So many promising startups fail for the wrong reasons and many groundbreaking technologies languish as a result. One of the most common sources of failure begins when an entrepreneur clashes with or simply fails to communicate effectively with the outside members of the company’s board of directors. This fragile dynamic often spirals downward rapidly and the predictability with which it does would be comical if the costs were not so high.
Trouble starts when the founder retains both a board seat and a large block of common stock and, therefore, a great deal of control even if the investors buy a preferred security that specifically includes things like protective covenants, board seats, and other preferences.
The founder welcomes the additional money but bristles at the oversight and control that accompany the funds and either makes a unilateral decision that catches the board off guard or withholds key information that the board views as critical to their investment thesis.
The best policy for the company requires that all parties keep their egos in check so that an open and honest exchange can occur between management and the board. Running a startup is demanding and unpredictable. Successful businesses find ways to avoid emotional pitfalls so that everyone’s energy can focus on growth.
The following list captures some of the more glaring items I have seen foisted on a new board. In each case, the damage to the company proved fatal.
- “Good news! Now that you have invested I have a new car and apartment.” A Series A investment should not be considered a liquidity event, even if it somehow improves your income (it rarely does). Your investors want their money to go towards the company and will react very negatively if they suspect that you see their decision to fund as an opportunity to advance your personal lifestyle.
- “Sorry, the technology needs a bit more work than I may have indicated.” Never oversell either the potential of your invention or its proximity to the market, even if you think you can successfully obtain a higher valuation. You will pay dearly in subsequent rounds if you over promise and under deliver on the technology.
- “By the way…in the early stages I lent the company several thousand dollars and I would like to be paid back.” Nothing irks VCs more than “founder loans” except undisclosed founder loans that always seem to appear right after the closing of a funding round. The investors want their funds to be spent on initiatives that will provide for future growth. Any payments that flow to past liabilities deviate from this mission and will be heavily scrutinized. Be prepared to accept equity in lieu of cash if you are a founder who funded the early days of your company with direct loans.
- “But he/she is a friend of the company, we could not launch without him/her and I promised 2% of the equity if we ever get funded.” Fully diluted means fully diluted. New investors want to know about every potential source of dilution before they put any money in the company. There is nothing to be gained from withholding any information about the company’s cap table and, if you do and you close on a financing round, you will very likely be in immediate breach of the representations and warranties in the newly executed invest documents. Nothing kills the spirit of a new venture faster than a looming breach of contract claim.
- “The Code? Well, I didn’t write it, my sister did, and she just moved out of the country.” Another surprise that carries serious risk of liability for both you as a founder and your company. If you represent (or even give the impression) that you either created or have full control over the company’s key intellectual property, the investment documents will likely reflect this and, once again, you will be in breach if your assertions prove false.
Finally, entrepreneurs need to remember that when you accept an outside investment you become a steward for both the actual dollars and your investor’s reputations. Your VCs do not work in isolation and need to defend the case to invest in your idea to their partners, the limited partners in their funds, and the tight knit community of early stage investors. They will defend their reputations doggedly and will come down hard on founders who they view as abusive. Your best practice as a founder: foster open and honest communications with your board from day one and avoid the distractions that arise from internal squabbles.