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For the past decade, venture capital has been on a bull run with record-breaking cash infusions and soaring startup valuations. For better or worse, VC pandemonium during the pandemic caused default dead startups pumped up with dry powder to reach unicorn and decacorn statuses.
High-profile SaaS companies have been raising and exiting at 50x revenue but are now fewer and farther in between. As the economy enters recession, investors sober up and cause growth-stifling and unprofitable startups to struggle to attract new capital.
With that, priorities are shifting from growth at all costs to profitability first. Committed founders are trying to adapt to the changing market environment in order to save their creations and the value locked in them – but this can bring about a dilemma.
Investors on the cap tables of startups typically aren’t interested in holding equity in anything less than a future 9-10 digit valuation prospect. And they have neither appetite nor patience for dividends from cash cows.
To most them, what moves the needle is asymmetrical returns from equity value appreciation of the winners in their portfolio. And they would rather founders go all in than settle for a medium sized business.
Bad investors will try to brute force their power law expectations by bestowing a grow or die mentality upon their founders or applying pressure to the board to replace the founders. Worse will block a premature exit despite near certainty that the company will die if they keep at it at the same pace as before.
Good investors will instead look for mutually beneficial outcomes for all stakeholders involved in a fallen angel, even if it means writing off their investment in the startup. This can seem counterintuitive but more on that later.
Acquisition tends to be the best option for a venture distressed company. And for startups with revenue and foresight, it doesn’t have to be a fire sale as there is usually a business to salvage, either by the founders themselves or by new owners.
This article will attempt to lay out the options available to the many investors and founders that now find themselves in a tough spot thinking they have to keep going or shut down. So let’s look at the arguments for why founders and backers should consider selling early if it can’t become a unicorn but would be a valuable asset to a competitor or could become a profitable SMB in its own right.
Before looking at redemption options for venture distressed startups, let’s consider the knee-jerk reaction of investors already on the cap table to the phrase premature exit. Specifically, let’s double click in on why trying to force founders to stay the course when the forecast demands a change in direction is a fool's errand.
But first let’s take a step back and define what a venture distressed startup situation looks like. Well-funded startups that can’t grow at the pace they need to with the amount of capital they are able to attract are sometimes also referred to as fallen angels.
In traditional Wall Street jargon, a fallen angel is an investment-grade bond that over time has had its rating reduced to junk bond status. Not too dissimilarly in venture capital and angel investing speak, a fallen angel is an investment where the underlying asset, i.e. the startup, has seen its value drop significantly.
“Quick sidebar: if you consider that 9 out of 10 startups fail, these guys are in fact the silent majority, which is why most founders carry around a survivor bias passed on from the loud minority that live to tell the tale of the elusive unicorn.”
Multiple downrounds and liquidity issues are clear tell signs of an angel in free fall. Because without fresh capital to fund the loss-generating operation of a typical growth venture, the startup will run out of runway.
Even if there is a small chance that the startup could scrape together more money to outlast its competitors and win market share in an economic downturn like this most recent recession, the founders might not be onboard. And for good reason.
Raising a downround will dilute founders further which moves the goalpost for the eventual exit and dwindles the prospect of a future payday for the team. The time horizon of an IPO now seems infinitely far away, which most VC funds’ time horizon and many angel investors piggy banks won’t accommodate easily.
In situations where founders don’t wish to go down with their ship, investors will have to make a choice. They can attempt to block a premature exit and try to force them over the edge in a Bonnie and Clyde grow-or-die attempt to cross the canyon. While it can seem admirable it is at rock bottom suicidal (as were Bonnie and Clyde).
Fighting against the will of the founders by pressuring them into committing to the unicorn path with the writing on the wall is almost certain to backfire. Not only is the startup likely to fail, the effects of forceful behaviour from the side of the investor will damage their reputation and negatively affect access to future deal flow. Why? Because founders talk.
Replacing the founders with a new management team is far from easy to do and few groups of investors have the voting power to do so. Even when it is within the realm of possibility, data shows that founder-led startups are more likely to outperform. And the signalling effects associated with a coup d'etat can create unwanted externalities in and outside the portfolio.
Instead investors in the startup-venture game should try to stay long-sighted and opportunistic about the avenues in front of them. Short of funding the business themselves to deliver on their own 1000x expectations, these ultimately boil down to three options.
Option 1
The first is to simply cut losses by writing off the investment completely, wish the founders good luck and move on. This frees up time for the investor who no longer has to partake in board meetings and advice sessions. Leaving the founder team high and dry doesn’t, however, redeem the principal of the initial investment.
Option 2
The second option is to stay invested, lower expectations and change the mechanism for returns from an equity appreciation strategy to a dividend-seeking approach. This becomes relevant when the founders are dead-set on continuing the quest financed by their own revenue, which often involves scaling back operations to get the business running sustainably and profitably. More on that here. While this option stands the chance of recuperating the principal investment, it is not really an option to most VC and angel investors.
