The champagne times are over in startupland. With stock markets and economies weak, startups are finding it harder to raise. And investors are more cautious.
This kind of market turbulence is new for many members of Europe’s tech ecosystem; back when the dotcom bubble burst, Skype — arguably the region’s first big success — didn’t even exist. Given that lack of experience, the few old tech hands around say there are things startups should be looking out for but likely aren’t aware of.
One of those is how board dynamics — and the relationship between founders and investors on the board — can change when a startup hits hard times. In a worst-case scenario, board conflict can result in founders being pushed out of a business.
But what exactly should founders and investors be careful about?
Downrounds and liquidations
Startups are governed by boards that can include some or all of the founders, and usually representatives from major investors like VCs. The board votes on strategically important issues like budgets and fundraising. The majority of European early-stage companies have between four and five board members, according to law firm Orrick.
The dynamics can get trickiest when startups are faced with tough situations like poor performance, which means they may have to raise money again at a lower valuation than the last round — called a downround. We’ve seen some very public downrounds this year, including fintech giant Klarna’s 85% valuation drop.
In these cases, decisions about funding or even selling the business can benefit some shareholders over others, leading to conflict.
“In a downround scenario, the misalignment of economic interest is a common challenge — not only between investors and founders but also between investors that came in at different stages as well as potential new investors and existing investors,” says Speedinvest general partner Mathias Ockenfels.
“But those horrible things are fundamentally necessary and they are in the name of one objective: being in control of your company, and that is really, really important”
He says that misalignment can “paralyse the board” — for example if there’s a tie in a board vote, leaving the group unable to take a decision.
In another situation, founders can lose control of the board completely, leaving them at the mercy of investors who might try to remove them. That can happen, for example, if the startup raises from existing investors in a downround but only some of the investors participate in the new round. That can skew ownership and control to one investor, who might negotiate for another representative on the board or argue for others to leave the board.
While additional money — even at very unattractive terms — can seem too good to pass up for a founder under stress, “most people can avoid getting themselves into this predatory environment by saying, ‘I don’t want the money. We’re fine,’” says Chris Wade, partner at Isomer Capital.
That can mean “horrible things” like founders having to fire staff or take pay cuts.
“But those horrible things are fundamentally necessary and they are in the name of one objective: being in control of your company, and that is really, really important.”
Board member advice
Those kinds of nightmare situations are, of course, often hypothetical. But there are still things that founders can start doing today to avoid the worst.
First, startups should now be prepared for increased “interference” — i.e. more questions about strategy and financials — at the board level, says Praetura Ventures managing director David Foreman. “It’s natural in a state of heightened alarm. Everything is a bit more real.”
“You really want to be having a conversation with people who can make decisions for you. You need to know what the firm thinks rather than what the investor thinks”
He says startups should also pay particular attention to the VCs on their board — especially if they foresee needing cash soon. Sometimes the VC on a board might not be one of the most senior people at his or her firm — which can be a problem when a founder needs a straight answer on whether or not a VC wants to continue to back them.
“You really want to be having a conversation with people who can make decisions for you. You need to know what the firm thinks rather than what the investor thinks,” he says.
Working towards profitability, which frees startups from the need to depend on outside capital, can also be a powerful step for founders to secure control over the board and the company in the long term, says Isomer’s Wade.
General advice for working with boards
But it’s not just founders who need to be prepared; VCs who may not have experience working extensively with companies that aren’t performing well should also remember their role.
“VCs don’t have a moral obligation to follow-on” and provide more capital to a company that is not performing well, says Praetura’s Foreman. “But I do think they have a moral obligation to try and get a good outcome for everybody.”
“Typically and unfortunately, few investor board directors are willing to ‘roll up their sleeves’ and get their hands dirty when things get tough”
Ockenfels of Speedinvest says that it’s also important that one or more members of the board works closely with founders and management to improve performance. Advisers with fresh perspectives — like future board members from new investors — can also be valuable resources here, in his view.
“Typically and unfortunately, few investor board directors are willing to ‘roll up their sleeves’ and get their hands dirty when things get tough. This can happen for multiple reasons, including a lack of time or even a lack of confidence that the startup can be turned around,” he says.
“But as long as someone on the board is willing to put in the time and work to come up with creative solutions to give founders the support they need, the effort (more often than not) does pay off.”
Eleanor Warnock is Sifted’s deputy editor and cohost of The Sifted Podcast, and writes Up Round, a weekly newsletter on VC. She tweets from @misssaxbys