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08/26/2005

When to Catch A Falling Knife

If you ask any public investor “When should you catch a falling knife?” their answer will invariably be “Never”.   That’s because public investors have learned over time that stocks in a free fall often continue falling all the way to zero, so you are better off selling now and buying back later.  Unfortunately, things are often not so clear cut in the world of Venture Capital.  The very nature of start-ups is that they are bound to have fits and starts and make major changes in product strategy, target markets, or business models, all in an effort to find the right combination of factors that will ultimately lead to success.

What this means is that VCs, more often than they might like, are bound to be confronted with the following situation: a once promising start-up that they funded unexpectedly falls on hard times and the VC must either invest more money in the start-up in an attempt to “rescue” it or find an honorable way to wind it down (which usually means a quick sale or a quiet shut down).

I myself have faced this situation several times and have also watched others suffer through it.  Despite the fact that I started out my investment career on Wall Street, where the saying “sell your losers and buy your winners” is often recited as Gospel, I can tell you that simply walking away from a VC investment is harder than you might imagine.  Some of this difficultly has to do with the fact that Venture Capital is, by its nature, an optimist’s endeavor, some of it has to do with the strong emotional bonds that many VCs build with their companies, and some of it has to do with the natural unwillingness to admit that you are wrong.

That’s not to say there aren’t times that a company clearly isn’t going to make it, but more often than not VCs face very tough decisions that are better served by careful thought than a black and white aphorism.  My own experiences with this situation have led me to develop several maxims for evaluating an investment in a falling knife.  They are:

  1. There must be significant changes in a company to warrant a new investment.  As the old saying goes, the definition of insanity is doing the same thing over and over again and expecting something different to happen.  To expect a failed business to turn around just because you give it more money is similarly insane.  The key to successfully catching the knife, is to recognize what aspects of the business are failing and to take immediate decisive action to change those aspects.  A significant corollary to this maxim is that firing the founders, or whoever else happens to be in charge, is not guaranteed to fix the problem by itself and sometimes may actually create new problems.  While it’s tempting to blame the founders for all flaws, the board must accept ultimate responsibility for the business going south.  Once the board takes responsibility, it’s easier to consider a much wider range of potential problems and solutions.
  2. There must be few if any legacy financial issues weighing the company down.   Even if you believe that the company has developed a great turn around plan, this will all be for naught if there are too many legacy financial issues to deal with.  Long term office space leases are a classic legacy financial issue.  For example, in 2000/2001 many start-ups found themselves saddled with wildly expensive long term leases for far more space than they needed.  While some landlords would cut deals to restructure, most would not, and this doomed many companies to  failure because the leases made them impossible to fund.  As a general rule, the bigger a company’s operating expense base and the longer it has been in business, the greater the number of legacy financial issues that you will have to deal with.
  3. There must be a strong foundation from which to rebuild on.  If the business is starting over completely with a new market, product, and team, it probably makes more sense just to shut the existing business down and create a new startup.  To justify the time and expense of a restructuring there must be some core assets of the business, ones that you couldn’t easily replicate with a “green field” startup, that provide a strong foundation for rebuilding the business. 
  4. The investment analysis must only focus on the future.  The easiest way to throw good money after bad is to justify the new money going in largely on the basis of trying to save the old money.  All financial analysis of an incremental investment should focus on the incremental returns.
  5. The partner on a deal must get a second opinion.  Unlike in the public markets where the best money managers have an unemotional, highly objective, and detached relationship with their investment portfolio, being a good VC almost requires a high level of emotional investment, something which is bound to cloud one’s judgment from time to time.   This makes it imperative for VCs to seek the objective opinion of their fellow partners when evaluating follow-on investments in broken deals for these partners can add a much needed reality check given their “fresh eyes” and relatively light emotional involvement.
  6. You must restructure the capital structure of the business with an ultimate emphasis on simplicity.  When constructing a “rescue” financing, you often face two choices:  A) Close an incremental round of financing on top of the existing capital structure or B) Restructure and recapitalize the company as part of the financing.  Option A is often the most expeditious because it requires less work, less consents, and does not upset the existing order.  Option B can take much longer but ultimately creates a more manageable capital structure.  In keeping with my post on how complex preferred structures often create more problems than they solve, I firmly believe that rescue financings should strive to ultimately reduce the complexity of the capital structure (even if that takes several step over time).

Now I don’t profess to be the world expert in successfully catching the knife (and I kind of hope I never am).  I’ve had some successes doing it, and I’ve also had some failures.  I do think however that these maxims can serve as a good foundation for evaluating whether or not to put more money  in a “broken” deal, as I know from experience that they can save you a lot of pain and suffering if you carefully follow them prior to putting more money to work.

P.S.  If anyone else has any maxims of their own they’d like to add, by all means add a comment.

August 26, 2005 in Venture Capital | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.