No Thanks, Call Me When You’re Dead

It’s no secret that Mark and I work with a lot of start-ups. In this capacity we align closely with various accelerators, incubators, venture capitalists, bankers and the attendant flotsam and jetsam in the early stage capital markets.

All of the above mentioned folks are typically focusing on working to finance, build and bring value to young companies. Not often talked about is what happens when things go wrong.

What Can Possibly Go Wrong?

Oh, lots can go wrong, trust me. The stats are hard to ignore: 75% of all start-ups will never make it out alive. Founders of these companies will work extremely hard, probably put all their net worth into their companies, sleep infrequently, mortgage the house, forgo time with family and friends, possibly get divorced and yet they will still fail.

I sympathize with this plight. As an investor closely guarding my capital, I cannot and will not however put money into a “sympathy” play. Many years ago I made that mistake and I will not make it again. That can only ever end one way, and it is rarely good for either party. I can’t tell you how many times I’ve had founders say to me:

Oh but Chris, I’ve put all my money into this, I’ve worked my ass off and therefore my valuation/salary makes sense

Unfortunately that’s normally just not the case. As an entrepreneur you’re signing up for the “potential” to make a little or a lot of money but don’t expect it be easy, unless you’re in social media with good PR skills in which case you should probably take the money and run.

Right now we have one particular company whose metrics are quite simply kicking ass. The founder and management are taking zero pay and have done so almost from the beginning. We believe they’re on the cusp of something big. This is not because we want it to be so, but because the business is gaining a lot of traction. They have an awesome platform and yet with all of this they have struggled to raise capital. All the while we’ve watched absolute garbage companies raise funding at nosebleed valuations. Hey, who said markets or investors always act rationally? One of their failings has been not having someone on the board that can market, tell the story and raise capital on their behalf.

Then we have another company in our portfolio run by a young, very smart, driven gent who lived on his grandmother’s couch in order to self-finance and bootstrap his dream. The company has recently secured half a dozen high-profile clients, and their revenues and business have exploded. Then we have another company which Mark and I invested in many years ago which is likely to be taken out back shortly and shot. Things don’t always work out.

The fact of the matter is that as an entrepreneur, do you want to accept early-stage high-risk capital? If so, fine, but it shouldn’t be cheap. The higher the risk the greater the return required. Whether it’s a convertible note on a company with no tangible assets or straight up equity as a founder, you’re going to have to give up more than an already profitable company would. Don’t be pissed off. It only makes sense.

It is pretty rare for Mark and I to meet with founders who are NOT confident in their ability to conquer the world. We’ve had some who even when countered with solid factual data which invalidates their business models, remain steadfast. Call it confidence, call it cockiness or call it arrogance, it doesn’t really matter, entrepreneurs tend to have this trait. Quite frankly it is probably required to succeed, though from an investors perspective this all to often needs to be countered with experience, and a healthy dose of “sanity check”. Yet another reason we focus so intently on management.

Unless you’re a start-up building an app that will clean your fingernails or perform some other life-changing function, in which case now is the right time to go get you some silly Silicon Valley money, you’re likely going to have to deal with investors like ourselves. That means your small company which you’re placing a $5 million pre-money valuation on is probably, being realistic, more likely to get funded via a convertible note with follow on financing being done at substantially less than that especially if you’ve failed to gain traction. And sometimes as is the case with the company I mentioned earlier on, it’s best to let them die.

Which leads me to…

Bottom Feeders or Value Hunters?

There exist turnaround specialists or activist investors focused on corporate restructuring of larger yet unprofitable businesses. Sometimes unenthusiastically called “chop shops”, activist investors have made fortunes in taking unprofitable companies and selling off various parts whereby the value of the “parts” equal more than the whole.

Operating in a similar environment are turnaround specialists who focus on getting rid of wasteful practices, incompetent management teams and caustic investors that are destroying shareholder value.

Moving even further down the chain we get to those companies in liquidation. These are the companies which have done what so many start-ups do… fail. They’ve died of natural causes, or maybe they’ve been taken out back and proverbially “shot” by their VC or investor group. One can only hope that it was quick because it never is painless.

It was around this time last year Mark and I were pitched on a deal. It was an existing, relatively small business. The company was up for sale. The story was it was a consolidation and being divested from the core assets of the largest shareholder and owner. Digging deeper we believed otherwise and instead sat on the sidelines while a good friend and colleague kept a watchful eye on the proceedings.

About a month ago, together with our friend, we bought the company from the liquidators for less than 1/20 the original offering price. It actually made sense to buy it dead rather than alive, as we were really just after a few key assets.

The risk reward ratio has now dropped substantially. In some (not all) instances it’s actually far easier to paint on a fresh canvas than it is to take an existing, flawed painting and try redo it so that it’s perfect.

One of the most profitable strategies one can employ is buying during, or after a collapse. This is true of large stock markets, sectors and it’s equally true of individual public and private companies. It takes patience and a fair bit of guts, but the potential rewards if you get it right can be life-changing.

– Chris

I’ve got two quotes for you today. Both are from the recently departed Felix Dennis. I didn’t know much about Felix Dennis and was recently put onto some of his work by my friend Chris Mayer who writes the excellent Mayer’s Special Situations . I think they’re particularly apt for any investor to consider.

“I think having a great idea is vastly overrated. I know it sounds kind of crazy and counterintuitive. I don’t think it matters what the idea is, almost. You need great execution.” – Felix Dennis

“Good ideas are like Nike sports shoes. They may facilitate success for an athlete who possesses them, but on their own they are nothing but an overpriced pair of sneakers. Sports shoes don’t win races. Athletes do.” – Felix Dennis

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