What To Do When One of Your Startups Is Struggling
12 minutes, 4 links
Updated September 19, 2022
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founder A majority of your startup investments will likely fail to return your investment. Understanding why startups can fail will make you a better angel investor. This section should be helpful for founders as well.
The fact that the majority of companies don’t get acquired or execute an IPO doesn’t mean that you should just accept it when you have a portfolio company in trouble. While your legal options to take action are often very limited, you may be able to help with your own efforts and expertise and by rallying your fellow investors. First, we’ll look at common reasons startups fail, and then discuss how you can get involved in a struggling startup should you choose to.
Warning Signs of Troubles Ahead
CBInsights looked into 101 stories, and listed the top twenty reasons they found that startups had not succeeded. Let’s take a look at the top three reasons and the implications for things to watch out for.
No Market Need (42%)
By far the number one reason startups don’t make it is lack of demand for the product. This is nearly completely avoidable if a startup is following lean startup principles. With this approach, the team should have really strong validation about what customers want and are willing to pay for before they build the product. If you are not conversant in lean startup methodology, read the book that launched the movement: The Lean Startup, by Eric Ries. (There is even a 58-page summary ebook version for Kindle on Amazon.com for less than $3!)
How to avoid this scenario. In addition to making sure the startup you are thinking of investing in is following “lean” techniques, look at the customer traction very closely for validation that there are paying customers (a.k.a a market) for the product. To be clear, they may not have paying customers yet, or even customers, or even a product. But they should have talked to lots of potential customers to understand their needs and pain points deeply and validate that the features the entrepreneurs have in mind will be seen as valuable.
Ran Out of Cash (29%)
Some might argue that running out of cash is not the reason a company failed, but a symptom of another problem, like a lack of paying customers. That might be true for a company that has already raised its first round and cannot convince investors to put in more money. What is relevant to this discussion is that fundraising takes time and is best achieved when a company is making good progress and has hit its milestone goals promised in the prior round.
How to avoid this scenario. Make sure that the company is raising enough money to reach its next key milestone and will have a minimum of 12–18 months of runway. Keeping in touch with your investments’ cash burn rate and bank balance can help a lot, so negotiate for information rights at a minimum, and ideally observer rights to board meetings. The company should start looking for its next round no later than when it still has at least four months of cash in the bank.
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Not the Right Team (23%)
This can be a bit of a catch-all. Was there a functional gap in the team, like marketing or engineering leadership? Were the key founders not all fully committed? Did someone leave when the going got tough? Did they not work well together? Did they lack domain expertise?
How to avoid this scenario. We talked a lot about the importance of the startup team in Evaluating Opportunities, and beat the drum again in Business Due Diligence for Angel Investments. If you’ve taken steps to evaluate the team and are not convinced that this team is uniquely suited to achieve success in their market, this might not be the right investment.
The best hope to avoid a complete failure of a startup you have invested in is to stay informed and keep up-to-date on how the company is doing. A good startup CEO will send out regular communications to the investors. This should cover good news, bad news, and how the investors can help the company. If you are getting these reports, you should definitely read them, and you should have an idea of whether the company is executing well, when it is thinking about raising another round, whether the company is struggling to fill a key slot on the executive team, or failing to land key customers.
If you are not getting updates, be proactive in reaching out to the CEO or the lead investor in your financing round or other investors in the round who may be connected to the company.
Negotiating for information rights and board observer rights can be really useful, because being informed of problems early gives you the best opportunity to do something about it before the company runs out of runway.
Assuming you discover that things are not going well, you need to decide how much time and energy you want to invest to try to get things back on track. Part of being engaged as an angel investor is helping where you can when a portfolio company needs it, and if you have focused your investments in domains that you know well, there should be plenty of opportunities to help, including:
Talent gaps. It is very common for angels to get involved in helping a startup source and recruit key talent. Many active investors have strong networks, and they may even know seasoned executives and consultants that they can bring in on an interim basis if necessary to get companies “over the hump” on whatever issue is holding them back. This can be an effective stop-gap solution while the company continues to recruit for a permanent executive.
