Seed investing is a dangerous game. There’s a long road from a company’s launch and it taking its first investment to its eventual success. While some make it, many more don’t. Of the roughly 30 companies whose first funding round we participated in, 3 of them have already closed shop. And that’s in the 3 years since we started investing. From a statistical perspective, we know that there will be other casualties along the way.
The ultimate reason why a startup shuts down is most often because it runs out of money. There are rare cases when a startup decides to shut down and return money to investors even though it still has runway, but most often the founders try to make something happen as long as there is money remaining in the bank. All the other reasons commonly stated for why a startup fails, like slow growth and poor economics, aren’t fatal as long as investors are willing to continue financing the business.
The first step in a startup running out of money is often when an existing investor states that they’re no longer willing to finance the business. Founders usually speak with existing investors first and try to secure a term sheet for the next round before speaking to potential new investors because the vote of confidence signaled by having a term sheet in hand from existing investors makes it easier to get alternative offers. So if an existing investor isn’t willing to at least make an offer for the company’s next funding round, this may signal the beginning of the end.
Having invested in the first funding round of roughly 30 companies, we’ve been in a situation where we weren’t ready to continue financing a business 6 times. This number is higher than our 3 failed seed stage investments. The reason is that sometimes founders are able to raise money from other investors even if we’re no longer willing to fund the business.
The reactions of founders after their existing investor tells them that they’re no longer going to finance the business fall into two buckets. Founders either continue to fight for new funding or they give up without a fight. Of those that continue to fight, some are able to raise money from new investors and some aren’t.
Even if they ultimately fail, how founders go down says a lot about their character and their belief in their business. There’s a big difference between going down fighting, while leaving no stone unturned, and going down without having done your best to keep your business alive. I like the former.
Taking this a step further, asking how a founder will go down if things don’t work out is a valuable input into an investor’s original investment decision. You can’t predict this with full certainty, but you can develop an informed hypothesis. And backing a founder who you believe will go down fighting is a great way to make better investments.
Also published on Medium.