Jan 032010

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Dr. Earl R. Smith II


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:


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.

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