8 reasons startup founders fail – even when the businesses succeeds

We meet a lot of excellent founders at Zambesi. They come to us to spend time with leaders from companies like Canva, Facebook, Showpo, TEDxSydney and Koala to learn how to grow their startups, pitch their ideas, make sales, lead teams and raise capital. Our mission is to help these founders build successful businesses.

Lately, I’ve begun to notice more and more founders in a new category. Great people, with great ideas who’ve done all the right things and who have built successful businesses; but at the end of it, get nothing. Or worse than nothing, they’ve endured several years of stress, relentless hours and low or no pay. They’re burnt out, disheartened and broke.

Unlike our regular articles, this post will not help you grow your business. Instead, we’ve interviewed four industry heavyweights including Peter Dunne of Herbert Smith Freehills, David Kenny of Hall Chadwick, Alan Jones of Muru-D and M8 Ventures and My-Linh-Dang of Metis Law. They advise our most successful founders, as well as many who haven’t been as fortunate.

We’ve compiled a list of the top 8 watch-outs that could lead to you losing out as a founder. We haven’t covered topics like running out to money, failing to grow, missing out to a competitor, burn-out or any of the myriad of reasons why your company might not succeed. Instead, we’ve focussed on what to watch out for in deal making that could lead to you losing personally even if your business is successful.

It’s important to note while some of the watch-outs are avoidable (like not having proper co-founder and shareholder agreements in place), many will be inevitable when you raise capital (possibly liquidation preferences). We hope this article will help you to be more aware of the potential impact of some of clauses in shareholder or fundraising docs. It’s also important to note that there are lots of other pitfalls in fundraising – these are eight big ones – but it is not a complete list. You should always seek legal advice before entering into company founding, shareholder or funding agreements.

Founders are naturally optimistic. I’ve been guilty of skimming over dangerous terms when negotiating investment. I believed that my business would do so well and that the investors were all such lovely people that none of the scary clauses would ever come into effect, and we needed the money! This naive optimism seems crazy in retrospect.

We’re running an event in Sydney to discuss this topic on Wednesday, 31 July, from 4.30 – 6.30pm at Hall Chadwick. Tickets are $10 and include drinks / $5 with the code ‘ZambesiMember’. You’ll meet the experts, hear real horror stories and have the opportunity to ask questions. Register here

 

 

8 founder traps to watch out for:

1. Co-founder fall outs

My-Linh Dang runs Metis Law, a boutique commercial practice specialising in early-stage start-up, capital raising, mergers and acquisitions. My-Linh advises Ability Map, Neighbourlytics, Open Sparkz and Zambesi.  According to My-Linh: “The number one call for help we get is co-founder break-ups. Two friends will have started a business together in good faith. They’ve both worked hard, seen some success and now one wants the other out. Perhaps they disagree over strategic direction, one might feel like they’re contributing more than the other or one person might want to leave for personal reasons. Co-founder fall outs are horrible because there’s usually so much emotion and blame involved. It destroys relationships and often destroys the company.

“That’s why it’s so important to put in place a co-founder agreement upfront. This is a simple document that should outline the responsibilities of each person, how important decisions are to be made (will one founder have veto rights over certain decisions?), vesting provisions for shares (usually four years), what happens if one founder wants to leave and what happens to their shares after they leave.”

Peter Dunne is a partner at Herbert Smith Freehills whose roster includes Atlassian, Canva, Safety Culture, Campaign Monitor, Deputy, CultureAmp and many more. Peter says: “I used to be very against founder vesting. If you’ve built your company together over several years, then you should own your shares. For example, when Mike and Scott raised the first round of capital for Atlassian, there wasn’t founder vesting. But they’d been together for eight years by that stage.

“It’s different for founders in the early stages of a company. Going into partnership is a leap of faith and giving equity to someone who doesn’t deliver is a huge risk. An investor will usually insist on founder vesting because they’ll want to know that all founders are motivated to stick with the business. And if you’ve had someone leave and they still own a chunk of equity then it’ll be harder to raise capital. An incoming investor will want you to ‘fix the cap table’ which can be difficult or impossible if the person has left the company.”

 

2. Too many shareholders can kill your business

It’s common for founders to be loose with equity at the beginning of a business. When I started Posse, which became Hey You, I gave shares to the guy who made our first logo, a family lawyer, web developers, a recruiter and several advisors. I’m sure if the office cleaner had asked for equity in lieu of fees, I would have agreed. There were 23 different investors in the first capital raise, and some wanted to split their shareholding between multiple entities. Before I could say ‘minimum viable product’ we had 50 shareholders and had to become a public company! Managing so many shareholders was not only difficult and time-consuming, it actually almost led to the collapse of the business.

Peter Dunne says: “Founders need to be careful of bringing onboard too many Angel investors early on, otherwise you can waste a lot of time giving investor updates. And if you do put together a group, then agree on one person to be the conduit. Send a quarterly update to everyone else.”