Option 3
This brings us to the third option which is to help find a buyer and get the founders onboard with the idea of an early exit. This is usually not a problem for fatigued founders but equally, any realistic founder faced with near certain death will tend to go for a premature sale. The ideal acquirer profile is in many cases a strategic buyer who can absorb the assets of the business into their existing operations without penalising the startup for its balance sheets. However, the practice of getting a startup profitable can also be employed in the short term to get the business ready for sale as it increases the pool of potential buyers.
Given the unattractiveness of leaving founders high and dry without recuperating the principal and the untenable option of having permanent equity in cash cow SMBs, let’s consider the third option in more detail.
As a founder, finding a new home for your creation under distress can be emotionally tolling. But it can also be a huge relief if the burden of your baby is weighing you down. If that is the case then the obvious solution is to sell it and to do so while it is still valuable.
This should ideally be a business decision first and foremost but of course, emotions and thoughts about legacy creep in. Taking too long to decide, however, can be quite detrimental. Remember at the end of a startup’s runway is either profitability or bankruptcy. There’s not a whole lot in between.
Of course, a premature sale of the company will never be the exit anyone intended. But with the back against the wall and an opportunity to cash out chips before game over, an early acquisition can be a very sensible option.
Selling too early rather than too late ensures nobody goes home empty-handed. Sticking with the same analogy it also frees up hands to work on other things, which is a huge plus to fatigued founders who feel like they’re fighting the current by beating a dead horse.
There are many ways to structure a deal depending on the nature of the business and the situation of the distress. A common misconception is that an exit is only a desirable path for revenue-generating or even profitable companies. But in fact, pre-revenue and deep tech startups with users or valuable assets to their name can have respectable outcomes, too.
The key to a good deal is beginning the process of looking for a buyer early. Never rely on just network to find a buyer. Use an acquisition platform to broadcast your search to a large pool of relevant acquirers. BitsForDigits helps owners attract offers from thousands of deep-pocketed prospect acquirers.
Having the foresight to list a business anonymously for free on a marketplace can feel a bit premature but actually has no downside. The upside, however, is that it can prevent a desperate, discounted last minute fire sale, where assets get sold for cents on the dollar.
A timely and very public example of a high-profile strategic acquisition by a competitor is the sale of Gorillas to Getir. The deal will reportedly value Gorillas at $1.5bn which despite being below the startup’s latest priced round at $2.2bn still manages to cover all $1.3bn in capital raised over the lifetime of the company.
Even though breakevens are not what VCs or angel investors set out to get when they allocate capital to early stage startups, having their principal returned remains better than nothing.
But most importantly, what investors really ought to care about is creating a win for their founders. Hence wise investors will never act petty and fight over scraps – even if their liquidity preferences allow them to. Rather they will favour the wishes of their founders.
For what might be peanuts and breadcrumbs to investors are typically life-changing amounts to founders. And unlike investors, founders don’t have a fully-loaded magazine–they have one bullet, i.e. all eggs in one basket. So to create or maintain a positive reputation amongst founders, investors should prioritise creating a dignified exit for them even if it’s a small win.
Adopting a long-term fiduciary mindset can be helpful here. Take for instance one of the best VC firms in the world, Sequoia Capital, which prioritises their stakeholders in the following order:
Fortunately, the rise of micro private equity has brought about many micro PE firms like Tiny Capital on the lookout for venture distressed businesses. They pride themselves with creating win-win scenarios for investors and founders alike while carrying on the legacy of the business either by buying out current shareholders of a majority stake and keeping founders involved or by acquiring it outright wholly.
This private equity firm is a good example of a buyer doing majority acquisitions of venture distressed startups. Their investment criteria are of course a total contrast to that of a VC, but also distinct from a traditional PE in lower revenue thresholds and more flexible terms:
Other types of buyers will employ different methods. Roll-ups will acquire multiple startups and consolidate them into larger entities to achieve economies of scale while search funds and acquisition entrepreneurs will do either a full or majority acquisition stake or business outright to operate it themselves.
The point is, despite venture capital drying up there are still many different types of buyers looking to make full and partial acquisitions of startups that have already done the hard work of building a business from scratch.
Today is reckoning day for the taboo of selling early. So let this be a call to action for all the operating founders and investor teams out there with distressed ventures on their hands:
Explore the option. And don’t wait too long!
Further resources: Failed Startups, Default Alive or Default Dead, Personio Reaches $8bn+ Valuation, Adobe’s $20bn Deal For Figma, Fallen Angel, Fire Sale, Who Owns Gorillas Acquisitions Getir Sale
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