Episode Transcript

Jon: I've seen multiple founders in the last couple of months, and something I predicted is that most of the founders who previously raised money would go dry during the summer. And many of them, I think we're just hoping or assuming breadcrumbs would come in or they'd get their next round of funding. And I think sadly, what they realize that they should have listened to VCs 12 months ago when they said, start hoarding cash, change your model.

Jon: You know, make decisions now. I think the ultimate thing that I've seen or the hard reality is a lot of founders, we tend to be optimistic. And so when the world changed, we thought we were different. And so the question is, Peter, what what do we do now? And so we had a we had a private dinner with fintech founders about, what, about a week ago, two weeks ago.

Jon: This is one of the questions that came up. But it's also something I'm just seeing again and again where people are hitting me up what I do, who's doing bridge rounds. So let's go from there. What are your thoughts?

Peter: Yeah, no, I mean, it's it's a major issue, right? A lot of companies and it's largely stems from the fact that, you know, let's be honest, 2021 and even years prior, like tons of money flooding into the system, you had lots of angels that had made money on bets in the consumer tech wave that we're now kind of redeploying cash into startups.

Peter: And there was just a ton of money flowing into a ton of companies. Yes. That's like a huge number of people coming into tech coming in, you know, and then leaving tech and starting like large tech and starting their own businesses and so forth. And a lot of them were like first time founders, not a ton of experience.

Peter: And and so I think all of those things led to where we are today, where you have lots and lots of companies that raised pre-seed and seed rounds that, you know, haven't been through a recession before, haven't been through challenging times, believe and this is something I see a lot, is that entrepreneurs generally, we look at the last 3 to 4 years and say, well, this is like the status quo.

Peter: This is what's normal. And in my experience having, you know, been a venture investor for the last 15 years now, like I feel like the last couple of years have been like an anomaly. And so, like, there's this like big disconnect. And so it's not surprising that a lot of entrepreneurs are like, Hey, of course I'll be able to raise another round.

Peter: Of course I'll be able to get that valuation that I think I should get. Of course, like for the last, you know, over a decade now, everything has been up and to the right year after year after year. So, yeah, I mean, you've got a lot of these companies that have started up in the last little bit. They're running out of cash and all of a sudden there's not as much cash available in the market.

Peter: Now, I don't think that's necessarily because there's less cash today than there than like the long term average or whatever. In fact, if anything, I think there's a lot more cash than there has been historically. It's just the cash is sitting on the sidelines as venture investors have become super wary. They're watching what's happening in the public markets where like company valuations have come down substantially.

Peter: That then has turned investors upside down on their investments at the growth stages that then trickles all the way down. And as a venture investor, all of a sudden you got to be a lot more picky about which companies you're going to put money into because you don't know who's going to, you know, beat them on their next round of capital and so on and so forth.

Peter: And so like all of these things, like the fear and the uncertainty has just dried up. A lot of the cash that's arguably still there, just not as freely available as it once was. Anyways, so I just say all of that is like context, because I think it does inform to a certain degree. Like what do you do now right.

Peter: It's important to understand that, you know, a friend of mine, Kyle Harrison, wrote this article a little while ago about, you know, predicting that this would be a tale of two cities or a tale of two startups, that you would have some companies that were extremely well positioned, that were growing, that were doing really well, had a chief product market fit, were growing in spite of everything, had good efficiency on marketing and so forth.

Peter: And they were they, you know, they had been able to demand very high valuations. I think a very good example of that is the company with in the cybersecurity space that raised recently did so at a very high valuation. but phenomenal business. Right. And that was why And then outside of that you have everybody else. And the reason why you can have these tale of two cities is because you have all these people have a lot of money that are willing to that are chasing after quality, right?

Peter: There's this like flight to quality, even though it appears like there's not a lot on the other side. So if you're you're at the seed stage, you're a pre-seed, you know, what do you do? I think the first thing is to go, if it were me in my mind, I would go to my inside investors. Right. And and I think that's the first place you have to go.

Peter: And you have to basically convince those insiders that whatever money they put in to your company will allow you to get to the milestones and metrics that are necessary to entice new investors. And if we go back to this idea that it's like a tale of two cities, a tale of two startups, there is money out there.

Peter: There's a lot of money out there for companies that are absolutely crushing it right? And all the things that we talked about, like really strong product market fit, really good efficiency on marketing and so forth. But if you can't credibly achieve those metrics, it's going to be very, very challenging. And even if you can, it could be very challenging in order to raise, I think the challenge with seed and Pre-seed is that usually it's before you've achieved product market fit right?