There are a few important things to consider as your cap table expands.
– Without special provisions in place, any single shareholder can hold the business to ransom. Most shareholder agreements are drafted so that 100% of shareholders are required to sign-off on amending the agreement. You might have agreed that X% of shareholders or just the board can sign-off on issuing capital, but often an incoming investor will require changes to the shareholders agreement itself – which means 100%. It may be possible to avoid this by having small shareholders sign Power of Attorney docs early on. Peter Dunne and My-Linh both recommend you seek legal advice to try to avoid this very common issue.
– A company with more than 50 shareholders must convert to become a public unlisted company. This happened to us and it was a huge headache. Our company needed to be audited every year which cost a lot, took loads of time and added no value to the company. There are a number of other annoying implications of converting to a public unlisted company outlined in this article by LegalVision.
– Investors hate messy cap tables. I’d often give great investment pitches and shudder at the end of the meeting when the investor would ask: ‘Send us the financial model and the cap-table’. I knew what the reaction would be. ‘How do you manage all these people?’ Investors like clean cap-tables so, going forward, they know they’ll be able to work with the founders to build the business, bring in further capital if required and make decisions without having to get consent from a phone book of shareholders. And if you’ve accidentally become a public company, like we did, that automatically rules out a lot of corporate investors and funds whose mandate blocks them from investing in a public company.

 

3. Too much dilution

Again, it’s easy to give away shares early on because the business isn’t worth anything. David Kenny from Hall Chadwick provides strategic advice to a huge number of start-ups and is an investor in Blackbird and mentor to Startmate. David says: “I constantly see inexperienced investors take too much equity early on. They’ll set onerous terms and often put in place a complicated structure.

“It’s likely that a company will need to raise several rounds of capital and create an Employee Share Plan so the founder is going to get diluted right through the life of the company. If you give away too much early-on, then it’s easy to become whittled down to 10% or 20%. At some point, this will be demotivating, and you’ll wonder if the company is worth it when you could start something new and own 100% again. Future investors will want to ensure the founder has a significant enough stake in the business to continue to drive it. If a founder is down at 10% then that’s a huge red flag and can make it difficult to raise further capital.”

 

4. Investor veto rights

Incoming investors will almost always ask for veto rights over certain decisions. They’ll present you with a huge list upfront and it’s a process of winding back this list throughout the negotiation. Peter Dunne says: “Be very careful which veto rights you agree to. Never give the investors the right to veto issuing shares. This could block you from raising further capital from external investors and the existing investors could force the founders to take further investment from them on worse terms.

“Before you offer any other decision-making veto rights you have to ask what the investor can add to the business plan that the founders can’t.” My-Linh adds: “It’s dangerous to give veto rights on running the business (business plan, key hires, budgets etc) to someone who isn’t working in the business day-to-day.”

“A professional CEO is a steady hand who will lead your company into a slow, calm, neatly managed death.”

 

5. Board control and replacement of the founder

Alan Jones is a Partner at M8 Ventures and mentor to Startmate, Muru-D and Blue Chilli. He was a founding team member at Yahoo! Australia and has more than a decade’s experience working with founders. “One of the top catastrophes for a founder is to be sidelined in their own business. This usually happens because they’ve given board control or a veto right over the appointment of the CEO to inexperienced investors.

“At the start, everyone is excited by the opportunity of the company. But when there’s a set-back (and there’s always something), the wrong investor will switch from being driven by opportunity to being driven by risk. They might try to liquidate too early or move a founder out to bring in a CEO they perceive as being experienced. This almost never works.”

If your board is considering replacing you with a professional CEO then check out this excellent post by Andreessen Horowitz on why they prefer founder led companies. They argue that a professional CEO will only maximise the existing product but won’t have the insight, risk appetite or moral authority to make sweeping innovations when required. And that innovation is the core competency of the business. A professional CEO is a steady hand who will lead your company into a slow, calm, neatly managed death.

Another issue is that a professional CEO is a red flag to future investors and could make it difficult to raise capital. Many funds will only back founder-led companies for the reasons mentioned above.

Alan’s advice is to make sure that you develop strong relationships with investors before you let them become shareholders in your company. “If investors insist on a board seat then make sure you either retain control of the board or, that there’s at least one credible experienced ‘safe pare of hands’ on the board. For example, if you can get investment from one of the top tier funds like Blackbird or Airtree, then you’d want one of those partners on your board. If you can’t get one of these funds onboard then find someone of similar calibre, form an advisory board and have them attend meetings as a board advisor. If you’re working with inexperienced investors, then you need to make sure there’s an experienced, sensible person at the table when the conversation gets tough.”

David Kenny adds: “I’ve seen too many companies get stolen from under the founder’s eyes. There’s a lot of naïve investors and founders who will put in place a board too early. A formal board before Series A is overkill.”

