As shareholders of startups, we all know how it’s supposed to work. We make an investment. The company grows. The company is acquired or goes public. Our initial investment yields a stupendous return.
Let’s do the math! Suppose we invest $25K at a $2.5M valuation. We own 1% of the company. A few years later, it is sold for $100M. We get 1% of $100M = $1M; a remarkable 40x our initial investment. Yay!
But, what if the company is sold for only $1M? Then, we get just 1% of $1M = $10K. Not so good, but it’s not like the math is any different. Right?
Well, that depends. Were there any liquidation preferences?
Over the last year, I’ve observed a recurring pattern:
- A pre-revenue (or low-revenue) start-up pitches an exciting new product or service. The start-up asks for a seed investment, with a budget showing that the new capital will provide approximately 18 months of runway. Projections show the start-up achieving target metrics for revenue, active users, customers, or the like within a year. After those milestones are reached, the start-up plans to raise additional financing at a significantly higher valuation.
- The team is impressive, the market seems substantial, and due diligence indicates that potential customers are eager to work with the start-up. Investors invest.
- 15 months later, the start-up is back. Everything is going great — but the software development scheduled slipped and the pilot customer loves the product but can’t make a decision on a purchase because of a management transition. The company’s success is inevitable. It just needs more time — and, therefore, more capital. Would the initial investors please provide a “bridge” investment?
My question is always “A bridge to where, exactly?”
As a Sand Hill Angels member, I sometimes have the privilege of being the Director of a portfolio company, and, as such, get to work closely with the CEO. I recently spoke with a CEO who was struggling to communicate effectively with the company’s investors.
We started by talking about the appropriate items to include in a monthly investor update, using Jason Calacanis‘ blog post on the topic as a guideline. Using a suitable template is a good step, but I also wanted the CEO to have a good mental framework for thinking about investors. Communication is not just about what is said but also about why it is said.
Over a decade ago, I had a conversation with Dick Hardt, who was at the time the Founder & CEO of ActiveState. He told me that (to paraphrase) “Investors are just a different kind of customer.” I didn’t understand what he meant at the time, but Dick’s insight is profound, and one that every CEO should understand.