Peter: And as a seed investor outside of the cap table, if I'm looking at that, it's like, do I buy in to this company that still hasn't achieved product market fit at arguably a higher valuation because they've raised a bunch of money? Or do I place my bet in a brand new startup? Right where it's it feels like the risk is similar, except for in one case, like there's a lot of deal fatigue.

Peter: There's a lot of you know, spent capital, there's higher valuations, there's different expectations. Right. And I can avoid all of that baggage if I just invest in a brand new company. and so that's why it comes back to like it used to be in 2021, it was just like, yeah, like we're growing, we're doing well. And there's another round of capital there for us.

Peter: and I don't, I don't really see that being the case anymore unless you've, you're really kind of achieving escape velocity. So. So if you go to your insiders, right, the hope is that they will come in at terms like, you know, a bridge round or something to help you along. The challenge you have is that as a seed fund, seed funds are in the business typically and not all the time.

Peter: There are a few exceptions, but for the most, most part they're in the business of placing a ton of bets and just hoping that a handful or even a couple hit it big right? And so they're more incentivized to just cut losses on the ones that are struggling and plow any additional dollars they have into the ones that are winning rather than trying to prop up, you know, the ones that are struggling.

Peter: So you kind of have that dynamic working against you as well as a startup founder. So that's where you might go to them and say you kind of dial up the risk, right? So you're like, Hey, look, if if you don't believe that we're going to win, you're going to write us off anyways. And in that case, we're going to kind of force your hand a little bit earlier.

Peter: So that can be an interesting tool that entrepreneurs will sometimes use. So maybe they do like a pay to play around. They basically say, Hey, you know what insiders you need to pony up to keep this thing alive. Or you need to acknowledge now that this thing is a write off and take the hit on your books.

Jon: Okay, So let's do the first thing. Go to the bridge round. If it were me, let's just say I've got company, Acme Acme Inc.. Yeah, sure. I would one identify. I do. I have product true product market fit is it need to have or nice to have. Yep. If it's a nice to have I would then say how do we get to a need to have fast if we can't I'd probably shut down.

Jon: Yep. Assuming I have a need to have. I wouldn't say what does it really take to get to the spot where we are? Venture or excitable or VCs would be excited to invest. Yep. Identify what those metrics are. I'm assuming at the same time I would try to cut costs by 30 or 40% if possible. Yeah. Ideally be someone would have done that 12 months ago.

Jon: Yeah. But I feel like that's not not happening. I think people felt like they got funded in the same things would continue. Yeah. And then I would offer a bridge around to my existing investors, probably a ten or 20% discount and, and just make sure that they like.

Peter: As a convertible note or a discount of the last round.

Jon: Price discount to the last round. So whatever the terms were last time, I'd make them probably 10 to 20% more favorable.

Peter: I think the problem with that, though is that like as a VC, why would I take that deal?

Jon: I think that's part of the penalty of a bridge around. Right? You're stating what you need to get to as a VC if you believe in the startup and that valuations have changed. So you're taking the 10% hit off the last round primarily because valuations have changed. Yeah, and it's in this way, but it.

Peter: Feels like valuations have come down more than 10 to 20%.

Jon: Okay, well then what you know depends on what you're saying.

Peter: So one of the things you have to remember is like what's going on in the VCs head, right? So they don't really want to take write downs in valuations. Right? Right. Unless they have to. And at a seed stage, it's almost like.

Jon: So they give them warrants like we talked about in previous episode something.

Peter: So you keep it, you keep it flat. I mean, what most VCs do is they do a convertible note and they kick the can down the road on valuation so they don't have to take a hit on valuation on their their books, especially if they're fundraising. Like, you really just don't want to have a whole bunch of zeros or down rounds pop up, right all of a sudden.

Peter: So you have that like dynamic, which is not a particularly healthy one, right?

Jon: But that would be one if I was going to existing or. Yeah, but you know, a new investor who's willing to do bridge around.

Peter: Yeah. Yeah. Now I agree. Look if you can like I said earlier, if you can get a bridge around done with your insiders at flat or even a slight down around do it 100% like that would be the very first option to explore. You can't do that. Then it's like, hey, can we find do we implement some sort of pay to play?

Peter: Right? Let's reward the people that do stick up and support us.

Jon: Right?

Peter: and if you can't do that, then and you've kind of tapped out other sources of capital, right? Maybe you do equity crowdfunding and try to go that route, you know, what have you. then, yeah, I think, I think you do. Shut it down. I'm curious, what are your thoughts like? I've had conversations with entrepreneurs where I've told them not to shut down and keep grinding and I've had conversations and I've told them to shut down.

Peter: well, as a founder, how do you think about like, how do you react to those types of conversations from, you know, advisors, investors, other founders like, Hey, shut down?

