The Startup Pivot

There has been a lot written about startup pivots.  They happen.  Many of the companies I have invested in have done pivots.  Some are small changes.  Some are massive.

I invested in a company, Get Video Stream.  They are optimized for both iOS and Android.  They had a nice business, but they found what they were doing wasn’t sustainable over the long haul.  They pivoted to Route This.  That business seems to be doing a lot better and looks to be sustainable.  I invested in Kapow when it wasn’t even called Kapow.  They built a business based on one thesis, and slightly switched their approach to the market.  Their new approach is working well but it’s a very different looking company.

Often times, companies start out with a small niche, and then expand.  Amazon was originally just a book seller.  Now I can get Amazon Prime to deliver anything to my remote cabin in Grand Marais, MN.  Twitter was a microblog.  Then it disrupted the breaking news market.

Almost every company goes through some sort of pivot. If the path to prosperity was totally clear without uncertainty, everyone would do it.  At seed stage, entrepreneurs start out with a view on how their business will solve a particular problem in the market.  They might conquer that niche, and then start to see where their product can really disrupt adjacent niches.

My point is, over time situations change and businesses change.  Often, the team changes.  But, the capitalization table doesn’t.  That’s the one thing that is set in stone.  There is a legal agreement in place, with duties and responsibilities.

At seed, investors certainly invest in ideas-but more importantly they are investing in the person. Good seed investors understand that the founder will often have to change some things to make the business survive.  That’s betting on the jockey.

When the pivot happens, the entire original business model might be totally different.  But, those seed investors still own a stake in the company.  Seed investors are betting that founders can execute.  It doesn’t matter if they invested in one idea and now the company is executing on a different idea.

This is a huge problem I see with convertible debt notes and  SAFEs.  Many entrepreneurs continue to raise and raise and raise and raise money to survive on the same note or SAFE.  They can go years without conversion.  When they finally hit on something where a bona fide investor wants to write a substantial check in a priced round, their capitalization tables usually are really messy.

They are left with three choices that are not optimal.

  1.  Convert the note or SAFE.
  2. Raise at a high enough valuation which is probably too high
  3. Crush down existing investors

Having notes or SAFEs open for a long time comes back to bite entrepreneurs in the ass when a priced round happens because when they convert there is often not enough equity for the team.  The only way there is if the priced round is valued at a higher valuation than the note/SAFE.  Even when you convert at par, team equity can be too small to provide enough economic incentive to execute the business.

The only way to remedy that is to create a large enough option pool, or sweeten the pot with warrants that give the entrepreneur the economic incentive to push forward.

Suppose a company raised $2M on a $5M capped convertible note (or SAFE) over the course of 2-5 years.  They hit nirvana and an investor wants to write a check in a priced round-but because it’s still sort of a seed round Mr. Investor is willing to write a $750,000 check at a $3M price.

$2M of that gets converted at a discount to the $3M.  You can see how founder equity gets chewed up quickly.  The $3M pre-money becomes a $5.75M post.  47% of the firm is owned by investors with a high probability of 3-5 rounds to go.  If you assume founders sell 20% of their equity at every funding-and that fundings take place every 16 months-the runway becomes very short.  It’s really impossible to build a billion dollar firm.

If the founders can persuade the investor to invest at $5M, the equity still gets eaten up.  A $7.75M post sells off more than 35% of the equity.  The $2M converts at a price of $4M.

Suppose they can persuade the investor to invest at higher than the note.  The equity can work, but the bee in everyone’s bonnet will be the next round.  If the company can’t raise at a higher valuation in the next round the house of cards falls apart.  By higher valuation, I mean a minimum of double the post money on the last round.  That’s the bare minimum.

The other option is to crush existing investors down.  I have been crushed down in a refinancing and it’s not fun.  As an investor, you aren’t supposed to write the loss off on your taxes-and usually there is no chance of even seeing money back.  Companies become zombies in your portfolio.

Ethically, entrepreneurs shouldn’t do that to investors on a pivot but many do.

This is why I really like priced rounds from the outset.  I understand they are more expensive and can take longer.  But, they make for clearer cap tables and all the parties involved know exactly where they will stand.  It’s a much different conversation with an entrepreneur if I invested in a priced round at $4M, and now they are going to do a down round at a $2M.  As an investor, I might not like it but at least I know what it’s going to take for me to break even or make money.