These are my notes from the Handling a Failing Investment panel, moderated by Adriana Gardella of The New York Times.
Esther Dyson, founder of EDventure Holdings is sorry that she took a phone call during the introduction. She invests in startups in the US, Europe, Russia and Finland
Cindy Padnos from Iluminate Ventures: I am a reformed serial entrepreneur and now a venture investor focused on early stage investing.
Manu Kumar from K9 Ventures is an entrepreneur turned investor, currently I invest in very early stage companies, typically two people and an idea.
Guy Hirsch founder of StayHired, first startup successful, second not, third one up for grabs.
Esther: People problems are harder to change than technology problems. I immediately called the board together to change the management... that's not true. [laughs] Instead, you go through a bunch of stuff like the grieving process. You might notice that he never gives a straight answer, or you notice that the sales people aren't getting along with the CEO. You start talking to the other board members; it's really important to have a board who will take action instead of ignoring the problem.
In one case, the CEO never talked to more than one person in the company at the same time. Each person would get a different story. You need to step in if you think the person closest isn't managing the company effectively. Usually, if you're having doubts, you're correct.
Guy: When you know you're going to fail you want to optimize downward. You're optimizing how much cash you have left, you optimize vendor management, letting go of employees, and essentially you have to get your investors to be very proud in how you do it. Even though the company is winding down, that's how they're going to remember you by. Showing that you can manage that part, like managing $250k of debt when you have $200k of cash, can reflect on you even after the company ends.
The next time you start a company, you don't need to deal with creditors and bankruptcy. You don't want to go there. You will be the black sheep of the family for a while, but you need to make sure that your investors will be people that you can reference. If you're an entrepreneur, you can't stop being one. Getting a reference call a year from that point is the number one thing that you should focus on.
Esther: There was a company called Meritocracy that had a user commenting and ranking tool. It just didn't get traction. The lead gently closed it down, and came back to the investors this summer and asked to have de-brief. He wanted to sell the software and make use of the assets that were left. I would hate to be involved with a company that had some amount of debt; but the fact that instead of making us force him to close it down, he came to us and said "I stopped believing in it, and this is why." If he came back to me with another idea, I would invest in it. The other one was a company called CyberCode. It amounts to Facebook on a cell phone, but 10 years ago. Again, no traction, and he closed it in a classy way.
Cindy: There are other options between wild success and closing it down. We had one experience with a company that wasn't going to become a wild success; it was pretty obvious that it could be a very, very long time before the company could see any success. In the end, we sold the company back to the founder. He still strongly believed in it, and we thought it was the right thing to do. We could have continued to own the IP, but what were we going to do with it? So, for $10k, we sold it back so he could do whatever he wanted with it.
Manu: I haven't seen that in my past, but I have another example. Last year, we had a great team of founders out of UC Berkeley, smart guys with an awesome product. For the longest time, they said they just needed to crank and build our product. Finally, the day before funding the company and build the team, they got hit with a frivolous lawsuit. No investor will want to put money into that company, because you don't want your money going to lawyers. The way the founders handled the situation was so impeccable, that if these two guys go off and start another company, they have a blank check from me. The first thing they did was to call all their investors and tell them about the lawsuit; they could have sat on it for 12 hours and gotten the financing. Secondly, they were very up-front with the whole thing, and told us exactly how much money they had and did the graceful shut-down.
Cindy: My best people will call me pro-actively to let me know that something is wrong. The first time as CEO, I didn't realize that my job was to manage the board. The second time, I had the opportunity to form my own board. Really, you want no surprises.
Esther: Twenty years ago, I was on the board of a company that was run by a geek who was basically killing the company. No experience; it was clear that this guy had to resign as CEO, but nobody on the board wanted to do that, so I went to the CEO and said "I don't know how to do this, but you need to resign as CEO and this other guy has to take over, how do we do that." So I basically made him ask me to resign and get the other guy to buy in to it.
Q: Does anyone have a story of the closest a startup came to hitting the mountain and then pull up?
Manu: I think that happens with every startup. Every startup has to be close to death before it succeeds, and if you don't have that almost-dying encounter you're not going to be able to succeed thereafter. In my own startup, there was a time that we had $1000 in my bank account and there was a $35k payroll to make. That was the closest my company came to hitting the wall; we got on the phone to all those who owe us money and made them wire us the money the same day.
Cindy: You have to have the ability to love the highest high when you get to the top of the peak, but you still have to deal with the lows so you can see the next peak ahead of you.
Guy: Technically speaking, you cannot go up if there's no fuel. You can optimize that scenario if it happens by avoiding long-term contracts, making sure that exits from your vendor contracts are at short notice, and the same with employees. All of your commitments need to involve shutting down within 15 days. On the execution side, you can use the leverage of the VC to have your vendors wave a lot of money for you.
Esther: Failure is valuable because it gives you courage. You know you can survive. It's much more terrifying if that's never happened to you. There is life after this, and someone who's been through a shutdown knows not to freeze up.
Q: Can you have too little fear of failure?
Esther: You can be too careless, sure.
Manu: Back in 2000, I had a company that was on track to be acquired, and was on track for a 3x return in a 2 year period, but the founding CEO made a big blunder, which involved showing all his info to the potential acquirer, including the cash on hand. You need to put up the facade of an alternate plan; the acquirer said "hey the company is almost out of cash, I can wait a few weeks and buy them for a tenth of the price." The lesson for me was that if you're doing a transaction, you want to create a market, and have at least two people at the table.
Q: What do you look for in companies that are pitching to you?
Manu: I actually ran an experiment of sorts. What works better: to have a founder who is really good at sales, or is really technical and can solve any technical problem? I went on two ends of that spectrum to see what works better; my conclusion was that none of them work. You need a technically-capable founder who also understands the business side.
Q: What if the investors still want to believe, but the founder sees the opportunity for exit?
Cindy: We had a company in our founder who was approached in an M&A transaction. Everyone would have done well, but the founders had been living on a shoestring and wanted to grab this opportunity. The founders didn't have control, but they could have split the decision. We brought in more investors to continue; the founders were able to get some of their cash off the table which made theme more comfortable, and less than a year after that there was another cash offer and the company sold for 3x what it would have previously, and everyone did very, very well.
Esther: You get this all the time, and the answer is "it depends." It's what separates the good VCs from the bad VCs. If I look at all my investments, maybe 10% are a big success, but it's not like the others disappear. Many of them end up being bought.
Q: How have companies that lost money for you done in the long run?
Manu: The company that sold for 30 cents on the dollar ended up becoming part of a bigger company, and their product is still around today.
Q: My investor is concerned if someone happens to one of the founders of the company. He's asking about life insurance. Has this happened to anyone?
Esther: I have a company where one of the two co-founders thought we were too mean and went out and started a new company, and eventually was put in an institution. The incapacitation of one of the two founders was definitely a key problem.
Manu: My investors were putting in a bunch of money and they insisted that I have an insurance policy on my head; I was literally worth more dead than alive. [laughter]
Q: Are there situations where you have a monetary gain, but you still call it a failed investment?
Esther: This is a problem of being a minority investor, you can't control people. I have an investment I can't control.
Guy: Many times I end up with more money than I started with, but that's not what I look for in determining success.
Q: Is there anything in terms of culture that investors look for?
Cindy: I look for an environment where the customer is king. How do we build and deliver something that absolutely delights the end user?
Manu: I also look to the founder's lifestyle to see how he will manage the company's finances.