Monday, August 8, 2016

Are your investors double dipping in your startup?

I've been working with a number of small companies this year. I'm on a mission to help CEOs, especially women, figure out how to grow their businesses, manage their investors and boards and to create a level playing field for themselves.

But as I have spoken to some of these CEOs I've seen several data points which are very worrying, and which I hope don't make a line! These data points are investors putting money in to companies, and then taking the money back out for services - so effectively reducing the cost of their investment. Double dipping.

For example.... The professional service provider:

This is the case for a small software company, lets call them W. W has developed a software technology to improve building management, and so reduce insurance costs. It wasn't an easy company to raise money for and in the end the CEO raised from angels, one of whom invested $480k. Nice.

But he then turned around and sold W the development service to create the product from the technology for $490k. He didn't require it, but it was "expected". Assume a typical margin of 50% then the service cost for the angel to deliver is $245k and he has a profit of $245k. So he got $480k worth of equity in W for $235k. And to make matters worse, when the product delivery was not to the satisfaction of the CEO she found it very difficult to push back on him in the way she would have been able to push back on an independent contractor. It's awkward to say the least, but I think it's what in a public company would be called a related transaction - it is simply not independent and so has the potential for conflict of interest.

The investors with a side business:

Another small app company, raised money from an angel group. The angel group has a strategy of creating an ecosystem from their companies, and providing services to them to drive the market adoption. But, unlike the old school VCs like Mayfield and KP, or even the new large scale guys like Andreessen Horowitz, this group turned around and charged the company (which had only raised $1.5M) $11k/month for marketing. That's $132k per year - which could have been spent on another engineer or a lot more marketing consulting from an independent.

The board member who wants a salary:

This time a technology company in the security space. Killer technology, but a turnaround from a prior (not-well-run) incarnation so raising money was hard. In the end money came in from a PE firm. But after the close the PE firm put in an executive chair to "help" and insisted he be paid $180k a year for a few days a week. Now I am supportive of a board deciding a CEO needs some help and adding in an exec chair if the CEO agrees (or even if she doesn't if it's really needed) but to pull a salary out of a company that is not profitable is very tough on the company. And in the end it's not in the best interest of the investors; it doesn't make sense.

I wonder if I have seen a few outliers and this is not the new normal, or if this is a new trend? Is it a result of the number of angel groups out there who are not professional investors (and so to give them the benefit of the doubt we could assume they don't realize the impact of what they are doing), is it a result of the tightening of investment (and so they can get away with it) or it is a result of the simply huge number of startups and first time CEOs who can be taken advantage of? If you have an example in  your own company inmail me on LinkedIn.

1 comment:

Anonymous said...

I was once one of five founders in a startup. The angel investor helped us find office space. Turns out he was getting a kickback from the landlord. This continued to ever greater amounts as the business grew and needed more space. The office furniture and equipment was leased from a related company.

Unsurprisingly the startup collapsed. The angel was pulling money out faster than we were making profits.

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