Jon: John I think if you look at my historical background, I operate more like a cockroach. Writers, it don't die and perhaps when I should have died. So I'm probably not the best person to give advice. I think a lot of it's situational. I think it depends if you have a family or not. It depends on did you really collect the data needed to make the right decision?

Jon: That really depends on how much they believe in it.

Peter: Yeah, but what if they believe in it like a ton, but it's just not happening.

Jon: And you need to believe, I think would be a good time to talk with a couple of inside mentors to say, Here's the data. Am I being blind or not blind? Yeah, I think strategic exits or mercy killings are always appropriate. Yeah.

Peter: And so what are the questions you ask yourself? Right when you're in that situation?

Jon: I don't think I've ever really been in that situation.

Peter: You've never been in a situation where you're working in a startup. Obviously not going to work out.

Jon: I think what happens is I said, this is what's happening and I've learned. And so some of the some of the new entities where you shut down one and started another one was really, Hey, I'm making a pivot, We're changing the team, we're changing the cap table. But in my mind, it was just it was the same, same mission.

Jon: It was just the people who started didn't want to continue. There was a pivot. But I feel like a lot that pivot was backed by market data, and so is how much do you believe in it? But I think it's always, whenever possible, surround yourself by people who are smarter than you and try to give them the information needed.

Jon: And then when they, you know, tell you to walk away, consider it heavily. And if they tell you not to consider that, but yeah, make sure that someone doesn't have the, you know, the confirmation bias.

Peter: Yeah, that's hard, right? It's hard to overcome confirmation bias.

Jon: And it's a super vague. Right. I mean, some people that you and I think should shut down shouldn't and vice versa. Sure. I mean, I've talked with some people right now. I said I would change the business model to this. Yeah. It would significantly change your margins. It makes you no longer a venture packable company if you make this pivot, but I think it's a great business that could be worth five, ten, 20, 30 million.

Jon: Yeah. And then you've looked out for all your investors. Sure. And I think in that case, that's their out. I would go with that company or in the meantime they're looking to get acquired for 20 to 30% of total cash invested.

Peter: Yeah. No, I mean, obviously every situation's nuanced, right? But just trying to think through like, what would be the questions I would ask myself to determine, you know, how much I really want to put into this going forward. Because I think I've seen other situations where, yeah, the entrepreneur, to your point, is kind of like a cockroach. They're just grinding year after year after year.

Peter: And I think we all know entrepreneurs that have been in that situation where they would have been so much better off just shutting it down, hanging the spurs and going, you know, picking something up new. Right. Instead of wasting time.

Jon: By their belief, those if you stay in a space long enough, you figure it out. Generally speaking, that maybe not all the though the case but if you if you take your punches. Yeah the market eventually teaches you to they're out to go.

Peter: Sure if you can survive that long.

Jon: If you can survive that long for sure. And if it's the appropriate risk.

Peter: But why? Why can't you learn all of those same things? Not in a startup.

Jon: I mean, you can learn a thing.

Peter: Why not just shut it down and and get a job in the industry and keep cranking away until you discover. So that person, that big thing.

Jon: I think and I think having a job versus being a founder is different.

Peter: That's true. No, 100%.

Jon: You're getting different. Beat your feedback cycle and your data set is very different.

Peter: Yeah, in both good and bad ways.

Jon: Yeah. So I think it's just it's, it's too hard to have a case by case. But I think the general rule was have trusted people who've done both, taken both routes. Yeah. Share the data, take them to dinner.

Peter: Yeah. I mean I think that can be helpful. I know I just come back to this idea of, you know, an earned secret. in that, like, do you, like, what? Do you know that's true that other people would disagree with you on. Right? And really spending some time introspectively asking yourself if what you believe to be true is actually true.

Peter: Like there's the data match. Can you, like, support it? Can you can you demonstrate like, hey, yes, there is something meaningful here, Right? And I think in a lot of cases people get enamored with like the idea of being a startup founder without ever like really pushing themselves and asking that question. But I think to the extent you can and say, hey, no, look, things are challenging now, but the core thesis of what we believed when we started this is still true.

Peter: Like we are solving a huge pain point for people. We just need to survive long enough to demonstrate that. Right? And I've got portfolio companies where or companies that I know and have met with that are in that bucket, right where it's like, Yeah, things suck right now, but we are still confident in the thesis that we originally put forward and if you can survive, you will thrive, right?

Peter: And then there are other companies where it's like, you know, we got behind this thesis and we were wrong, right? The data clearly demonstrates that we were wrong and we should shut it down or pivot to something else, right? Correct. So, I mean, I just had a conversation, last week with an entrepreneur that was going through that same thing.