 

6. Convertible notes

A convertible note is short-term debt that converts to equity, typically in conjunction with a future funding round. The investor is effectively loaning the start-up money in return for the principal plus interest. Convertible notes are typically used in two scenarios: very early stage companies who don’t want to put a valuation on their idea and later stage companies who need to bridge financing between funding rounds.

In the very early idea stage of a start-up, it can be difficult to place a value on the company. The founder will think their idea is genius and worth a lot, and an investor might think that while the founder and their idea are promising, the company hasn’t built or proven anything yet and therefore isn’t worth much at all. Using a convertible note, instead of an equity round, can put off the valuation discussion till later when the next lot of investors, typically at Series A stage, will value the company. The founder and seed investor will agree that the initial funding will be on the basis of a convertible note (loan) that converts at the time of a Series A investment. Usually the seed investor will get a discount to the Series A investment (usually up to 20%) to reward them for taking a risk early on.

In the later stages of a business, founders will use convertible notes to bridge finance the company between funding rounds. Perhaps fundraising is taking longer than hoped and they need to bring in funding quickly, or perhaps the company is on the verge of launching a new product or partnership and wants to put off capital raising discussions till this happens. A convertible note is usually much easier to raise because it’s a loan with a pre-set time period. If the founder raises capital within the set time period, then the loan + interest will convert to equity at the valuation of the incoming money, again, usually at a discount.

The risk here is that founders are often optimistic about how long it will take them to close the next round of funding. My-Linh says: “It’s common for founders to underestimate how long it’ll take for the next funding round to close. If they miss the deadline then there’s a risk the note holders could call their loan and force the company into liquidation. They could sell the business just to get their loan back. We always try to renegotiate terms at this point, but the founders and the business is in a poor position.”

 

7. Liquidation preferences

Most investors will ask for a liquidation preference to protect their investment. In Australia, a 1X preference is standard. This means, on a liquidation event (any type of exit) the investor is able to have their money returned before any other shareholder (including the founders). If the company does well, and the return to the investor is to be greater than the amount they invested, then the return is spit according to the share register. But if the investor’s share of the exit is less than what they invested, then they can take the amount they invested out first before the remainder is split between other shareholders (including founders).

The investor’s argument is that they are risking their money. But the founder’s argument should be that they are also risking a lot – time, sweat and most likely significant forgone income. Why should the investor be protected over the founders, the employees and the early Angel investors?

David Kenny says: “The risk with liquidation preferences is that the company can actually do quite well; as the company grows the board will want to raise more and more money. Then the company might sell for $20M – probably not what everyone hoped but not a bad result. If the company has raised say $17M or more in capital, the investors will get their money back. The people who worked for years on peanuts and built a good business walk away with breadcrumbs or nothing at all.”

My-Linh says: “We come across this issue all the time. When there’s liquidation preferences in place and the company has raised significant investment, unless the exit is really big, the early investors and the founders end up with very little if anything.”

 

8. Understanding your cap table and the implications of how shareholding and rights play together

My Linh says: “A lot of founders don’t understand their cap table and how a change in levels of ownership impacts the rights in their shareholders agreement. For example, if you’ve got a drag-along right set too low (at say 50%) then you need to watch out for groups of shareholders whose ownership together reaches this point. If these shareholders have a liquidation preference, and no-one else does, then they could sell the company at a low price just to get their money back.”

My-Linh, Peter, David and Alan all echoed the same sentiments. “Founders are way too optimistic about how long it’ll take to raise money, to make sales, to hire key team members and to grow their business.” They’ll often leave fundraising until they’re desperate and accept bad terms, often from inexperienced investors. They’ll take-on a convertible note, believing they’ve given themselves enough time to close a subsequent round. They’ll be sure their company will be so valuable that a liquidation preference won’t matter, and they’ll seed board control and veto rights to investors who seem super nice and friendly people who are excited about their company.

The number one tip of our panel is to reference check an investor before you sell them an ownership stake in your company. Alan Jones adds: “Don’t just talk to the companies that they’ll direct you to. Go and find founders they’ve worked with that haven’t done well. Perhaps the company folded, or a professional CEO was brought in. Find out how this happened and how the investor acted under pressure. Did they take advantage of any veto rights to take more ownership in the company, did they continue to support the company in future funding rounds and how did they interact with the founders when the business faltered?”

 

To learn more from Zambesi’s panel of experts, come to our ‘Don’t get screwed’ event at Hall Chadwick on Wednesday 31st July. Tickets are $10 or $5 with the code ‘ZambesiMember’.

For an intimate workshop to plan your capital raising strategy which includes a small group legal discussion with My-Linh, join Rebekah Campbell’s ‘Raise Capital on your terms’ workshop in Sydney, Melbourne and Brisbane.