Don’t reward bad behavior in early stage startups!

For the last few years we have lived in an extra-ordinary time for venture capital. Early stage companies have been getting support from venture capital at unprecedented levels, and we have seen all kinds of headlines marking bubbles in seed, early stage and late stage investments. For a lack of better words, money has flown like wine into startups.

Availability of capital to sustain innovation and entrepreneurship is a good thing. However, the investing euphoria of the last few years also led to some careless, and possibly irresponsible, behavior among investors and entrepreneurs. Since entrepreneurs had an upper hand in investment negotiations, investors often caved in to terms that weren’t just bad for their interests, but also not beneficial to the entrepreneurs and startups as well in the long run. In my opinion it wasn’t just that ‘bad behavior’ was sometimes tolerated, whats worse is that it was often rewarded.

Some examples of such ‘bad behavior’ include:

  • investments in uncapped convertibles notes (some companies raised tens of millions that way before any priced financing took place)
  • investing in founders who sometimes wouldn’t even commit to full-time work, or agree to any period of vesting
  • lack of formal governance structures, Boards of Directors, or general accountability
  • no formal controls on compensation, expenses etc leading to startups taking on hefty liabilities (like real estate leases)
  • companies not hiring strong management teams, not investing in HR, patents etc, and not creating defensible moats around their companies
  • placing growth ahead of everything else, accepting negative gross margins for extended periods of time
  • ignoring financial controls and not understanding financial metrics (one company founder/CEO believed he had >100% gross margins)
  • not doing strategic thinking, and not sharing company strategy with entire team. Not creating KPIs, dashboards or such
  • not pitching with decks or any semblance of formal business plans/business models
  • ….

It is to be expected that not at all CEOs, especially first-time entrepreneurs, may know how above issues can negatively affect a company in the long run. In my opinion it is investors’ job to diligence such matters, and once invested to guide/advise/mentor entrepreneurs in instituting best practices in their companies.

But many investors didn’t do so over the last few years. They were too busy chasing the next shiny item, and didn’t want to burden themselves with the tough/hard work of helping entrepreneurs actually build their companies carefully. Worse still, even when they noticed signs of bad behavior, some investors rewarded entrepreneurs by throwing even more money at them. What is an entrepreneur to make of the situation the way they run their companies is rewarded by their investors? It reinforces their behavior, and any bad behavior eventually becomes ingrained in the company’s culture.

Unfortunately things don’t always go so well. Some times the macro-environment shifts, and some times a particular company’s circumstances change. For example when competition kicks into high gear, when hiring becomes tough, operational flaws lead to significant cash burn, feature creep and geographic creep becomes expensive burdens to carry forward, cap table gets too complicated, when funding dries up or a down round happens, when employees start leaving, and months of runway left suddenly starts to become the most important metric…that’s when how a company is organized truly matters in whether they are able to manage themselves in crisis or not.

My rant above is not to chastise anyone. But it is definitely to encourage investors to play a more active role in helping their portfolio CEOs, especially first-time entrepreneurs and CEOs, build cultures and corporate structures of excellence. Help CEOs identify mistakes they may be making early on, and help find solutions. Institute good governance, advise CEOs to set up formal Boards, focus on HR processes, don’t encourage foolishly priced rounds, promote transparency and trust, and proactively share best practices/KPIs/dashboard templates from other companies in your portfolio. Finally, cultivate a trusted partnership, provide mentorship and coaching to your founders, and enable a supportive network of peers in your portfolio. Entrepreneurs deserve to get this from their investors.

Related post: Friends Don’t Let Friends Have a Lazy VC/CEO Relationship