Peter: You know, they, to their credit, like they had to convince their VCs to believe, believe them that they should pivot the business significantly. But they were like, look at all the data, like there's no promise land for us to arrive at, like we thought there was. and so that's why we think we should take the remaining cash and pivot into something more interesting.

Peter: And to their credit, like they listened to the VCs early on and cut a lot of their burn when they were told to, which gave them a tremendous amount of runway.

Jon: But that was an example of a company that had something similar. They had a thesis, the initial thesis look true. They raised, what, 5 million or more?

Peter: Yeah.

Jon: And then in the process, they realized the data set was no longer true. And then they shut down, returned the cash.

Peter: Yeah, well, in their case, they just returned the cash, Right? Instead of pivoting into something new.

Jon: They were searching for a pivot now, but I think they felt like they needed a sign off from the VCs on a pivot.

Peter: Yeah, I will tell you, that's it's kind of an interesting situation when a company returns cash, because on the one hand, it feels like the valiant thing to do. On the other hand, I don't know and I don't know many venture funds that are jumping up and down to get the cash back.

Jon: Okay.

Peter: And the reason for that is because it's like I put the cash out there, I get it back. I'm only going to get, you know, $0.50 on the dollar of what I put in. I almost would rather have them pivot into something new and use my cash to build something new that could be worth at least what I put in, you know, maybe more.

Jon: Okay.

Peter: but that feels like a very venture fund kind of thing to do, whereas I feel like individuals are different. So if it's like an angel investor, you have a bunch of angels, they probably want your cat the cash back. They probably would rather take the 50% back. Raise the funds are still like because they have a like very diversified strategy.

Peter: They're probably still swinging for the fences and would want you to pivot now like every situation's a little bit different. So I can't speak to every single one.

Jon: But obviously you have to check with your current investors. But what percentage of investors do you think would want you to run with the cash and return it.

Peter: To pivot into something new? I mean, obviously it depends on what you're pitching, right?

Jon: Yeah. But just as a general like.

Peter: Can have you found some new thing that's actually compelling?

Jon: Yeah. so what does that process look like? Do you want them? Let's just say you gave me $1,000,000. Yeah, I burned through 500 k. Now, the current model doesn't work. Yeah, but I believe the data shows something. Or I've got to believe. Would you want me to come to you or just run and do it?

Peter: No, I think you should go to your investors and have conversations with them. Right, Because entrepreneurship is not a one time game, right? Done. Well, entrepreneurship should be a multi.

Jon: Year.

Peter: Multi run game.

Jon: So recommendations talk to the b, C but yeah, but go with the expectation that a lot of VCs would rather not show the write off right now.

Peter: I think you go to pieces with the realization that if you can craft the story well enough they will support you and taking another swing at that most of the time less okay. And that could be because they really truly like they bet they backed you. So theoretically they should really like you trust you believe in you, right.

Peter: if you don't have that, that's that's a whole other conversation. They don't want to take hits on their their balance sheet, effectively write on their portfolio and you know, look in their mind the cash is already out the door. So let's, let's do something meaningful with it and let's, let's try to get to some sort of favorable outcome.

Jon: Okay. Let's talk about another example that, sure. That we know of someone who did. So again, no, no, no information that could be shared. Yeah, but this individual and the team realized that as a Y C back company, their thesis was wrong. And instead of returning the cash, they said they they believe most VCs don't want cash back.

Jon: Yep. And they took that cash and almost and they did an acquisition or technically acquired. Yep. But that company acquired them for the cash balance, which as if this individual was acting as a VC into this new entity. But so now it's how does we explain to the investors on a percentage of this individual's company who got to acquire a new company so they maintain like a 10% position in the new company?

Jon: I've never heard of that happening before.

Peter: That's kind of weird.

Jon: But you've heard about. You know what I'm talking about, right? Yeah. Okay. What are your thoughts or is that just a really unique scenario for that?

Peter: I mean, I don't know that I'm I'm curious how on board his investors or her investors were.

Jon: To.

Peter: Pulling that together because I don't know the idea of like acquiring another business through another entity just kind of doesn't.

Jon: Seem to explain it the right way is basically like a cash investment. Hey, I'm taking this cash that you gave me. Yeah, I'm taking it over here. We're changing the structure.

Peter: Yeah, but, like, owning, like, a much smaller piece of another company.

Jon: But it was a larger company.

Peter: Yeah, I don't know.

Jon: I mean, it surprised me, so that's not something.

Peter: I don't think that that's something most VCs would be jumping up and down excited about.

Jon: Okay, But if you can pull it, that was another way to add another thing to being the.

