The hole in the ground checklist.
Eight filters to minimize founder disputes and related fallout.
As a mentor and a board member, there is a painful intervention I dread making. The one required when a startup falls apart due to a dispute between co-founders, investors or employees.
Disputes arise because of poor dynamics, fit, communications, emotional override or alignment. Some teams find mechanisms to defuse tensions and reach a resolution. Other trigger a self destruct sequence. Given the financial fragility of startup mode damages caused by serious disagreements often prove terminal for young teams.
Hence the dread. So much promise and potential; torn down, burnt to the ground and wasted.
The origins of these tragedies rest with simple choices we make at the start. Here is a list I wish more founders were aware of.
I wish I was aware of before I signed the paperwork.
TL;dr;
One. Non Qualified Investors. There is a reason why they are called non-qualified investors. You may be comfortable riding regular motor bikes on suburban roads but that doesn’t qualify you to race heavy sports bikes on graded tracks.
Two. Mindset. The right investor mindset and skillset creates value for your business in more ways than one. You need someone to kill your darlings.
Three. Difficult conversations. If you can’t or won’t have difficult conversations upfront, don’t pass go.
Four. Dysfunctional boards. What value does your board brings to the table?
Five. Compliance. Expense reports and tax returns is what they will hang you with.
Six. Communications. How do you break bad news?
Seven. Contract enforcement. You are not Dwayne Johnson.
Eight. Fit. You will know it when you have it.
One. Suitability. Qualified investors.
You may be comfortable riding regular bikes on suburban roads but that doesn’t qualify you to race heavy bikes on graded race tracks.
Venture investing is not similar to investing in the stock market, investing in a trading or manufacturing business, buying a lottery ticket, or even gambling.
If you did well with any of the above, it doesn’t imply that you will do well with venture investing. Even professionals with a proven track record in the field and stellar credentials blow up with regular frequency.
This specific style or school of investing requires a different mindset. Background in the invested segment, the ability to add and contribute value beyond dollars you bring to the table, a clear risk preference and tolerance for venture assets.
In most markets we use the concept of qualified investors as a gate check. Investors who understand what they are doing, can afford to book capital losses on their investment portfolio and can allocate the time required to run the correct selection algorithms.
Securities regulations require upfront disclosures and waivers to avoid abuse or later claims of ignorance and miss-selling. If you are not a qualified investor, you are not suitable to invest in this class of assets. If you are a successful traditional or conventional business professional, have liquid assets, have a track record of investing in equity markets or inherited family wealth, it doesn’t makes you a qualified venture investor.
You have to work at it.
Here is a simple test. If on a regular day you would not invest your life savings on a lottery ticket, you should not invest your life savings in an early stage venture fund. The two key words here are life savings and lottery tickets. Just because someone else you knew hit it big time, doesn’t mean lady luck will also smile at you.
If you are a founder, do yourself a favor and don’t take that $5,000 or $10,000 check from a non-qualified investor. I should be one to speak because I have taken that check multiple times in my life. It never ends well.
As a non-qualified investors, this world isn’t meant for you. You may have excess capital and you may want to allocate it. Your expectations are higher and better returns. But you don’t fully understand the loss distribution. By the time you do, you will only have heart ache, capital loss and regret to show for it.
Survivor bias is what got you here. It won’t make you whole.
Two. Investor mindset and skillset.
You may pass the qualified investor checkpoint but do you have the right mindset?
There are three key elements behind venture mindset. Payoff profiles. Portfolio structure. Holding period.
Your hit rate (think successful outcomes) is unlikely to be higher than 2%. This implies the number of investments where you book a positive return (payoff) on capital will be less than 2%. Everything else will likely be written off for a total capital loss.
Your average holding period (time till exit or liquidity event) for bets that do work out is likely to be 8 to 12 years. If you try and leave the table earlier, you will be penalized, may forfeit your stake and most certainly won’t get fair value for your chips on the table.
Incase you missed the terms above, here they are once more.
2% hit rate.
12 years holding period.
Deep discounts on early exits. Not always possible.
The same odds required to make things work as that of a lottery ticket.
If this sounds interesting, exciting, affordable and a good fit for your investment and risk preferences, you may have the mindset. Unfortunately there are a few more conditions you need to fulfill to qualify for a seat on the table.
