In this episode, Steli and Hiten share a story of an anonymous founder who was in a sticky situation with his investors. Landing investors can be very encouraging for a startup; however, it is knowing the RIGHT deal for your company that makes the all the difference. Steli and Hiten remind us of the red flags we need to consider before saying “yes” to that investment and the importance of separating emotion with sound judgment when it comes down to decision time.
Time Stamped Show Notes:
- 00:49 – Today’s episode is based on a story of a founder who asked Steli for advice
- 01:00 – The first set of questions are NOT the real problem
- 01:13 – The founder raised $1M
- 01:15 – $600K was spent to get a VP of sales who hired a team to do outbound sales that didn’t work
- 01:25 – The founder basically wasted 60% of his raised capital
- 01:30 – The founder wanted to learn how outbound/inbound sales work to grow his business fast
- 01:49 – Steli assessed the situation with the founder and was wondering why there was such urgency
- 02:15 – The founder told Steli they weren’t running out of money
- 02:37 – Steli asked why they needed the outbound sales to work while inbound sales were doing just fine
- 02:58 – Steli found out that the founder needs to hit revenue milestones set by the investors who gave the $1M
- 03:19 – Missing milestones will convert to HIGHER interest on the investors’ money
- 03:31 – The problem is hitting the revenue milestones in a short period of time
- 03:43 – 15% of the founder’s equity will be lost to the investors
- 04:07 – The timeline presented was 4 months, but it took them 1-2 years to hit $20K MRR
- 04:23 – The founder needed to hit $60K MRR in the next 4 months
- 04:41 – The founder started presenting wild ideas he could do to reach his $60K target
- 05:17 – Steli learned that by the end of 2017, the founder would need to raise capital again
- 06:20 – The model the founder was building was likely to crumble
- 07:10 – Hiten asked the founder, “What if you just shut it down?”
- 07:30 – He asked because the business may not work in the end
- 08:42 – Founders are sometimes TOO optimistic, to a fault
- 09:36 – Ask your investors for some sort of compromise
- 10:40 – The founder didn’t want to consider other options
- 11:23 – Look back on Episode 17 – The Art of Quitting
- 12:37 – Look for evidence for why the business should continue
- 13:09 – Should the business continue?
- 14:22 – It’s rare for an investor to set revenue goals
- 15:56 – It’s common for investors to implement a structure for businesses with aggressive projections
- 16:53 – “Split the logic and split the emotion”
- 17:38 – Have the conviction to push through
- 18:37 – What is your emotional state of being?
- 19:41 – The founder felt he could not accept the reality yet
- 19:57 – Paying a small cost vs risking the whole business
- 21:26 – Steli thinks the founder just doesn’t want to own up to his mistakes
- 22:30 – Take a stop on your emotions and look at your realistic options
- 23:42 – Think long-term
- 24:20 – That’s it for today’s episode!
3 Key Points:
- Don’t put yourself into a deal that can compromise your whole business, even if the amount offered is a generous investment.
- KNOW when you need to stop. Ask yourself: does your business still make sense or will it be more beneficial to exit/liquidate your business at this point?
- Own your mistakes—it’s only then that you can move past it.
Steli Efti: Hey, everyone. This is Steli Efti.
Hiten Shah: And this is Hiten Shah. Today, as we do sometimes with our podcast and this recording, we’ve got a story of a founder, anonymous of course, that Steli is going to share and that kind that have lesson that we’re going to talk about and talk through is basically in business how to choose the best of the worst. That’s usually applicable when you’re in a situation that’s really bad, let’s say, really difficult and you have some choices to make and none of them are the easy ones.
