@GastonBilder

An exit and two bankruptcies

Posted on May 18, 2021     1 Comment

Investing in startups entails an emotional ride. That is why you need to have an investment framework to validate your decisions and curtail your emotions. I will recount the lessons learned in terms of risks, from an exit and the two bankruptcies of startups I had invested in. Although these startups were not all focused on creating social impact, the lessons translate well to any type of investment.

Recycling capital

I consider my impact investment portfolio to be permanent capital, i.e., all the profits and exits within this portfolio will be reinvested into other social enterprises, a.k.a. socents. I would like these investments to be part of my legacy rather than my pension.

Even though the main driver for my investments is to achieve meaningful social impact, lurking the investor thesis for my portfolio is the sustainability of its assets. To accomplish such a goal, the companies I invest in need to endure and at, a minimum return, the capital invested. Successful exits pose the problem of needing to reinvest the proceeds. On the other hand, failed investments, i.e., investments that do not return the capital, break Warren Buffet’s Golden Investment rule of not losing money and reducing the available funds for future investments.

Any investment decision poses the classic dilemma of being prudent with capital allocation and accordingly targeting “safe” investments vs . ‘swinging for the fences‘. Unfortunately, this is a false dichotomy. Each investment may result in a permanent loss of capital. Even the “safest” companies – for the sake of debate, let’s call them US stock exchange publicly listed companies – make mistakes or fail to adapt. This generally results in substantial losses, abrupt changes in share prices, and occasional bankruptcies. Also, all the investments in an angel portfolio should be made swinging for the fences.

Outcome vs. process

I believe that you can learn from success or learn from failure; the critical part is learning. I must admit that like most human beings, I suffer from loss aversion and would prefer to learn from success cases.

As anticipated, I will recount the lessons learned from three investments. In hindsight, all three companies behaved like typical startups, as defined by Steve Blank, i.e., an organization formed to search for a repeatable and scalable business model. One ended up being acquired, and the other two in liquidation. As I will explain below, from my perspective, even the case in which I made a significant financial return on investment was a failure from the risk management perspective.

A valuable exercise for evaluating your investment decision, execution, and monitoring processes is to conduct a post-mortem analysis. For brevity, I will summarize some of the critical factors that resulted in different outcomes for these startups; nevertheless, the main lesson I have learned is that value is achieved and captured by consistently following and improving an investment process. This is more critical than understanding (if possible) what led to the different outcomes, mainly if we agree that the normal distribution for investments in startups is scaled against the investor. In successful VC portfolios, the Pareto principle 80/20 applies to their performance measured by return on capital).

I could swiftly get myself off the hook by arguing that outcomes (the risk of loss) are and will always be unforeseeable. Nevertheless, I am aware that I should have focused more on relentlessly identifying risks – defined as a range of outcomes – and seeking insights on the likelihood of such results. Had I done so, I could have had constructed a more resilient portfolio in terms of probability of distribution.

“Red flag” monitoring

Without giving names (please DM if you are interested in particulars), the following were the main factors that I should have identified and mitigated:

The fast exit

I joined other business angels in the seed round of a startup that raised more than US 750k for the go-to-market of a “smart” music sheet app. The app displayed the music sheet for several thousand tracks, listened to you as you played any musical instrument, and showed you where you made any mistakes. Moreover, the app could reproduce the rest of the musical instruments that would have played in any song. I was not convinced by the marketing strategy (which initially was b2b), but the addressable market seemed huge. The founders had resiliently worked for a couple of years on the product, and the fundraising secured could fuel the startup for a couple of years.

Three months after my investment, the founders announced that as a by-product of their efforts to launch in the US market, they had received an unsolicited acquisition offer from a US company that focuses on educational software. After less than one year and a half as an investor in this startup, we left with an IRR >30%. Like many other investors in this startup, I had hoped to remain invested longer and exited at a higher valuation. The founders accepted an acqui-hire and negotiated better terms for themselves as employees/shareholders of the acquiring company. I don’t think that I could have done better as a minority shareholder in terms of risks. I was well protected as an investor and got a ‘fair’ return. However, the feeling that founders have more options than the rest of the shareholders, and depending on their shareholding, can low-ball acquisition offers has stayed as a permanent lesson learned.

Doubling down?

Together with other business angels, I invested in a French ad-tech startup that had been doing indoor tracking and advertising retargeting since 2011. Everything was going right, and in 2016 I had the chance to double down when the startup decided to raise it Series A. It successfully fundraised E 3m. from two well know VC funds. I jumped on this opportunity, dreaming about the upside, i.e., what it could become (launching in the US, secured funds for 18 months, etc.), rather than on the risks. Soon the problems started creeping in. The VCs pressured the founders to grow as fast as possible. After years of devoting themselves to the startup, the founders realized that they were now working harder than ever. Unfortunately, they were not as incentivized as before due to the dilution they had accepted in the funding round. The business was scaling, but so were its expenses. Prospects were good, but there was no sure win.

Being the lawyer that I am, in 2014, I alerted the CEO and founder to this privacy risk. I was swiftly dismissed with verbal assurances that nothing similar could happen to the French startup. I was told that if anything happened, the problem would be addressed if and when it arose (i.e., not a priority when growing at such a fast pace). In May 2018, the General Data Protection Regulation (GDPR) was enacted. The startup in which I had invested was chosen by the French data protection watchdog, the CNIL, to serve as a testing ground for its criteria concerning the gathering of user consent. The CNIL started an investigation that resulted in the suspension of the company’s activities until the CNIL had satisfied itself that the startup’s activities were GDPR compliant. This six-month suspension, coupled with the previously mentioned tensions between the founders/managers and the VC funds, resulted in a freefall of the revenues and ultimately led to the bankruptcy of the startup.

I learned the following: (i) investors have different interests for investing in a startup; don’t follow the marquee names blindly. (ii) regulations – particularly developing ones – can be fatal. (iii) governance conflicts can be particularly exacerbated when incentives are not aligned. (iv) don’t scale before having found market fit.

One founder, two projects

I decided to invest via a crowdfunding platform in one of the first startups in Europe producing spirulina at home. This startup had created a device to grow spirulina at home, similar to this one. I was aware that the founder had started a side project for the commercial-scale marketing of spirulina.I decided anyway to invest a minimum sum regardless, hoping to promote the consumption of spirulina.

Sometime after the startup had repeatedly struggled to achieve any significant traction, the founder decided to throw the towel. My lesson from this experience was to take the time to interview the founder and really understand their motivation for addressing the problem / estimate their resilience. Although there are plenty of Elon Musk, Jack Dorsey wannabees out there, most of the founders can’t handle running more than one startup at a time. Aside from potential conflicts of interest, devoting time to more than one project should be taken as a sign of non-commitment or possible failure due to lack of investment by the founder.

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“Rule Number One: Never Lose Money. Rule Number Two: Never Forget Rule Number One”

Warren Buffet – Berkshire Hathaway CEO