Given the 2% hit rate, your portfolio needs to be structured as a mix of high probability low outcomes bets and low probability high outcomes bets. Assessing these probabilities and finding that right mix is an art. We all think we have mastered it. Most of us are wrong.
What is a high probability low value outcome?
Imagine investing in short term treasury (government) securities with a respectable rate of return. Everything you invest in the short term will generate a positive return. You are unlikely to book a capital loss. The return is not going to be something you will consider a life goal, a milestone, celebrate, or brag about on your Linkedin profile. But it will be positive.
What about a low probability, high value outcome event? The best example may be a lottery ticket. While a lottery ticket is pure luck, venture investing is more nuanced decision making using acquired skills, patience and aptitude.
Understanding these two terms and then acting on them is central to investor and founder alignment. We will come back to this later, after we review our skillset list.
Skills? What skills? I thought all I need was a cheque book? Essentially classification and pattern recognition using good old gut check and maybe a coin toss.
When presented with an opportunity to invest how do you dissect it? What do you look for? How do you know an idea is worth investing in?
Here is a short list.
a) Thesis formulation is the basis of your classification model. Classify ideas between investible and not, low probability and high probability outcomes.
b) Capital allocation is what we use to balance low probability high value outcomes with high probability low value outcomes. This is your portfolio structure model.
c) Segment selection. Within the segment, idea selection, founder selection, investment stage selection. These selection filters are where you refine and select your bets.
d) Decoding Term sheets. Terms under which you invest and under which the invested business will liquidate, if it fails. 98% of your checks will not return capital. Term sheets help you balance risk, incentives and returns and salvage some capital from investments that failed.
e) Portfolio pruning. Portfolio bets start as low probability high value outcomes. Sometimes they even start as a shot at a low probability high value outcome. As market validation and customer feedback flows in, we get sure of our assessment. When we are sure we have a high value outcomes bet, we feed and nourish it with more capital. When we know it is not, we trim the path, kill the bet, salvage what we can and re-focus on the winners in the portfolio.
f) Killing your darlings. Walking away from invested capital, booking capital losses, killing your darlings it not easy. Not everyone is cut out to do this. Understanding the opportunities that need to be fed and those that need to be starved is even harder. Explaining which one is which to partners who don’t have the right context is a gift. Often this is where the most blood is shed. I believe in the idea. I don’t. We can’t quit now. We should. We can’t cut the team now. It’s that or certain death.
It’s not personal, its investing. Hence alignment. Here is that word again. Absence of alignment, if not addressed correctly, leads to disagreement.
If we don’t agree on the classification algorithm (What is or is not a low probability, high value outcome), and the course of action (live or die), someone will always have an issue with pulling the trigger.
The six skills above ensure that when businesses do blow up, which they do more often than not in our world, as an investor you are not within the immediate blast radius. If you are just writing checks without doing the homework, or understanding the context, even the measly 2% won’t come back to you.
Do your investors bring this mindset and skillset to the table?
Three. Difficult conversations.
If you can’t or won’t have difficult conversations upfront, don’t pass go.
In early stage investments investors and founders are focused on making things work. The goal is to make good impressions, build a relationship, make a decision, close the deal, allocate capital and move on to the next stage.
When it comes to expectations management, contract language, governance models and dispute resolution, we often think that these items and elements can be taken care of later. The hope is that the goodwill generated and created by closing the deal will help figure things out later. Ideally before we need to.
More often than not, this is not the case. In the startup world stumbling, falling apart and hard times are a certainty. If it isn’t written down and locked, it is open to interpretation. Sometimes even when it is written down and locked, it is open to interpretation and contest. People change, preferences change, context and environment change.
In litigation it is the party with the best documentation that wins. You also win all the battles you avoid getting into because you had better documentation.
Write it down and lock it.
If your counterparty says later, remember, later is code for never (with due apologies to Tom Cruise and Knight and Day.)
Contracts and relationships work well when things work well. The real test is when things don’t work well. When they fall apart. Seasoned founders and investors discuss and document decision making criteria under such scenarios upfront. Right at the start. Fresh founders and investors often feel that such discussion may go against the spirit of good will they need to close the deal and avoid them. It is a filter. If you can’t have difficult conversations at the start, you won’t be able to have them when you need to have them.