Steli Efti: I think the concept of picking your poison comes to mind. Here’s the scenario. I was at a conference a few days ago. This founder comes to me and he starts asking me for advice. This is the funny thing. I know that you’ve been in the situation many times before where the first layer of questions or problems that are presented to you are never the real problem. It was a similar situation here where at first he approached me and he said, “Listen, I had raised a million dollars, I spent 600,000 of that million on a VP of sales. This guy hired all these sales people and they’ve tried to do this whole outbound thing and it basically didn’t work, so I’ve wasted a shit ton of money. Now, I have 400K and I need to figure out how to make outbound and inbound work and I need to figure out how to grow really fast. What do I do now?” At first, I had to ask him, okay, well, tell me more. Why does it matter? You had a million, you spent 600,000, it didn’t work. What didn’t work? The economics of outbound didn’t really work. Are you running out of money? Are you trying to raise money? What is the urgency that I can sense from you? I get that it sucks that you hired somebody that didn’t work out. They wasted a lot of money and time. That sucks, but I sense an urgency that we need to get to something. What is it? Are you going to be bankrupt? Are you trying to raise money and you need to hit some numbers? What is it? He was like, “Well, you know, it’s really … I mean we’re not going to run out of money. We can manage being cashflow-positive, so that’s not really an issue.” I’m, like, okay. Are you trying to raise money right now? He’s, like, “No, we’re not trying to raise money right now, either. It’s probably going to be later in the year.” I’m, like, okay. Why do we need to make outbound work immediately? Why is outbound a problem? Is inbound working really well for you? He’s, like, “Yeah, inbound sales works really fantastic.” Like, why are we not just keep doing that and expanding on it? Why do we have to figure out this outbound thing? He said, “Well, because we’re making too little money per customer and we need to hit some revenue numbers.” I’m, like, why do we need to hit these revenue numbers? Then, we got to the real problem. Well, those investors that put a million dollar in his startup, they had set a certain amount of milestones that he would have to hit revenue milestones. If he hit those revenue milestones, their money would convert at a certain percentage and if he missed those revenue milestones, it would convert at a much higher percentage so, basically, they would get a lot more equity for the million dollars they invested. I’m like, all right. Now we’re talking. It’s not about outbound, it’s not about this bad hire. It’s about you were trying to hit a certain revenue number in a very short period of time. First, how much more equity will you lose to these investors if you don’t have that number? He was like, “15%, I think” say we’d have to give up 15% more than he has. I think the percentage that he gave up before is not that crazy. Maybe 10 or 15% so this would bring him up to 30. I get it. I was like this is going to double the amount basically of equity they get for the money. I get that that sucks, but the timeframe that he presented was a four-month window, so he has four months from December. It took them, I don’t know the exact numbers, but it took them a year or two years to get to 20K MMR and he needs to get to 60K MMR. You need to add 10K MMR every single month for the next four months and his average customer pays him $200 a month. He started then kind of proposing to me all kinds of funky ways that he could imagine and how to get to 60 MMR. One was to do some aggressive outbound stuff himself. One was to do all kinds of other things. There were a lot of wild ideas and you could tell that he was scrambling to figure out some way to get to 60K, so he wouldn’t have to give up that extra 15% to his investors. My question to him was, all right. Hey, if we step back, whatever percentage you give to these investors, will you have to raise more money in a year or two, or will you be profitable forever or cashflow-positive? He’s like, “No. By the end of 2017, I’m pretty sure I’m going to have to raise money again.” At that point, I told him, “Well, you have a bunch of shitty options and you’ll have to choose one of them.” Because it seemed very unlikely that his plan of trying to get to 60K MMR in four months is attainable. It seemed to me that his current solution was that he would do all these incredibly risky, very expensive things, that were very short-sighted to try to get to additional 40K MMR. The most likely scenario, based on everything I had heard, would have been that he would just fall short of the 40K MMR anyways. To me, if he succeeded getting to 40K with all these short-term tactics, yes, okay, he saved giving 15% to the investors, but now he has all these unsustainable ways to grow and this trajectory to those investors that’s not accurate, so he’s going to keep doing these shitty things and, eventually, the chickens aren’t going to go back to roost. Eventually, the model that he is building, the scale that he is creating is going to crumble, is going to create issues down the line when he tries to raise money again. Either, that’s going to happen or even worse, which is the more likely scenario, he’s going to do all these short-term things to get to 40K additional MMR and he’s not going to get to that goal. He’s going to get to 20K or 30K MMR, so he’s done all these short-term stuff, he spent all this money wastefully and he still will have to give up the 15%. At this point, I’m going to pause and instead of telling you how the conversation continued, I want to hear your first thoughts on this. Imagine you’re standing next to me, listening to this founder and my summary of the situation. What’s your first gut instinct? What are your thoughts? What would be questions you would ask to this person? What are you comments at this point?
Hiten Shah: I go pretty extreme in these cases and just ask, what about if you just shut it down?
Steli Efti: Ooh.
Hiten Shah: Then it leads to all kinds of interesting discussions, so that’s actually …
Steli Efti: Why are you asking that question, though? To just clarify that for the listeners, why would you ask somebody like that, hey, what would happen if you shut the business down?
