We Told A Founder To Shut His Company Down And Take Our Money With It - 10/29

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📰 Today's Edition: We Told A Founder To Shut His Company Down And Take Our Money With It

A portfolio founder came to us recently and said he thought the best move was to shut his company down.

After talking it through with him, we encouraged him to do exactly that. Which means we take a loss on our investment.

That probably sounds backwards. It makes complete sense once you understand how venture math works and why hanging on costs everybody more than the loss does.

Why does portfolio construction beat picking?

More than dealflow, and more than picking ability at pre-seed, portfolio construction is the single thing that determines whether you succeed as a startup investor. It's also what lets you sleep during rough markets.

Over nine years of investing we've watched companies go from zero to unicorn and back to zero. We've watched obvious losers turn into winners. We've watched clear winners quietly wind down.

Predicting who wins is extremely hard, so you build the portfolio around the assumption that you won't know in advance. Good venture investing is a set of probabilistic constructs. Throwing darts and hoping just looks similar from the outside.

What is a pre-seed company, really?

Every pre-seed company in our portfolio is an experiment.

A founder has a thesis. Over the next one to two years, you set out to either disprove that thesis or produce enough evidence that it looks promising. That's the whole job at this stage.

What we see constantly is founders and investors dragging the experiment out far longer than the evidence justifies. You don't need $5M and five years to disprove a thesis. You don't need to pivot ten times trying to force something to work.

Treat it like a science experiment, and be willing to end it when the result comes back.

When is it time to wind down?

Three conditions, and when all three are true you have your answer.

a) You've done the best you can at experimenting and iterating on those experiments.

b) There just isn't a business there.

c) You've lost morale.

If that's you, there's no shame in winding the business down. Stop spending your life on this one and go do something else. Maybe you start another company immediately, maybe in five years. Either way it's a different experiment with a different set of hypotheses, and it deserves a fresh run.

The reason people stay past this point is loss aversion, and it hits both sides of the table. Founders are afraid of letting people down: their investors, their team, the friends who congratulated them when the round closed. Investors are afraid of losing money and want to claw back whatever they can.

Both instincts feel responsible. Both usually make things worse. Founders invest their actual lives into these companies, and it's painful to watch someone keep pouring time into something when they already know the answer and are waiting for permission to say it out loud.

Why doesn't clawing your way back to 1x help?

This is where new investors go sideways. They hang on hard to the hope of getting back to 1x on an investment and do increasingly strange things to engineer it.

At the early stage, the difference between a company that returns $0 and one that returns 1x your money is close to nothing. It gets completely overshadowed by the 10x, 100x, and 1000x returners in the portfolio.

The corollary is the uncomfortable part. You cannot have a good fund without those outsized returns, so if you're trying to build a good or great fund, by definition you don't care much about 1x.

Pull up a portfolio model and run it yourself. Replace a zero with a 1x anywhere in the portfolio and watch how little the fund number moves. Then replace one of the small winners with a 100x and watch the whole fund change shape. That gap is the entire argument.

Meanwhile the time spent resuscitating a company that should be wound down is time not spent finding the next 100x. It can also hurt your reputation, which hurts your future dealflow.

What do investors remember when a company dies?

How the founder did it.

Was the founder transparent with us? Did the communication hold up right through the hard part? Did it feel like they stewarded our money well and ran honest experiments with it?

We have backed plenty of founders whose first companies didn't work. But only where those two things were true. If a founder was too spendy, or went quiet and ghosted their investors, that's the end of the relationship.

There's an irony here. When things are going badly, communication matters more, and that's exactly when most founders go dark. These are the moments where some founders shine, and those are the ones we know we'd back again on sight.

We also pay attention to how people get treated on the way out. Are you helping your employees land somewhere good, with intros, references, lead time, and honesty about the runway? Are you helping investors get back whatever cash is actually there, selling assets where you can and avoiding frivolous burn in the final stretch?

That returned cash won't move the needle on anyone's fund. The actions tell us what it's like to work with you, and whether we'd want to do it again.

Which brings it back to the founder who came to us about shutting down. We lose our money on that one. He came to us early, he was straight about where things stood, and that is the part he actually controlled.

It's also why he'd have no trouble getting another check out of us for whatever he builds next.

Until next time,

Dunky, the "knows when to fold" hippocorn

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