When people ask me for a single piece of business advice, I always say the same thing: Never, ever run out of money. And that goes for everyone involved: the startup and its investors.
When there isn’t enough money around, things get … let’s just say—weird. On the startup side, weird comes in the form of a “cram down.” Say the company’s product is flailing in the market or, worse, can’t get to market. The existing investors are loath to pour more money into it, and when they do, they demand more than their fair share of equity in exchange for the needed cash. The best a company can hope for is a transparent deal that motivates it to achieve specific goals and then rewards it with more favorable terms if successful.
Sadly, these types of punitive investments are common, but company founders can take comfort in knowing that such investors quickly earn reputations that keep them out of future deals. Call it karmic payback.
When a company runs out of money and investors can’t bail it out, the leverage could swing back to management. This is particularly true when management gets back equity in return for continuing to operate the company in distress. Often new investors are brought in to resolve a situation like this. But they usually exact punishing terms on the existing investors, who can’t afford to participate in new funding but don’t want to completely write off the chance of an eventual return. The startup’s management is stuck in the middle, praying that someone provides enough cash to keep the lights on.
All this sounds rational enough in black and white. Unfortunately, companies running on fumes tend to bring out the worst in everyone, especially when the paychecks stop clearing. Those with irrational egos try to make power plays; others just turn apathetic.
Which brings me back to my solution: Never run out of money. Startups and their investors must fundraise when they don’t think they need to or—even better—when their success gives them a tailwind of funding momentum. If they think they need $1 million, they should raise twice that much. They may lose an equity stake, but a startup with no money is one with no leverage.