Hiten Shah: If you’re in this weird situation, like you’re describing, and you have all this pressure and it’s kind of artificial in some ways, but then you still have to raise money by 2017, this business is probably not going to work. There’s these variables and just this line of thinking and this drag from investors that just make me feel like it’s just not going to work. My first intuition there is has he thought about shutting it down, or has she thought about shutting it down, and how does that person I’m talking to feel about that? It isn’t just like, oh, my opinion is you should shut it down. It’s more like, have you thought about shutting it down now? That tells you everything, depending on what their reaction is. Not even their verbal reaction, but the way their face goes. Sometimes they get pissed at me. It’s great. It’s awesome.
Steli Efti: Man, but most founders that have raised money, I would say the vast majority of them, sooner or later, they’re going to find themselves in some kind of a sticky situation like this where things are very complicated and messy and the options are not very attractive. I think that just habitually founders are just … Because founders are so optimistic to a fault and because they are very determined, if not stubborn to a fault, when you suggest this, even suggesting this is something that I could see a lot of founders becoming very uncomfortable with, even the thought. With this founder, I didn’t ask him this question, but I did ask some challenging questions in terms of, well, what if we didn’t do any of these things that you’re planning to do? Or, what if all this crazy stuff you say, what if it doesn’t work? Hey, what if we just give those people 15% more? What is the big deal here? What’s the big problem? What if we just go to the investors and ask them, tell them, hey, I’m going to do all these short-term shitty stuff that’s going to fuck the business to not give you 15%. We are totally misaligned right now. Why don’t we realign? Why don’t we get to a point where you see we’ve done it and we’ve had enough progress, things are going well enough. Don’t force me to do all these short-term things to hit some arbitrary revenue numbers so I don’t have to give you this extra equity. Let’s get to some kind of a compromise. I’ll give you an extra 5% equity, instead of 15, and I’m going to do all these good things for the business that are long-term that will keep this business healthy. Why not try to renegotiate this? As I was offering all these different options, even with like simpler options, how about shutting down the business, or have you thought about shutting down your business, he was very uncomfortable. You could tell that in his heart of hearts, he was attached and holding on to the idea that he’s going to figure out a solution to all of this. Which means he’s going to come up with some magical silver bullet that will get him to 60K in a way that is long-term and scalable and healthy for the business, so he doesn’t have to give equity to the investors and he just saved the business or created this massive inflection point right now of the business. Because he’s read all the books and all the stories of these moments, heroic entrepreneurial moments happening, so he didn’t want to let go of this idea of there’s a solution that will fix, that will address all of this in a beautiful way. It was even difficult to talk about like small options. But I love the question of, have you thought about shutting it down, because it’s a question that too many founders are not comfortable asking honestly. Most founders will go through the entire life cycle of their company, never ever asking that question, although maybe in their heart of hearts, it would have been a good question, an important question to ask. They just don’t. I don’t know. Maybe it’s a public shaming. Maybe it’s they don’t feel like they could even ask the question of can I shut down my business or not? Anyways, we did an episode. It’s Episode 17, the Art of Quitting. It’s a very important episode we made about how to decide when to quit and when to persevere with your startup. In his case, as the conversation continued, I think that there were a few options that I laid on the table, which was I thought the least appealing option was doing short term, trying to chase the 60K MMR goal with no plan that seemed reasonable. That seemed to me to be the stupidest version because he would fail at reaching the goal and he would burn through the money and he would do all these things that would lead to the demise of the business. I was, like, that’s the sudden death kiss option. I would not do that. That’s stupid, in my opinion. The other option was just accepting. Hey, give them 15% more and move on with life. Try to build a good business. Try to make this a healthy business and you’ll have to swallow that pill and move on with it.
Hiten Shah: What do you think his level of conviction was on the business?
Steli Efti: Dude, I don’t know. It’s a good question.
Hiten Shah: That’s all I try to get at. When someone’s in a difficult spot, it’s all about how much conviction do they have for their business. I don’t mean like, oh, I love it, or any of that. It’s just, like, do they believe in it? Is there any actual real evidence that this business should continue? Customers love it. There’s a growth rate that’s at least it’s there to some extent. One is emotion, the other is logic. What I’m doing is by asking the question, just like you did, shutting it down and all that, it’s like that’s emotion. What do you get out of the person, or what do you get in your own head when you have that thought and what’s the emotion around that? The other piece of it is, logically, should this business exist? Should it continue? Is there any evidence that you can make it? Is there any evidence that there is something here worth continuing? Because, otherwise, you give up the 15%, let that go, you’re still in the same spot of having to continue the business.
