A growing number of investors have begun to suggest that certain venture-backed startups that have yet to find so-called product-market fit throw in the towel. Their argument is that some startups have simply raised too much, at valuations in which they will never grow, and that clean, well-planned exits are better for everyone than messy exits. After all, the money can be invested in something with more impact. Importantly, founders’ time can also be spent on more productive endeavors, significantly improving their mental and emotional well-being.
It’s a reasonable proposition. Working on something that isn’t working can be soul crushing. Still, we’re not sure many founders would give up their companies for a long list of reasons right now. Among them: Fundraising is tight, so raising money for another startup is not a good idea. It’s a bad job market and most founders feel obligated to take care of their employees. Some very strong companies have sprung up from pivots, including the famous Slack, whose team initially tried to create a game called “Tiny Speck.” Finally, if investors have given founders too much money in recent years — and more than $10 million for a company that doesn’t fit the product market sounds like too much money — it’s really their own fault.
As we wish to further investigate the matter, we have today contacted well-known operator and investor Gokul Rajaram, who was in a tweet That “[m]all founders who raised large amounts ($10 million+) in 2020-2021, but then realized they had no [product-market fit]are currently going through an excruciating psychological journey.
Rajaram – who sits on the boards of Pinterest and Coinbase – had added on Twitter that an early closure could be a “graceful way out” for stressed founders, so we asked him if it’s practical, too, given the current market. He made the case for why it’s in an email conversation, slightly edited here for length:
VCs are not letting their own investors loose by reducing the amount raised, but they want founders to return some of their funding. Do you see a connection?
That is a good question. I don’t think the two behaviors are related, at least not yet. Now if you told me that VCs started returning capital to LPs I could see some parallels. VCs would return capital to LPs because they do not see attractive investment opportunities that are well suited to their mandate, fund size, [and so forth]. Founders who give money back do so because they can’t find business ideas that are a good fit for their skills, team, customer focus, etc.
Do you think pivots are overrated or that there can only be so many times a company can run before it’s obvious something is wrong with the team itself?
Many great companies grew out of pivot points. Twitter (Odeo) and Slack (Tiny Speck) are two examples of great products and companies created as a result of pivots. In my experience, most founders, when they realize that the original idea has no legs, try at least one pivot, either solving a different problem for the same group of clients, or using their insider knowledge, life experiences, and skills to solve a problem. to solve. other problem.
Each pivot takes a psychic toll on the company, and I don’t think a company can do more than, say, two pivots before employees begin to wonder if there is a method to the madness and begin to lose faith in the founders . If it’s a two-man business that hasn’t raised a lot of money, they can run indefinitely. The more people – and capital – involved, the harder it is to do pivot after pivot.
How much is a reasonable amount to burn through on your way to finding a product-market fit? In response to your tweet, many people expressed their surprise that companies without product-market fit this got so much funding in the first place.
In general, the rule of thumb has been that your seed round should be used to find [product-market fit]. So that’s $2 million to $3 million in capital in reasonable times. What happened is that in 2020-21 some companies thought or mistakenly assumed that they had [product-market fit]perhaps due to a COVID-induced behavioral change.
Second, there was FOMO/excess capital chasing “hot” deals. So during those 2 years we moved away from the fundraising stage gates that have been the norm for years.
It’s so much cheaper and easier to find [product-market] because of no-code tools – I strongly believe that for 95% of the software products out there, you can figure it out without writing a line of code. That’s a discussion for another time.
Aside from perhaps some immediate relief, what are the benefits to a founder who throws in the towel and returns some of the money raised? Is the argument that they will gain the trust and respect of investors and thus increase their chances of raising money in the future?
That’s just right on the trust point. I do believe that you gain the trust of your investors because investors are more confident that the entrepreneur can clearly think through whether he is multiplying value with time spent. Time is the ultimate currency for an entrepreneur. If they can’t convert time into a higher equity value, the company will have to be wound down or sold at some point.
Prior to this cycle, I have not been involved in capital return scenarios. I know of a company that returned 70% of its capital during the 2001 cycle after everything shut down and one of the co-founders managed to raise a successful round a few years later, but I don’t know if it was correlation or causation was related. That said, investors are clear on the sunk cost fallacy, and I don’t think they are [one’s] financing opportunities change based on whether you return capital or not.
Do you think going all out — without hitting a runway — hurts a founder’s chances of raising money for another company later on?
Not at all. If there’s one thing investors love, it’s an entrepreneur whose previous startup wasn’t super successful – whether the entrepreneur ran out of money or got a refund is immaterial to the calculus – but is still hungry to build something big and ideally related to the first company. Returning cash should not be viewed as a shortcut to securing your next round of funding, but instead an escape from the psychological toll that endless spinning takes on founders and other stakeholders.
Whether and when a company shuts down used to be a decision of the board, right? I wonder if VCs have given up so much of their rights in issuing checks in 2020 and 2021 that they can’t close businesses as easily as they previously could.
When something unethical is going on, like founders pulling outrageous salaries, investors and board members have a fiduciary responsibility to step in and stop it. However, when it comes simply to founders putting themselves, their professional lives, on the line and making bets—in other words, pivots—most investors will let them fight until the entrepreneurs themselves decide to give up. After all, an entrepreneur has only one company, while the investor has a portfolio.
What more investors could do better is provide entrepreneurs with a safe place, let them know that it’s OK to return money or close the business, that the option is entirely up to them, but that it’s an option that is right for them available, that they are not letting anyone down. It is in no way a scarlet letter to the entrepreneur.
Do you think external pressure on founders is increasing to return money based on the conversations you have with other investors?
It is self-imposed pressure from the entrepreneur. The larger the round that an entrepreneur has raised, the higher the expectations. I think companies will have a few choices in the coming months. A.) If they don’t [product-market fit] and have not raised much money, they will have no choice but to leave as the company has run out of money. B.) If they don’t [product-market fit] but have collected a lot of money, they can try to turn once or twice, but after that everyone is tired. Probable exits in this scenario could be an acquisition, a wind-down, or a small acquisition. C.) If they have [product-market fit] and has raised a lot of money, but the valuation doesn’t match the traction, the company may have to do a downward round.
GGV’s Jeff Richards had an excellent after stating that the companies with the highest employee [net promoter scores] were the ones who raised a down round. Isn’t that interesting? There is a palpable sense of relief when you no longer have the Damocles sword of your mad appreciation hanging over you. I think that’s the other conversation investors need to have with entrepreneurs — it’s OK to take a down round. It’s not the end of the world.
I imagine many founders don’t want to return capital, because in today’s market that means more people are struggling to support their families. Any advice to founders in this area?
I firmly believe that companies have a duty, an obligation, to treat their employees well. And I think making a decision early to close the business means more severance pay can be given to employees. The longer you wait, the less money there is to help employees through a transition period.