The dispute resolution and arbitration clause is the most important clause in your legal agreements. Done correctly it can save you from nightmares. Done wrong, it becomes one.
Four. Board structure and representation.
What is the value add of your board? Are you aligned? Your board may be your biggest asset, or your biggest liability. It depends on who you ask to sit on it and how you use them.
How is your board structured? Who are the people on it? What are the roles they play? What is their contribution to your progress, traction or growth? Are they on the board because they represent shareholder interests or because you respect and value their advise and suggestions?
What is the value add of your board? How does it help you get where you want to be?
The best boards I have served on carefully fill open roles based on identified expertise gaps. Governance, finance, technology, hard science, regulation, investor networks, talent management, transformation, operational excellence, performance analytics. If you map your board members against this list, do you have it all covered?
Functional boards are aware of their own limitations. Such boards allocate responsibility and expertise based on real world experience, listen to good advise and defer to expertise when they see it. They create and enable support networks that can help founding teams reach higher.
Dysfunctional boards don’t.
Five. Reporting, governance and compliance.
Consent, permissions and lines in the sand. You want to be innovative and inventive, do that with technology. Leave governance and compliance out of the innovation equation.
As a business and founder there are two lists you need to be aware of. The permissible list. The non-permissible list. Stuff you can do. Stuff you can’t do. As founders we need to understand where the lines are and the penalty for crossing them. Ignorance is not a valid legal defense.
There is an implied level of mutual trust between founders and investors when a term sheet is signed. It doesn’t take much to erode that trust.
We speak about innovation, breaking rules, moving at the speed of light in our world. None of these clichés apply to regulatory compliance.
When it comes to governance, compliance, book keeping, accounting, taxes and regulatory reporting, you want to be as staid, old school, conservative and boring as possible. Don’t redraw, move or cross these lines. You are not smart or rich enough to afford the fallout when you get caught or called out.
It is not about money in the bank. It is about good will, distraction and reputational damage. No founding team has banked enough good will to survive a regulatory action and then be able to build up on it.
Take purchases, for instance. There is stuff that you can expense and stuff that you should never expense under any circumstances. We expensed software, never capitalized it. Long painful debate. One simple choice saved our neck countless times.
Similar choices extend to what may be considered as official company expense and reimbursed and what would be considered personal discretionary choice and denied.
Expense reports and tax returns is what they will hang you with. Ask yourself a simple question. If this expense report or tax return was plastered on the front page of your leading national daily with your mugshot next to it, would you mind?
The company bank account is not your personal cash till. If one day you want to list on a public exchange and reach that liquidity event, run your business as a listed company from day zero.
Make sure that someone sits you down and explains this to you. If you have difficulty following directions, take notes. If you don’t understand law, accounting, taxes or governance, get help.
There are four things you can do to improve your game.
a) Processes and controls. b) Good accounting practices. c) Good accountants and lawyers. d) Paying the market rate for good advice.
None of these are cheap. Don’t short change yourself on accounting, compliance and legal advice. If you can’t afford it or understand the importance of this, do yourself a favor and don’t become a founder. Remain an employee.
I know as founders we often think that accounting and book keeping gets in the way. That compliance is an overhead, baggage that is going to hold us back. That in an ideal world, we should break all the rules. That we will fix it and get it right once we are done innovating, breaking even or after crossing the finishing line. My personal favorite, maybe post product launch when the money is flowing easier. We don’t have the margins or spread to do this right, right now. Rules don’t apply to us.
You either do it right, right at the start, or you don’t. There is no middle ground. If you don’t have the margins to get your accounting and governance right, you picked the wrong business. Or have the wrong priorities.
Take the simple example of employment contracts. If you are building intellectual property do you have the work for hire clause in your employment letters? No! Best of luck with the diligence cycle. The acquisition offer you had been working for gets side swiped by a steep discount because you were too busy to draft employment letters and don’t have clear title to your own intellectual property.
It’s not a discretionary expense. It is self insurance. When things fall apart, good accountants, lawyers, clean books and title can help save you from falling on your own sword.
Six. Communications.
How will you break bad news?
What is your mechanism for communicating bad news to your board? You need to ensure there is a record of how and when information was shared and reactions to that information.
There is an etiquette to breaking bad news. The best time to break bad news is before it becomes bad news. The next best is as it is becoming bad news. The worst possible time to break it is when it is already out in the open or public knowledge.
