January 12, 2023

In the venture capital industry, much is made of the massive winners (as well, of course, of those that raise a lot of money and subsequently bomb). The vast majority of founders, however, experience an outcome that falls somewhere in the middle of these two extremes. Learning how to maximize the exit value in these cases, when the company does not achieve product-market fit and does not break out, is, I would argue, a very useful exercise for both founders and investors. 

Recently, we made a seed investment in a highly technical founder that I admire. (The founder requested anonymity so I will not name him or his company). He and his team built a product in an emerging technology whose use case was compelling, but unproven. They identified two logical end markets (consumer retail and financial services) to go after, and, through connections and hustle, conducted over 20 POCs (proof-of-concept) in a short amount of time. For a variety of reasons (my view is that the product was too early for the market, but there were other reasons as well), the technology did not achieve product-market fit, and they did not convert any of the POCs. 

What the founder did next, was, in my experience, so unusual, that I wanted to write about it and think about any lessons that can be extrapolated and be of use to other founders that find themselves in a similar place. Often, when the product does not gain traction, a founder can resign him or herself to this fate and let the money run out and company wind down. Or they can try to raise more money and often fail because the proof points or series A milestones have not been achieved. This founder, on the other hand, was decisive and aggressive and engineered an exit. 

I am sure that some of his tactics may be useful to other seed stage founders: 

• As I mentioned above, the founder quickly conducted POCs to gather market feedback and try to sell his product. He worked in a couple of different end markets. He also iterated and added features to the product very rapidly for the later POCs.

• He very quickly concluded that the product/use case they had envisioned and built was not going to sell in a meaningful way. He came to this conclusion when he still had significant cash on the balance sheet (~40% of the cash raised from the seed round). 

• Given that he had recruited a strong technical team and built some good IP, he quickly struck a deal to sell the company to a larger strategic buyer in the space. The buyer was private, with plans to go public. 

• The consideration was not much more than what many would consider an acquihire price. The founder requested consideration to be paid in stock – AND – he very shrewdly pushed to be paid in common stock at the 409A price (i.e., a discount to the last preferred round). I have never previously thought of asking for such a request, but the buyer agreed to it.

The company did go public shortly after the sale, and when we ultimately sold the position, generated a ~2.5x cash-on-cash return. (The breakdown of the returns was approximately ~0.4x on balance sheet cash returned to shareholders, ~1x stock consideration, and ~1x stock appreciation from the 409A price to the publicly traded price at the sale.) Although this return is nothing to write home about, the capital was returned rapidly enough such that we could recycle the capital into the fund and re-invest it. All in all, it was a good outcome, and all of the founder’s shareholders were pleased.

It is worth pointing out that I am not in any way advocating that a founder needs to give up, that founder resilience is unimportant, or that significant product pivots are fruitless. To the contrary, I am simply advocating for rapid product validation testing at the seed stage and proactive and aggressive action to maximize returns even if the company does not break out.  

Some investors may say that what transpired above is bad financial outcome for a founder, as well as a fund. I disagree. I think it makes a big difference to a founder (as least those I want to work with) if he or she can make money for his shareholders or not, even if it falls short of a home run. As for investors (as well as their LPs) I understand the rationale behind the “go big or go home” mentality to some seed stage investing. I get it. But given the chance to get a multiple of your investment back and recycle it back into the fund and make 2-3 new similarly sized bets (vs. a likely loss, or even vs. never having done the deal to begin with), most investors and LPs would choose this outcome every time. 

I have great respect for the way this founder operated. He conducted himself highly ethically and with great deftness. He did right by his employees and his investors. If given the opportunity, I would 100% back him in his next venture.