Blog: Not All Investments Win
The Path to Failure
During the past, when I sat with Angel organizations, I've questioned the investors to find out what was the nature of their investments (failures) that did not return what they hope for themselves, and cause the greatest frustration.
The number one reason by far on everyone's list was when the invested company turned into a self-styled business. This happens when the founder and or team continue to maintain the ownership majority of stock and therefore the majority voting rights. and control of the company. Many agreements did not prevent this from happening.
These failures occurred for several reasons including the founder/entrepreneur not being coachable or the founder controlling the Board of Directors. As Angel investors gained experience and got smarter they now find ways to minimize or prevent this problem from a well-defined term sheet driving the final agreement. There are two clauses that come to mind to do this, one is called redemption one is called shared governance.
In my early investments in startups I was not aware of these type clauses and I believe it probably wasn't until the late in the 20 century they started to occur.in angel agreements.
Redemption can define in the agreement contract a clause that says the company has to buy back the investors shares if equity events (selling the company or an IPO) does not occur by a defined date. The action could also be forced if certain milestones weren’t met.
I have some investments that are over 10 years old that are still alive with the original founder in charge. In a couple of them, the founders don’t’ want to change anything to get to an equity transaction. The founders have a way of life, personal power being a boss and create sufficient cash to take home a great compensation. With a redemption close, some of that cash would be forced to buy back the investment made by the outside investors.
Shared Governance relates to Board of Directors. For an example, if there are five directors, the founder appoints two, the investors have two and an independent outside director fills the board. This is done to allow an independent outsider with a deciding vote when required to break a tie, if should one occur.
As a result, most of the deals I've been involved within recent years have controls and there is a good chance of preventing the company from becoming a self-styled business and thus preventing a return on the investment from ever occurring. However, in realty if the entrepreneur has lots of leverage, like being a real superstar or with the greatest idea since sliced bread, he may reject these clauses if an investor still wants to invest.
I have an investment now that is over 10 years, where the founder has made a deal that says if he meets the latest plan, in five years he will buy back the stock for ten cents on the dollar for investments made. I put that in the box that says,”investments dying.”
The second basic reason for failure is a poor cash management program, basically running out of cash. This can occur by several reasons, that include, enough cash wasn't raised in the beginning, or the CEO founder did a poor job in managing the cash.
Number three reason is with some very honest investors admitting they did a poor job with the term sheet and due diligence before they committed to the investment.
There's an interesting reason why investors don't get a return because they abandon their investment, that is called “pay to play.” As an example, in a company in a future investment round, a Venture Capital company came in and made a big investment that diluted investors quite a bit. Things get worse, because the company was then controlled by a VC, who kept continuing to ask for money, and if you didn't put the money in, you continued to get diluted (no pay, you couldn’t play). This company in 18 months had three requests for cash. The decision reaches a point where it isn’t worth investing more, so the choice is to walk away.
In another case I got diluted so much that I asked the latest CEO what my value in the company was since it still wasn't public. In different words, he basically laughed at my request because it was worth almost zero.
It's alleged that four out five startups will fail in year one. the investment will not get the expected return. At the same time, it's almost like a cliché but I've been to many seminars over the years and it always starts out by saying you have to make one big killing to take care of investments in the other nine.
So to be an angel investor, you have to have a strong expectation that everything will not be successful, no matter how shrewd you as an investor.