. Smith II
Managing Partner, The Federal Circle
DrSmith@Dr-Smith.com
Dr-Smith.com

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Venture funded companies exist in an uneasy truce between management and their investors. This is a healthy situation. The objectives of the investors are ordinarily different from those of the management team. Investors tend to see their participation in the company within the framework of an investment. They put up $X at the beginning of month one and expect to receive, at minimum, $Y within a fairly short time. For early-stage investors, a short time means anything from twenty-four to sixty months. They see themselves in a very risky business and attempt to mitigate that risk by spreading their investments over a portfolio of companies. Investors are in the business of extending their wealth.

The management team should be in it for a longer haul. They are interested in building the value of their equity; so their horizon might be ten or more years out. Entrepreneurs are in the business of creating wealth; theirs and members of their team. Their most likely exits are either retirement or departure under duress. Liquidity occurs when they are free to sell their interest in the company and there is a market for the shares.

If everything is going according to plan, this uneasy truce remains in place and everybody smiles at each other. But what happens when things start to go off the tracks?

The Ninety Percent

Roughly one in ten start-ups makes it to their fifth anniversary. The rest are what an investor friend calls ‘road kill’. For one reason or another, they do not develop the traction necessary to take off. Sometimes they hit a wall and die quickly. This normally comes about when the team tries to monetize a value proposition that cannot meet market requirements. Some companies neglect to build monetization into their business plan and are still born. Other companies have a viable value proposition but lack the team to implement it. When the truce breaks down, there are several possible outcomes. Here, in order of declining catastrophic impact, are a few:

Signs

Forced Liquidation: This is by far the most extreme of the signs. Investors come to the conclusion that nothing will save the company; it is time to shut it down. Most of the time, investors will reach this conclusion during a series of private meetings and after extensive, and unproductive, sessions with management. Investors decide not to send good money after bad. Management is stripped of its prerogatives, told to pack up and leave and possibly will be subject to a series of lawsuits. The aftermath of a forced liquidation can get pretty ugly. There is lots of finger pointing and blame assignment. Investors will look for any way to recover their investment. Intellectual property will be the focus of a tug of war; which the investors almost always win. Assets will be sold off or merged into another company. Investors will want to put the memory of their investment behind them as quickly as possible. The entrepreneur and team will be branded as a failure and find it very hard to attract investors for a subsequent venture.

Invasion: Under this scenario, the investors move to take over the business. They have lost faith in CEO and team. This is a stark indictment of the management team. The investors have lost faith in the leadership’s ability to monetize the value proposition. Further, they have lost faith in their ability to break out of the downward spiral. This is a major shift of roles for most investors. For the most part, they see themselves as money managers. They may be invested in half a dozen companies. Their vision of the process includes providing the funding, watching over their investment grow and then exiting with a profit. When an invasion takes place, all of that goes by the board. Founders will be crammed down or shown the door. Quite often the investors will have selected replacements. This process can move very quickly and takes some founders completely by surprise. Attorneys for investors will make sure that they have control of the intellectual property and other assets. Salaries will cease or be cut way back. If the team is allowed to remain at all, it will be with substantially reduced compensation and powers. Expenses will be carefully controlled and require outside approval. The company will be occupied.

Recapitalization: Generally referred to as a cram-down, a recapitalization means one thing above all; the interest that the management team has in the company is going to be substantially reduced, if not eliminated. A cram down generally occurs when a company has burned through provided funds and needs to ask the investors for additional investments. These requests generally carry the mark of failure. Investors are not generally pleased when a company fails to meet its performance metrics and turns to them for additional funding. The good rule is that every further chunk of inward investment is more expensive for the founders than the one before. Teams which fail multiple times to meet their performance metrics will find their interest in the company shrinking towards zero. Investors will, understandably, move to protect their interest in the face of such a systematic failure. The balance of power and the terms of the truce shift with each additional request for investment. Management can quickly find themselves little more than employees. A recapitalization is often a step towards selling or merging the company as investors work to at least recover their funds.

