The Trouble with Growth Capital
An entrepreneur gets the itch, writes a business plan, finds seed capital and becomes a founder. She launches the business. People love it. The business grows. She expands the team. The team needs things. The founder has no more friendly doors to knock upon. She goes into a huge and uncomfortable learning curve to find money. Investor courting begins. Wooing ensues. A connection is made. Terms are negotiated. Dues are diligenced. Issues arise. Attorneys draft redraft. IBs play up the middle. Founder (and team) go back and forth between elation and dread. Final terms are reached. Last minute crises occur. Calm prevails. Deal is revived. Docs are signed. Funds are transferred. Expensive dinner is served. Lucite tchotchkes are presented. Handshakes all around. It’s the beginning of the next great chapter. The elation and dread continue.
The day after I lived this story for myself, one of our longstanding advisors, with only a half smile on his face, gave us a prescient warning; “the good news is that you got a big check… the bad news is that you got a big check”. This is one of the truest evergreen reflections, and despite the current capital constriction, one that I find myself repeating to clients all the time.
Entrepreneurs are facing incredibly challenging odds. The funnel from Seed to Series A is narrow and narrowing. Inflation and recession fears continue to make investors risk-averse which has led to a major pullback in venture capital and smaller fund sizes. At the same time, startup valuations are being reset lower, creating mismatches between founder and investor expectations.
Investors are doing much deeper due diligence, scrutinizing teams and leadership more intensely, and focusing on profitability over the growth-at-all-costs model. With limited capital available, there is intense competition among startups, forcing investors to be highly selective.
If you’ve ever been there, even under the best of circumstances, you know the strangely desperate feeling of having a great young business that needs capital and the anxiety associated with trying to get it properly. Balancing the needs of all stakeholders and the brand itself can be, as a client recently put it “like I was eating my feelings daily”.
“The light at the end of the tunnel could be the light of an oncoming train” - Robert Lowell
So when we finally find an investor who seems to check the boxes, it’s a huge and potentially trajectory-altering moment. But it’s those boxes that really matter when it comes to choosing a financial partner, and they’re not just the boxes that are on the polite short list provided by the investment banker. We have to be consciously aware of the warning by the American poet Robert Lowell that “the light at the end of the tunnel could be the light of an oncoming train”.
The process of due diligence is often seen, especially nowadays, as a one-way street - the potential investor is determining whether or not the company’s books match the presentation deck, whether there are any parts of the story that weren’t told in the hockey stick graphs and visual timelines. Founders often feel a sense of pre-indebtedness and a desire to please the potential investor and so they devalue their own side of what should be a mutually beneficial examination; a chance for both parties to kick the tires and look under the hood. It goes without saying but is nevertheless often overlooked that the implications of the deal points need to be understood. The good as well as the bad and the ugly. The investor will certainly understand the nuances as they are no doubt drafted to mitigate downside. This is their world. It is vital for the management team to understand the intricacies of the deal and to push back in the negotiating process to protect itself. It’s not enough for the founder to say “I’ll figure it out later” or “that’s for the lawyers and accountants to deal with”. These are not the iTunes terms and conditions, to be clicked and forgotten. They are the future of the company, best and worst case. The management team also needs to be clear on what the investor prioritizes in terms of governance, reporting, and growth expectations.
Particularly in the case of strategic partners, getting clear on what the company requires beyond money (marketing, human resources and accounting support, access to a professional network, etc.) and contrasting these needs against what the investor group actually brings to the table and what bandwidth it has to deliver them are essential to determining whether the partnership will live up to its promises or whether it will be limited by competing interests or simply a lack of available non-cash resources.
Metaphor time. Before deciding on a life partner, we might come up with a wishlist of desired qualities, maybe even separate them into two categories: need-to-haves and nice-to-haves. While we’re dating, we experience our mate’s attributes, idiosyncrasies, and their limitations. We do our own internal comparisons and figure out whether or not the good outweighs the less good. When the time is right, we make an informed decision and pop the question. We may not catch every eventual annoyance or gift but we’re likely to land a lot closer to the pin than if we had not considered anything at all. This same rationale should apply to our investors. Our management team should collaborate on the wishlist; “if we could have it all our way, our next capital partner would….”. Once we come up with our criteria, we can realistically categorize them the same way; “need-to-haves and nice-to-haves”. Then we can organize our questions accordingly. Here are some of the many questions we asked. I’m not suggesting you ask these specific ones but that you consider your situation and concerns.
What are your expectations regarding the frequency and detail of reporting?
What are your expectations of board representation, size, meeting tenor and cadence?
What are the actual services that you can provide and what are concrete examples of how that will play out? Do you have the capacity to help us with these?
How is the story of this investment going to be told? What details will be shared? Which won’t?
Where might there be conflicts of interest down the road?
How do you react to a sub-par period financial performance?
What vision do you have for our brand? Yours?
What are your pet peeves?
How do you resolve conflict?
What failed partnerships have occurred and what were the takeaways from them?
What do you not want us to know about your organization?
You can and should create a report card that allows you to assess each of the deal terms as well the other ancillary but critical points. Now you can effectively score your potential partners and literally check the boxes and see where the gaps are.
Godspeed.
Fast forward.
Partnerships are hard. So many things can go sideways. Getting up front agreement on expectations certainly helps mitigate rifts between investment groups and the management teams of their portfolio companies. But after the docusign has dried, anticipating the common problems up front gives everybody a greater chance to get it right, work through hiccups faster and keep the trains running on time.
When we formed our first real board, Danny Meyer gave us some great advice. He told us that board members are busy people who want to be useful and that being proactive in our requests would help them be helpful. To that end, we would not just send an advance packet with the prior period results, forecast and marketing initiatives but often include a letter. In it, we’d share the concerns we were thinking about and our specific requests for contacts, resources or guidance based on their experience. To the extent that we did this, the board could really come ready to be productive. As a coach and advisor, I share Danny’s advice with my clients.
Investor and management team dynamics can be difficult. While many board relationships become contentious, especially when the company isn’t performing, I’m a big believer in another lesson I learned from Danny, the notion of charitable assumption. For the most part, investors don’t invest in companies to overtake or ruin them. They invest in them simply to see their holdings accrete in value. The funds they deploy for their investments come from limited partner investors not completely unlike those we enroll into our seed rounds. They are simply able to write bigger checks. These investors have complex investment strategies, timeline and return models that govern their funds. While it’s true that some investor groups have an earned reputation for being exploitative, opportunistic and unsympathetic to the companies they invest in, entrepreneurs have a responsibility to do their homework, understand fully what they are signing up for and to do their part to mitigate the problems that come up, namely…
Actively addressing a lack of trust and avoiding communication breakdown
Firm doesn't feel that management is being fully transparent
Management feels the firm is being overly meddlesome
Lapses in regular reporting and information sharing
Aligning or realigning on incentives and priorities
Short-term focus of the firm clashes with management's long-term vision
Disagreements over appropriate use of cash
Management’s compensation not properly structured
Avoiding excessive firm oversight and control
Management team feels micromanaged and lacking autonomy
The firm wants more control than agreed governance model allows
Disputes over major strategic decisions like acquisitions
Focusing proactively on achieving performance expectations
Firm's projected revenue/profit targets not being met
Impatience from firm’s side if turnaround is taking too long
Management team unable to execute on agreed operational plan
Resolving cultural clashes and people issues
Fundamental lifestyle/values differences between the parties
Toxic interpersonal conflicts between key leaders
Departures of champions on either side derailing the relationship
Requesting thoughtful firm engagement
The firm is too passive and hands-off
The firm is not providing anticipated strategic guidance or industry expertise
There’s an overly transactional approach
Boards and management teams need to work together. Maintaining transparency, developing trust through open communication, and striking the right oversight balance are crucial to a healthy and prosperous relationship. Not easy today but neither was getting to Series A.