Peter: Such as, I guess, yes, it can work, but it's definitely onerous.

Jon: Okay, let's say you've raised let's say you raised like 1.5 million. You are kind of break even. Yeah. You have a company who wants to a competitor who wants to buy your revenue for $0.50 on the dollar. Okay. as one option. Option two is you can shut it down.

Peter: But you're close to break even. The best thing, if you're close to break even and you have a credible story of getting to break, okay, most investors will give you enough to get to break even.

Jon: Okay?

Peter: Because theoretically, once you get to break even, you have like limitless runway.

Jon: So technically, this scenario is probably less than break even. But they if they did some adjust, they made.

Peter: Some cuts, they.

Jon: Could get.

Peter: To break even.

Jon: Yeah, we're close to it.

Peter: I mean, that's the thing too is that like a lot of companies think that they can just cut to break even and they quickly find out like when you make cuts, it makes cuts in revenue and it makes it really hard to get to break even. Yeah, but back to your original question, like if you're in that scenario, I mean, I would try and get the VCs to put more money in to get you to break even.

Peter: Right? And to the extent the VCs, if the VCs basically say no, then what they're really telling you is that they don't believe that you can get to break even and that they would rather take the write off, then put more like good money after bad, as they say in the industry.

Jon: Okay.

Peter: So in that case, they probably will be pushing you to do some sort of strategic exec to get as many chips off the table as they possibly can.

Jon: In that case, should they take the let's say there was an offer for $0.50 on the dollar of your revenue. Yeah. Or you could get equity in a new company which runs on the company.

Peter: Depends on the company.

Jon: Right. But I think if it's.

Peter: If it's not like a good company with clear exit, you know, potential at a reasonable valuation, my impression is that most sophisticated VCs are going to want the cash.

Jon: Okay.

Peter: This is the same thing that happens with like like we did this deal like years and years and years ago. It was like one of my first deals, a company, you know, had a thesis, didn't really play out, ended up getting acquired in like this pseudo acquired deal. They, they had a bunch of these earn outs tied to it like earn outs like hardly ever hit, you know.

Peter: And so it was like, you know, the team tried to hit their hours but obviously kind and it was disenfranchized and then they left. And like the victim, you know, you get a whole lot for. So it was like, would I take a little bit more guaranteed with no or announce.

Jon: Or.

Peter: More with or announce I would take the guaranteed without or notes that makes sense. And so back to your question. Like I think about it in a similar light, right? If that company is, you know, like like I just saw another deal where this company needed to sell, there's another company who was going to buy it, but they were going to buy it at such with all equity at such an extremely high valuation.

Peter: That would have been really hard for investors to get any money out of it. And I think ultimately because of that, the deal fell apart because, you know, in this particular case, they wanted the investors also putting up some more money to support. Right. And it was just like I wouldn't invest in that company at a high of a valuation regardless.

Peter: So why would I do that like with this startup? So, yeah, I don't know.

Jon: What about the last option or something you talked about earlier is about the pay to play option.

Peter: Yeah, what about it? It's an aggressive move, so you have to be careful with pay to plays because when you do a pay to play, going back to what I said earlier, like it especially if you're first time entrepreneur, you want to play the game again and again, right? If you go to your investors and you say We are doing a pay to play, it's a super aggressive move, right as a founder.

Peter: And you're basically you've got to be willing to basically say, if this doesn't work out, I'm not going to be able to raise from these investors again, Right. Because I kind of stuck it to him with this pay to play. on the other hand, if you can get one of your investors to be quote unquote be the bad guy, right.

Peter: And lead the terms with the pay to play, then they can sometimes like take, take the heat and people kind of expect it because VCs want our sharks and to yeah. Are perceived as being, you know, very focused on financial gains and returns. Right. So that that would be like the best way to do it. Find a V.C. that or an investor on your cap table that still has high conviction and belief and you have them lead the pay to play, then you reach out to all the insiders and say basically like, look, company's going through a really tough time.

Peter: We are pivoting, we are doing whatever we want. You know, we're doing this round because we need to raise the money. And if you don't pony up right and support us now, then you're not going to get the fruits of supporting us now. So you can just like sit back on your haunches and let other people like, well, would.

Jon: High level bird in terms of I pay to play look like.

Peter: basic pay to play is something along the lines of if you do not participate at your pro rata, which is basically your ownership of the company right. So if you own 10%, I got to put up 10% of this new round, right? Yeah. so yeah, if you do not participate at your pro rata, then we take all of your prior investments, we convert them from preferred shares, have liquidation preferences, board seat rights, voting rights, like all of those things, right?

Jon: