‘Gracious exit’: Investors offer some struggling founders to close up shop and return funding
A growing number of investors have begun to suggest that some VC-backed startups that haven’t yet found their so-called product market fit are throwing in the towel. Their argument is that some startups have simply raised too much, at valuations they will never expand into, and that clean, well-planned exits are better for everyone than messy exits. After all, the money could be invested in something more impactful. Importantly, founders’ time could also be spent on more productive endeavours, dramatically improving their mental and emotional well-being.
It’s a reasonable proposition. Working on something that isn’t working can be overwhelming. Still, we’re not sure many founders would quit their companies right now for a long list of reasons. Among them: Fundraising is tight, so raising funds for another startup is not a given. It’s a lousy job market, and most founders feel pressured to take care of their employees. Some very strong companies were born out of kingpins, including the famous Slack, whose team initially sought to create a game called “Tiny Speck”. Finally, if investors have given founders too much money in recent years – and over $10 million for a company with no product market fit seems like too much money – it’s really their fault.
Wanting to explore the matter further, we reached out to renowned trader and investor Gokul Rajaram today, who watched last night in a Tweeter that “(m)all founders who raised large sums of money ($10m+) in 2020-21 but later realized they didn’t have (product-market fit), go through currently on an excruciating psychological journey”.
Rajaram – who sits on the boards of Pinterest and Coinbase – had added on Twitter that an early shutdown could be a “graceful way out” for stressed founders, so we asked him if that was practical too, given of the current market. He explained why this is an email conversation, slightly edited here for length:
VCs aren’t letting their own investors off the hook by cutting the amount they’ve raised, but they want founders to return some of their funding. Do you see a connection?
That’s an excellent question. I don’t think the two behaviors are related, at least not yet. Now, if you told me that VCs were starting to return capital to LPs, I could see parallels. VCs would return capital to LPs because they don’t see attractive investment opportunities that fit well with their mandate, fund size (and so on). Founders who return money do so because they can’t find business ideas that fit well with their skills, team, customer focus, etc.
Do you think pivots are overrated or that there’s only a certain number of times a company can pivot before it’s clear there’s something wrong with the team itself?
Many great companies have been formed from kingpins. Twitter (Odeo) and Slack (Tiny Speck) are two examples of amazing products and companies that were created as a result of pivots. In my experience, most founders, when they realize the initial idea has no merit, try at least one pivot, either solving a different problem for the same set of clients or using their previous knowledge, life experiences and skills to solve a different problem.
Every pivot has a psychic impact on the business, and I don’t think any business can do more than, say, two pivots before employees start wondering if there’s a way to the madness and start to lose faith in the founders. If it’s a two-person business that hasn’t raised a lot of money, it can continue to spin forever. The more people – and capital – involved, the harder it is to pivot after pivot.
What reasonable amount of money should be spent to find a suitable product for the market? In response to your tweet, many people noted their astonishment that companies without suitable product-market that received so much funding in the first place.
In general, the rule of thumb is that your seed cycle should be used to find (product-market fit). This therefore represents 2 to 3 million dollars in capital within a reasonable time frame. What happened is that in 2020-2021, some companies wrongly thought or assumed that they had (product-market fit), possibly due to a change in behavior induced by the COVID.
Second, there was FOMO/excess capital looking for “hot” deals. So during these 2 years, we moved away from the barriers of the fundraising scene that had been the norm for several years.
It’s so much cheaper and easier to find (commodity market) with no-code tools – I strongly believe that for 95% of software products, you can figure it out without writing a line of code. That’s a discussion for another time.
Other than perhaps immediate relief, what are the benefits for a founder who throws in the towel and gives back some of the money they raised? Is the argument that they will gain the trust and respect of investors and thus improve their chances of raising funds in the future?
This is exactly the point of trust. I believe you gain the trust of your investors because investors are more convinced that the entrepreneur is able to think clearly if he multiplies the value with the time he devotes to it. Time is the ultimate currency for an entrepreneur. If they are unable to convert the time into increased net worth, at some point the business must go out of business or be sold.
I did not participate in capital repayment scenarios before this cycle. I know of a company that returned 70% of its capital in the 2001 cycle after everything closed, and one of the co-founders managed to raise a successful round a few years later, but I don’t know if he was it correlation or causation. That said, investors are clear-headed about the sunk cost fallacy, and I don’t think the odds of funding change depending on whether or not you repay principal.
Do you think going all the way – running out of leads – hurts a founder’s chances of raising money for another company later on?
No way. If there’s one thing investors love, it’s an entrepreneur whose previous startup wasn’t very successful – whether the entrepreneur ran out of money or paid money back does not matter for the calculation – but who still wants to build something huge and ideally related to the first company. Returning the money shouldn’t be seen as a shortcut to raising your next round of funding, but rather to escape the psychological cost that endless pivoting places on founders and other stakeholders.
The decision of whether and when a business closed was a decision of the board of directors, right? I wonder if the VCs gave up so many of their rights as they issued checks in 2020 and 2021 that they can’t shut down businesses as easily as before.
If something unethical happens – like founders taking crazy salaries – investors and board members have a fiduciary responsibility to step in and stop it. However, if they’re just founders putting their professional lives on the line and making bets — in other words, kingpins — most investors will let them keep fighting until entrepreneurs get them. themselves decide to give up. After all, an entrepreneur only has one business, while an investor has a portfolio.
What investors could do better is provide a safe space for entrepreneurs, let them know that it’s okay to return money or close the business, that the option is entirely theirs but it’s is an option available to them, that they are not letting anyone down by doing it. This is by no means a scarlet letter about the entrepreneur.
Do you think there is increasing external pressure on founders to return money based on conversations you have with other investors?
It is self-imposed pressure by the entrepreneur. The bigger the round a contractor has raised, the higher the expectations. I think businesses will have a few choices over the next few months. A.) If they don’t have (product-market fit) and haven’t raised a lot of money, they will have no choice but to walk out since the company is out of money . B.) If they don’t have (product-market fit) but have raised a lot of money, they may try to pivot once or twice, but after that everyone is tired. Likely exits in this scenario could be an acquisition-hire, liquidation, or small acquisition. C.) If they have (product-market fit) and raised a lot of money but the valuation is inconsistent with traction, the company may need to take a downturn.
GGV’s Jeff Richards had an excellent job stating that companies with the highest employees (net promoter scores) were the ones that raised a negative turn. Isn’t that interesting? There is a palpable relief once you no longer have the Damocles sword of your mad assessment hanging over you. I think that’s the other conversation investors need to have with entrepreneurs. This is not the end of the world.
I imagine many founders don’t want to give capital back, because in today’s market, that means more people might struggle to support their families. Any advice to founders on this front?
I firmly believe that companies have a duty, an obligation, to treat their employees well. And I think making an early decision to close the business means there are more severance packages that can be given to employees. The longer you wait, the less money there is to help employees through a period of transition.
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