Wildly successful failures

Probably once a month or more I briefly discuss with a founder or CEO their recent widely successful failure.

• Type 1: The company succeeds, the founders fail:
  • Wildly successful: The company exits at a valuation in tens of millions of dollars, usually after 5-10 years of effort.
  • Failure: The founders walk away with perhaps $1-$2M after 5-10 years of effort, achieving $200K/year - less than they would have made had they kept a high end day job.
• Type 2: The company fails, the founders succeed:
  • Wildly successful: The founders get their investment back times 2 or more (including tax deductions and credits, etc.) after 2-3 years of effort possibly plus a decent salary.
  • Failure: The company goes bust and isn't worth the paper (or even the bits) comprising the founding documents.

So how does this happen?

Somewhere along the way there is a misalignment of interests. It can be intentional from the start, accidental from the start, or happen along the way. And I have seen each of these.

• Intentional: Bad actors of all sorts can screw you. Whether it is founders who are frauds trying to get cash from investors or investors who take advantage of weaknesses or naivete, they come into the situation seeking to find ways to take unfair advantage and often succeed at doing so.
• Accidental: This is usually the result of inexperienced founders or investors not recognizing or understanding the situation, not getting good advice from people with more experience, or having unrealistic expectations. They get into binds because they missed something important or couldn't accomplish what they were willing to make a big bet on, and they lose.
• From the start: When bad actors are there from the start, or founders don't know what they are doing and don't get and follow good advice, things almost always fail, and in bad ways for the innocent. Fraudulent founders are quite common, and even if they don't intend to commit frauds, their tendency to lie (they might call it exaggeration) leads to bad situations. There is a saying in the investment space: 'let the seller beware', because legally, lies by a founder to investors is likely a fraud. But the reality is most investors don't want the reputational hit or the cost of litigation.
• Along the way: People make mistakes, and sometimes they get screwed. Investors at the venture level are usually very good at protecting their financial interests and often take advantage of founders who want the money badly and don't pay careful attention to deal terms. On the other hand, I have had investments that dropped in value by a factor of 20 in a few months when executives failed to do their jobs properly and went for growth ignoring things like regulatory requirements and honesty. In my case, I usually get in early enough so that even these levels of failure in the growth stage leave me without substantial loss (and sometimes even reasonable gains), but we all get screwed if we invest in enough high risk ventures. Having said that, the rewards can win out if you are reasonably diligent, even though you will get screwed every now and then.

The worst case is frauds from the start. This almost always comes out badly for the innocent. It often ends up in legal processes, and that is almost never a good outcome... for someone. Having said that, I have had instances where frauds got punished, innocents made money, and investors lost less than usual in a shorter time frame.

Don't make the bet if you cannot afford to lose it. For early stages, investors lose most of the time anyway, and losing less more quickly is far better than losing more and not finding out till later.

The best cases, which is not really all that good, is accidental along the way, usually screwing the founders when the company succeeds but the founders end up so diluted it's not a very good deal. In most of these cases I have seen, the early investors also lose (or more often barely break even after years), because the larger investors who come in later take advantage of contract clauses that heavily favor them.

How can we avoid it?

The solution is to keep interests aligned. But this really comes down to good people vs. bad... the Heroes and Villains.

Due diligence is the first and most important thing in avoiding these situations. It is not a one-time affair, but has to be ongoing as companies evolve. And there are clues along the way:

• Being ignored: When an investor asks a question of the CEO of a company they have invested in, and no answer arrives within a few days, something bad is likely happening. Worse yet, when the investor is ignored during a (typically online) shareholders meeting, it seems a sure sign of bad news not being announced.
• Delays in financial reporting: When financial reports are due, they are due. Delays almost always relate to a problem in keeping the books, possibly frauds detected, or perhaps not yet adequately hidden. Shareholders have legal rights to accounting for what's happening in a company. But many investors these days are not shareholders. They have notes or other instruments that do not grant them the same rights as shareholders. Which is one of the many reasons I will not invest without owning actual shares of stock.
• Not listening: As an advisor to companies, and as a shareholder, I try to stay involved and provide advice to assist CEOs when they run into issues. I host CEOs forums for companies I invest in so that can share experiences, concerns, and provide mutual assistance. And I find from my experience that those who do not participate are less likely to demonstrate successful outcomes.
• Avoiding direct answers: If they start to sound like politicians, avoiding direct answers, spinning into something else, it is a bad sign. When I try to push them back to answering my question and they refuse to do so, it is a sign that the answer cannot be a good one.

Of course all of this applies before you invest, and more certainly before you invest again. I am not a fan of following my own investments, but for those who are, watch out for these things.

Who gets screwed?

Hopefully you and not me? OK - Seriously... we all get screwed, and not in a good way, when interests are not aligned. If you go in trying to take advantage of me, you are not doing you or me any favors. And as soon as I find out about it, it becomes my job to reverse it on you. Which you deserve. So the question is who gets hurt worse rather than who wins more.

My view is that there are innocents who just don't have what it takes to succeed, folks who try but fail and keep trying, and folks who are malicious. I try to help the first two categories, but the 3rd I do not tolerate. Rather, I try to reverse the situation and eliminate the moral hazard they present to the rest of us.

Conclusions

You can win even when the company fails, and you can lose even when the company succeeds. Experienced people who do their diligence tend to do better, and people who seriously consider advice from these folks tend to do better as well.

More information?

Join our monthly free advisory call, usually at 0900 Pacific time on the 1st Thursday of the month, tell us about your company and situation, and learn from others as they learn from you.

In summary

Luck favors the prepared.