Monday, November 10, 2014

Bringing Phoenix Value to Failed Startups

Entrepreneurship is strewn with startup corpses.  Dynamically, the world’s entrepreneurs, investors, governments, business schools (and their supporters like attorneys, accountants, incubators, consultants and advisors) have created millions of new startups in the last few years.   But startups have a high failure rate.  Yet few commentators discuss the painful process of what happens to failed startups. 

Like political questions, a “startup failure” depends on how you define it.  About three-quarters of venture-backed firms in the U.S. don't return investors' capital, according to a Wall Street Journal report on the research of Shikhar Ghosh, a Harvard Business School senior lecturer.   For him, “failure” means 0% ROI.  The same article cited more optimistic venture capitalists’ estimates that 30% to 40% of startups “fail completely” while another 30-40% return the original investment, and only 10% or 20% yield substantial returns. 

“Startup corpses” have “Phoenix Value.”   A “loser” is any project with 0% ROI.  Starting with the “Dot Bomb” bust in 2003,  some are purely domestic, like the web developers who offered new social “community” business models in 2003 for $500,000 that today would cost $5,000 to $20,000.  Others involve cross-border startups (and more mature enterprises) entering the U.S. markets seeking customers, funding, talent and sometimes a new home.  For example, this category includes “pet robots,” web analytics software and online video editing. 

A “winner” is a successful traveler from the Gulf of Nothingness to the radiant shores of Exitness.  Steps could include incorporation to “friends and family” funding, to VC rounds 1 and 2, to bridge loans where the founders mortgaged their souls (and shares), to sale of non-strategic assets, refinancing, generation of strong customer relationships and highly profitable exit sale.

However, don’t think that failed startups are always lost causes. Professionals can resuscitate, reutilize and reintroduce the lost value from startup corpses.  To help recover value from the startup crematory, an ecosystem of “Phoenix Value hunters” has arisen.   They consist of attorneys, restructuring experts, valuation advisers, investment bankers, stable businesses looking to fill tech gaps and “Phoenix Value” investors. 

Here are a few lessons learned from the trenches.

  • Founders and early-stage investors in startups want to ensure the legal entity owns the intellectual property, trade secrets and, to the extent possible, the people doing the innovation. 

  • VC investors want a preference in liquidation.  This means not only a preferred payment (ahead of common stockholders) but also a preferred return (the “liquidation preference” multiple of invested capital).
  • VC investors need the right to fire the founder from management roles.

  • Founders can leave failing startups and build anew, but the manner, timing and perceptions about their departures will impact their ability to raise capital in the future.

  •  “Phoenix Value” investors can make good money by buying distress assets from a failing or failed startup.  They don’t anticipate any more “funding rounds.” “Phoenix Value” investors create Phoenix Value for transformation of “dead” or “useless” innovation into productive assets in a sustainable, well-funded business.

  • Proper foresight in management and administration of intellectual property (as well as the people who create and manage it) can reduce losses, increase gains and avoid surprises that can kill or delay prospective acquisitions.

  • Some bankrupt companies in one country might reappear in the markets of other countries, thanks to Phoenix-stage investors finding and generating new value from the ashes.

 So, when considering a startup or a new product development plan, keep planning for both success and failure.   Understanding how failures can be used to retrieve and revive a “sunk cost” can make a big difference in your personal and professional success.

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