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Beyond the Pitch

Who is Responsible if Your Company Runs Out of Money?

Money

The number one job of a startup CEO is making sure the company never runs out of money. From time to time, I have heard CEOs of startups express frustration that their current investors are unwilling to make further investments in the business. Is that a fair criticism?

Making one investment in a company is not a promise to make future investments. Investors—even friends and family—make investments with an expectation of returns. Serious investors do not generally make investments in businesses to help the founder or to be nice guys. Whether they be individuals, angels, or funds, they expect to earn an appropriate risk-adjusted return.

Some investors provide money, and that’s all. Some investors provide additional value to a company through their willingness to serve as corporate directors or by making introductions to potential customers, strategic business partners, or investors. Most investors become cheerleaders for the company, at least to some extent. They want the company to succeed. After all, if the company succeeds, so should the investors.

The relationship between an investor and a company can be complicated. When an investor invests in a company, that investor obtains certain basic rights under the law: the right to vote on significant corporate transactions, the right to see the company’s financial statements, and, usually, the right to vote for corporate directors.

Sophisticated investors often obtain even greater rights under contract, for example, the right to appoint one or more directors, affirmative and negative covenants by the company, pre-emptive and anti-dilution rights, and often special rights in the event of certain corporate transactions.

It’s fairly common for startup companies to seek to raise additional funds from investors who have already invested in the company. Many investors make their initial investments with the expectation of participation in later rounds. Some may hold some “dry powder,” additional funds to deploy as follow-on investments when the portfolio company achieves certain milestones.

Frequently, however, startups fail to meet the milestones set out at the time of initial investment. They often find that they need additional money sooner than originally forecast. Management often reaches out to the original investors to pass the hat.

Having previously invested in a business, an investor may have more incentive than an unrelated third party to consider a new investment. Making a follow-on investment is one strategy to protect an earlier investment. Current investors also have a first-hand understanding of the business, and they may still value the opportunity, even if the timing between milestones has extended.

Even so, the new investment is still an independent investment decision that stands, or falls, based on the economics of the deal at the time that follow-on investment is made. Just because an investor invested once does not guarantee that an investor will come in for a subsequent round.

When an investor in a business is unwilling to make a follow-on investment, there’s a very good chance that it’s because the investor does not believe the new investment makes economic sense.

Why would a current investor in a company not make a follow-on investment?

Some reasons are obvious:

  • The company has missed critical milestones or revenue targets, and the investor does not have confidence that the management can make the necessary corrections.
  • There is broken trust. The investor has concerns about the honesty or ability of the management team.
  • The market has changed or there is significant progress from a competitor. The investor doubts the company’s business model can succeed.

Other reasons are subtler:

  • The company initiates conversations about a follow-on investment near the date it will run out of cash. Brinksmanship like this reflects badly on the management team’s ability to run the business.
  • The company argues for investment terms for the follow-on round that do not reflect the reality of the company’s progress or position. No one likes a down round, but if the company’s performance does not merit a higher valuation, a down round may be necessary.
  • The company has been inconsistent and incomplete in providing regular updates about progress and challenges. Management should manage cash flow tightly, keeping investors continuously informed of the company’s cash position and well-advised of plans to address any shortfalls. When it comes to cash, investors and Board members should be as informed as the CEO.
  • Management has ignored or resisted advice from the investor. It’s tough to get more money because the company missed plan after ignoring advice from the person who you are now asking to give you money.

In conclusion, no one has to make a follow-on investment. It’s up to the CEO to prove the case by setting realistic expectations, achieving milestones, and communicating regularly with investors in a way that is transparent and inspires confidence. It’s your responsibility as CEO is to make investors want to invest in your business.

Investors will re-invest when they believe the company is making progress, when they have confidence in management, and if they believe they are being treated fairly and respectfully.

Even if progress is spotty, most investors will stick with a company and make follow-on investments if they believe management is performing with integrity, capable, transparent, making the right decisions, and willing to listen and take advice.

The number one job of a startup CEO is making sure the company never runs out of money. If your company runs out of money, it’s not your investors’ responsibility, it’s yours.

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