Specific execution challenges. Founding teams are necessarily small, and young entrepreneurs often have gaps in their business experience. For example, strong technical founders may need help driving customer growth, which might be slow due to poor positioning, inefficient marketing, ineffective pricing, or a poor initial user experience. Arrange a working session with the team and spend several hours digging into a specific issue. You may be surprised how effective your own business experience, domain expertise, and seasoned perspective can be in overcoming challenges.
Angels can help with product feedback, finances, and introductions to potential customers or marketing/distribution partners as well.
In short, many problems that might otherwise cause a startup to fail are solvable if the company still has enough runway to execute and the investors are willing to get involved. The key is to keep track of what is going on with the company and rally your co-investors as necessary.
dangerAt the same time, don’t go too far. Do not, for example, offer or agree to become a guarantor of the company’s debt. Sometimes companies will want to issue you a warrant or give you other compensation to guarantee their debt. Just say no. The scenario that some creditor will come after you to pay off the company debt is one you want to avoid. The downside here is much bigger than losing your investment.
exampleIn an ironic personal twist, Pete invested in an LLC with an individual who had guaranteed a debt in another LLC. That other LLC failed, and this individual had to declare personal bankruptcy. As a result, the LLC Pete invested in was shut down.
Not having a market for the product or service is the number one reason startups fail.
A pivot, a term popular in startup culture, happens when a company realizes that their current product or business strategy is not going to work and they change course to a new product and/or business model. A classic pivot scenario is that a company is struggling to sell their product, while potential customers keep asking them if they can solve a different but related problem.
exampleA company may be struggling to sell a digital advertising network product. Their sales prospects don’t see the need, since the existing solutions are sufficient; but they keep saying that what they really need is an ad network analytics product to inform them on how the advertising networks they are using already are performing. The company uses the same team and pivots its product strategy to an analytics product.
The history of successful startups is full of pivots: Twitter started out as a podcast directory; Pinterest was initially a shopping app called Tote. Some successful startups have pivoted multiple times, in some cases to completely new product categories. So if your portfolio company is simply not finding paying customers for its current product in its current market, perhaps they need to pivot. You can be helpful by encouraging that exploration and acting as a sounding board for new ideas.
Pivots work best when there is significant runway (more than three months!) left in the company and the team can apply some aspects of its team and technology directly to the new market. It takes time to evaluate the new market and get a detailed enough understanding of the new customer set to be able to build new features with confidence. It also takes time to build those features, update the website and all the marketing, start prospecting for sales, et cetera. The more the team can leverage their existing assets, the more likely they are to succeed. The more the team stays within its domain expertise, per the example above, the more likely it can save time in customer discovery and have some existing relationships that it can leverage for early sales.
importantPivots are not to be taken lightly—it is akin to hitting the restart button. Suddenly, the company has no product, and it has no customers for the new product they don’t yet have. There are times, however, when the new idea is so compelling and it comes directly out of the company’s experience with its existing business that the entrepreneurs can convince existing investors to provide some additional interim financing to get the company to a significant milestone on the new business. Then it will be in a position to raise an external round with new investors.
In writing this book, we wanted you to benefit from our collective wisdom. With Joe’s extensive legal experience working with startup financings, and Pete’s experience as a startup founder and executive of successful and failed companies, and as an angel investor in Seattle, we believe our perspective will help you avoid the mistakes we’ve made along the way, and look forward to successes.
Keep in mind that when you start angel investing, it is all great. You invest in smart teams chasing big opportunities, and you are getting in early. But the sad fact is that most startups fail. It is only after a few years that you will start to see which of your portfolio companies are doing well and which are underperforming.
We have found that we learn more from the failures than the successes, so we’re passing along some of those painful lessons. By following the guidance in this book and doing your due diligence, you will hopefully decline to invest in a lot of companies with poor prospects, and get the most out of the investments you do make that succeed. Below are some of the keys we’ve found to unlock a great angel investing journey.
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