The illusion of investor leverage

When an investor believes that a portfolio startup which is raising money isn’t performing well due to poor execution, they have two options. The first is to not invest in the company’s next round of funding. The second is to invest but with conditions which require that the entrepreneur change their execution to reflect what the investor believes needs to get done.

In theory, the startup’s need for capital gives the investor leverage to implement the changes that they believe are necessary for the success of the business. Examples of such changes include a change in the company’s product, different hiring practices, and a reduction in the company’s burn rate.

There are two ways in which these changes can be implemented. The first is by communicating them verbally and trusting that the entrepreneur will put them into practice. The second is by making the release of new capital contingent on the company hitting milestones which show that they’re making progress in the investor’s desired direction.

If an investor is considering the second approach, I think the plan is doomed to fail from the start. The reason is that this approach clearly shows that the investor doesn’t trust the entrepreneur, and this is likely to kill any motivation that the entrepreneur has to execute on the plan. Without the entrepreneur being motivated and taking ownership of the changes, they’re unlikely to be implemented in the way necessary to successfully change the course of the business. This is why we don’t use this approach.

We have, however, tried the first approach of communicating the changes we’d like to see to the entrepreneur and trusting that they will implement them after the round. Unfortunately, this approach also rarely works. Although the funding round does give an investor theoretical leverage over the future direction of the company, as long as the entrepreneur remains in charge of the execution, these changes fail to take place with the conviction necessary for them to produce successful results.

The company makes some of the product changes you agreed upon, but since the entrepreneur doesn’t believe that the changes are necessary, the new features are half-baked on release. The company changes its hiring practices on paper, but since the entrepreneur doesn’t apply these new practices in their own recruiting efforts, other members of the organization don’t either. The company does reduce its burn rate, but only by removing those costs which are negligible to the business, without making the deep cuts that are necessary for the business to increase its runway.

The bottom line is this. While a new funding round gives an investor theoretical leverage over where the startup is headed, this leverage, whether applied verbally or on signed paper, is unlikely to change the course of the business. The leverage is just an illusion. To the contrary, the fact that the investor believes that they need this leverage to fix things is a strong signal that they shouldn’t participate in the round.