Steli Efti: I think when it comes to some of the core fundamentals of the business, at least with my understanding with the conversation that I had with him, it sounded like there were a lot of things that seemed to be healthy. The inbound funnel seemed to be working well. Churn didn’t seem to be a massive issue so retention was good. I think that, and I don’t know enough about the business to confirm it …
Hiten Shah: Sure.
Steli Efti: … but I felt like in his mind, he made a big mistake, probably because he was stressed about that revenue goal that the investors put in place. Inbound was working well and he had something that was going fairly well, then he hires this expensive VP of sales. That VP of sales does all these crazy things to get to that revenue goal and, eventually, he realizes it’s not going to get us to this goal and it’s burning through all my money.
Hiten Shah: I want to definitely put this out there. It is very rare to hear an investor put a revenue goal like that on a founder and it be a good thing. Very rare, so already for me, that’s a big red flag on the situation, which is, like, well, why do they feel the need to do that? You’re the founder/CEO. You probably have a forecast, unless your business is superearly, I think this one’s pretty early, right?
Steli Efti: Yeah.
Hiten Shah: All your forecasts are BS, so what are you doing? Why did you let them put that goal? I’m sure it was a contingency on giving him money, but then it’s like, I don’t know. This is just not a common thing I hear, so there’s a fundamental issue there, first and foremost, of the amount of control that he has enabled the investors to have on a business that he is running. They’re not running it.
Steli Efti: I absolutely agree with that. I don’t think I would ever advise anybody to agree to something like this because it’s going to be a bad thing for the business, for everybody involved.
Hiten Shah: Exactly.
Steli Efti: Because it is incentivizing non-organic hacky behavior to hit some arbitrary number to not give investors more equity. That’s crazy to me. In this example, this is a European startup and in the European scene it feels to me that …
Hiten Shah: That’s more common, right?
Steli Efti: It’s not totally common because the investors in Europe has kind of aligned itself much more with what’s happening in the US, in the Bay Area specifically. More so there’s more sophisticated, really good investors in Europe, more than probably a decade ago, but it’s still more common for these investors to come up with these structures that are not a typical startup structure that’s good for that business. It’s basically a, hey, you’re giving us these really aggressive projections to justify why we should put a million dollars into the business with a whatever for if you’re somewhere … If you’re not in a startup company in Europe, not in like a Berlin or a London, any kind of smaller European country, the investors will go, well, I put a million in this business and you want a $2 million valuation? There’s nothing here. You have these really aggressive goals. Well, what if your goals all fail? It’s kind of a negotiation tactic with, like, well, if you do amazingly well, sure. Let’s have this higher valuation, but if you don’t, I want more equity for my money. I think that that’s kind of the worth now.
Hiten Shah: Yeah, and if he got in that situation, he needs to own it and deal with it. Just to give people a framework, split the logic and split the emotion, and figure out … If any of those are imbalanced, like logically there is no business here, which it sounds like in this case, there is business, great, there’s a business here. Then the emotion is like, are you done or not? One of the things that people don’t really talk about in startups, whether it’s funded or self-funded, is like if the founder, the CEO, the people running the company, executives in a larger company, if they’re done, the business is done. You’re not going to be able to continue it. It’s hard to tell if you’re done sometimes, but in these situations, it’s a great test, in my mind. It’s just like, are you emotionally done? Do you really want to continue? Because this shit ain’t easy. Nobody said it was. You should know that by now and if you don’t have the conviction, based on your emotion and your ability to just push through, then you’re not going to make it. To me, the framework is just logic and emotions splitting those two up. Logically, he got himself into this deal, so trying to weasel out of it now or do something weird, that’s not going to work. That VP of sales was probably brought on by his investors to some extent, or they pressured him or whatever, but he shouldn’t have listened if he had conviction to do it a different way, or had a belief that there’s a better way. Maybe he should have made that decision faster. All that stuff’s done now, though. He already made all those mistakes. He probably learned a ton from them. To me, logically, it seems like the business is healthy enough. Emotionally, it seems like he needs to check himself and really think through whether this is worth it for him.