Changing the Team: In the beginning, investors fund a business because they believe that the management is capable and trustworthy. If they are professional investors, they establish well-defined performance metrics for the team and company. Failure to meet these performance metrics will undermine this trust. If the investors are less professional, they will have only vague performance metrics. But even these can go unmet. In both cases, evidence builds that the company is not going to be successful. The first tendency of investors is to look to the team. Sometimes they come to the conclusion that major surgery is necessary; as either an alternative or precursor to recapitalization. They may focus on individual members of the team or entire groups within management. The result is an intention to ‘shake things up’. This response often occurs when a company has burned through the initial investment and is seeking follow-on commitments. Such requests give the investors pause and cause them to focus on the performance of management. Changes are in the wind. This often involves substantial changes in the management team. They will identify team members who are not pulling their weight. This could range from the CEO, who is not leading and motivating the team, through the CFO or controller, who is not maintaining adequate records. The rule of thumb is that, once this process begins, it usually results in the departure of a major chunk of the team. The greater the short-fall against expected performance is the more radical the changes that the investors are likely to insist on. The net effect is that the investors, not the CEO, will be calling the shots.

Changing the Value Proposition: If the team has been doing its job well but is not getting traction with customers, the investors may decide that the original vision of the founders was wrong. They will go back to the business plan and projections with the intent of finding where the company started to go off the tracks. This occurs when a core technology or service can be attractive to a range of customers. A company may have started with a focus on a particularly industry; only to find that potential customers do not have the ability to purchase it. Investors will drive management to reconsider that focus and shift to another group of potential customers. Once a new focus is agreed upon, there will be changes in the team; mostly driven by the needs of the new client base. Business development is one area that will feel the brunt of such a change. Marketing may be another. Shifts in value propositions almost always bring changes within the management team.

Increased Oversight: In most start-ups the board of directors is relatively inactive. Initially, investors are not very interested overseeing the day-to-day operational of the company. They may take a seat on the board and will normally be satisfied to have a say in the strategic direction of the business. Oversight might include capital expenditures above certain dollar limits, decisions about expenditures for new product development, significant expansion of existing facilities or establishment of new ones, the sale of major assets, the formation of joint ventures, and management of the company’s credit lines. Most management benefits by the discipline imposed by external oversight and from the experience of the board members. They can bring valuable experience and skills to the business and may sometimes even take on a semi-executive role, if so required. This arrangement provides the company with skills which it may otherwise not be able to afford.” However, if the investors begin to worry about their investment, they will move to increase the oversight of the board. That is to say that, if the investors come to think that the company might be saved, they may reorganize the board. At this point the board becomes much more pro-active and invasive. Management will be asked to brief the board more frequently and in greater detail. Their decisions will be much more carefully and thoroughly reviewed.

The Shifting Balance

Entrepreneurs can go into denial when things start to go off the tracks. They look for reasons and think that having reasons is enough. This is a major mistake. Investors will not see it that way. For them, excuses are an unacceptable substitute for projected results. As the signs that the uneasy truce is starting to break down accumulate, management needs to conduct a clear and open gut check. The road that such a breakdown leads along is fairly well defined and none of the results are as favorable to them as getting the company back on track. It is up to the team to keep the investors in their ‘money managers’ role. The only reliable way to do that is to meet or exceed expectations. When the signs of stress start to appear, most of the options are in the hands of management. The longer these stresses remain and the more they increase, the greater the shift in prerogative to the investors. Unchecked, all of the cards will be held by the investors.

© Dr. Earl R. Smith II

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Related Articles:

• The Money Chase: Oil and Water

• The Money Chase: Should You

• The Money Chase: One Way to Avoid Being ‘Avoided’

• The Money Chase: Who They Do Not Invest In

• Funding Strategies for New Businesses

• Angel Investors to Avoid

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Dr. Smith is Managing Partner of The Federal Circle. The Federal Circle partners with teams and existing companies. We help them up their game and win big in the Federal space. We also arrange funding for acquisitions and expansion by acquisition. Our model is based on the belief that, if you select the very best and work with them in a highly professional and focused manner, the results will be truly amazing. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.

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