You can never hide bad news. It always comes out. Best to break it as quickly and as early as possible. Always break it in writing.
As a courtesy you can break it personally, or on the phone as advance warning before the mails go out, but make sure that the mail does go out. Remember documentation will be your best friend when no one wants to return your calls.
There are no rules for breaking good news.
Beyond news there is that bit about personal communication. Talk to your partners. Don’t bottle things inside, don’t keep score, don’t hold things back so that you can throw them in their face when you need to. Your partners at work are partners at work, not punching bags.
When you are not talking or done talking, listen. Communication is not one way monologues. Check up on each other. Check up on how team members who should have a say in the direction your business takes, feel about the direction the business is taking.
Seven. Contract enforcement.
This is a tough one. The first question you have to ask is, intent.
Contract enforcement assumes commercial intent. Commercial intent is reasonable. Malicious intent isn’t. Which one is it that you are fighting?
Commercial intent is easy. Focus on the relationship, before you get the lawyers involved.
There is perhaps an expectation gap. Fix it. There may be a communication issue, resolve it. Honest mistake, admit it. Unintended offense, apologize. Apologies are less pricier than legal fees. You may find them more difficult but they are certainly cheaper. Given the friction caused, some compensation or adjustment in billing may be required. Offer it willingly, even if it is not asked for. If you can’t afford all that is asked for, be upfront and honest. Ask nicely, don’t blow your top, negotiate it down, pleasantly. And what you can’t negotiate down, charge to goodwill and reputational risk.
Long drawn, protracted court battles are expensive, weary and not worth the trouble. Avoid them, if possible. If your legal counsel recommends arbitration, resolution or settlement, take it.
“I will see you in court”, sounds cool when Dwayne Johnson says it on the big screen. These will be the most expensive and regretted six words you will utter in your life. Expunge them from your vocabulary.
Also you are not Dwayne Johnson.
You may have once worked for a large corporation with its own inhouse general counsel, its army of lawyers on retainers and very large, numerous and substantial bank accounts.
As a poor, impoverished founder, this is sadly no longer the case. Reality, bites.
If you need courts or lawyers to enforce a contract, you have lost the battle. There is clear nuisance value to dragging everyone through legal hearings and maybe there is a reason why it is worth something to you. But if you slipped down to that level, we are no longer talking commercial intent.
This by the way was the best legal advise I have ever received from a lawyer. It is not about being fair. It is about what value you could create with the time you would save by not spending your bandwidth in and around court.
How do you fight malicious intent? You can’t. Best not to get on the same train with it. Easy for you to say that. What if you are already on that train?
Get help. You are not alone. Don’t delay this. Find leverage wherever you can find it, you are going to need it.
Then check documentation, title, your claims, your ability to defend said claims, information and data leakage, weakest links and the counterparty’s case.
If you can afford to go on the offense, go on the offense. If you are facing bullies, offense sometimes work. Sometimes it backfires. Sometimes the counterparty is so powerful and well connected that your best bet is to cut your losses, run and hide. Not necessarily in that order.
Once that is done, try and get off that train as early and quickly as possible. While you try and do that settle down for a long, painful and dirty fight. It is going to be a long, cold winter.
Eight. Fit.
Fit is a magic pill. It’s the x factor. Fit by itself is not enough. But without it, nothing works.
You can’t define it. You can’t document it. You can only feel it. You know when you have it. I don’t know how to tell you how to test for fit, this is something that you will have to do on your own. Even when I thought we had fit, we didn’t.
Fake fit breaks when tested. Real fit bonds harder. That is all I know. Just put it on the list.
There is no alignment without fit. There is no valuation, exit or liquidity without alignment.
Not easy, I get it. If it wasn’t impossible, it wouldn’t be so hard.
In memory of all the teams that had a shot at re-imagining the future, but didn't. Didn’t because they couldn’t resolve a difference in opinions, alignment or direction. Didn’t because they received bad advice, waited too long, took a wrong turn or acted in bad faith.
This is neither investment nor legal advice. Please find and consult with a good lawyer or accountant if you need professional advice and assistance. Your mileage may vary.
Good advice is hard to come by and rarely cheap. You get what you pay for. Listen to your lawyers and accountants. Do what they tell you to do. You are not as smart as you think.