Steli Efti: We’ve talked about this and shared some of the frameworks that we have for this, but I think this is one of the most challenging questions for founders is what is my emotional state of being? Where am I? Am I still truly passionate about this, or am I just attached to it? I think that most founders, even when they’re emotionally exhausted or done, it seems incredibly hard to admit that to yourself and anybody else. To anybody else maybe to a harder degree, but I know for sure. I had one company out of all the businesses that I have built where I was holding on for way too long and it was just impossible for me to admit defeat. If you’d ask me, I knew. I knew I was. Are you burned out? I knew I had no passion anymore for it, but if you had met me and asked me, hey, are you done? Have you ever thought of shutting this down? I would have never admitted that. I would have been like, no, I’m going to make this happen, just trying to force situation with pure determination. Although in his case, just to be honest, I want to be fair to him, I don’t necessarily think that he was emotional, or he didn’t seem that he was emotionally done. It just seemed that he could not accept reality. He could just not accept that, just like you said, hey, I made some bad choices. Maybe agreeing to that with investors was not a good idea. Maybe bringing this VP of sales was a bad hire. I made these mistakes. There’s a cost associated with it and the question is, am I going to pay a small cost and learn from the mistakes and move on? Or in an effort to avoid paying any cost, will I ruin the business? That was my interpretation of the situations. He wanted to avoid paying the cost of his past mistakes and in order to do that, he was steering his business towards the iceberg. Like he was trying to come up with all these really wacky short-sighted ideas to get to some crazy revenue number that he hasn’t accomplished in a long time because his customers are much smaller customers, to rectify the mistake with the VP of sales and to not have to give up more equity. Again, I don’t remember the exact numbers, but I actually asked, I tried to understand how much equity he had given out to investors and how much he’s still owed. It didn’t seem amazing to me, but it didn’t seem to a point where I was, like, oh, dude, you’re done. You should shut down the business. It makes no sense anymore. Which has happened before where people are like, well, yeah. Well, the investors got 60%, and then will get another 20, and then I have these contracts that they got 5% each, and it’s like, dude, you haven’t even started with this. You only own 10%. This is going to be a really hard journey. It didn’t seem to be the case here. It was not amazing, but it was not at a point where I thought this is such a toxic deal where it makes no sense anymore for you as a founder. My sense was just that he didn’t want to bite the bullet. He didn’t want to own up to his mistakes and take the losses of those.
Hiten Shah: There you go.
Steli Efti: There you go.
Hiten Shah: That’s an emotional thing, right, that needs to be addressed .
Steli Efti: Yeah. I love that, and I think the tip you gave earlier and I think that’s a good one to wrap the episode up with, which is the separating the emotion from logic. First asking, are you done? Are you angry? Are you burned out? Are you depressed? How do you feel about all of this? Then, okay, what are the numbers telling us? What are the fundamentals? Is there still a business here? Is there still an opportunity here? Separating those two seems to me to be something that 99% of the time people don’t do, and then the emotions and the logic are all kind of mixed up. It’s impossible to make good decisions and understand why you’re making the decisions you are making if your emotions and your rationale is all mixed up in a pot. The tip that I’ll give for wrapping up this episode is, additionally to taking stock on your emotions and on the logic behind your business, is really putting down in writing all your options, all the options that you can think of, and the true cost, the true chances for these options to succeed and the risk if those options fail, and think really long-term. Don’t just think, like this him. Once we talked this through and we said, well, if you gave them 15% more equity, what would happen next? What’s the consequence of this? How will this affect the business in the next two, three, four years? You could sense on an emotional level, he started feeling bad about it because he thought, “Well, it’s not really the end of the business. I don’t that it’s going … If we fail, it doesn’t matter if we succeed. I’m not sure how much of this will matter at the end.” It seemed much less of a massive issue if he thought about it just long-term enough, so think through. Write down all your options. Write down the chances of success, as well as the risk that you’re taking with these options, and then think about not just what will happen in the next months, but what will happen in the next one, two, five, 10 years. That oftentimes helps give you a framework of perspective that you’re lacking in the moment and that can clarify what option is the right option to take.
Hiten Shah: That makes a lot of sense. I’m glad you unpacked that because I think people need that. It’s easy to confuse logic and emotion, especially in business. It shouldn’t be, but it really is easy to confuse the two.
Steli Efti: Well, we’re humans and both logic and emotions are in the same body and in the same human …
Hiten Shah: Exactly.
Steli Efti: … so it’s challenging. All right. I think that’s it from us for today’s episode. We’ll see you very soon.
Hiten Shah: Bye.