Weekly Briefing Note for Founders 3/10/24

2nd October 2024
CATEGORY:

Startup funding: The Four Zones of Risk

Why do startups fail? Unsurprisingly, as virtually every study shows, the number 1 reason is because they run out of money. In the early stages, most startups depend on raising capital to stay alive. Without these injections of cash they are, according to legendary investor Paul Graham, 'default dead'.

In Graham's famous essay, Default Alive or Default Dead, he says that most founders don't ask themselves whether they're 'default alive' or 'default dead': that's because they assume it will be easy to raise more money. "But that assumption is often false, and worse still, the more you depend on it, the falser it becomes."

Founders by their very nature are optimists. They have an opportunity-centric rather than risk-centric mindset. But, when it comes to funding, it pays to be acutely aware of impending risks so that mitigating action can be taken.

Some of the risks that might prevent a startup securing funding can be neutralised if they are dealt with early enough. Time is always the founder's greatest enemy. To help risk-assess a startup's position in the 'default dead' timeline, we use a simple framework: We call this 'The Four Zones of Risk'.

Starting 12 months before a startup must secure funding (i.e. before running out of cash), we divide the next 4 quarters into 'zones of risk'. The timeline is approximate and will vary depending on many individual factors, but the essence of the framework still applies:

Four Zones of Risk:

  1. The Zone of Uncertainty (typically 9-12 months before cash out)
  2. The Zone of Misplaced Belief (6-9 months out)
  3. The Zone of False Hope (3-6 months out)
  4. The Zone of Insolvency (<3 months out)

The principle behind the framework is that if you don't proactively handle the risks in each zone they just get carried forward to the next. They then compound until you eventually face an almost insurmountable challenge.

Today we look at the common risks in each 'zone'. We then identify what experienced founders do to counter them. Finally, we look at why a diligent approach to risk management can protect directors against a shareholder or creditor lawsuit if everything goes south.


Zone of Uncertainty (9-12 months before cash out)

Common scenario: With 12 months to go, the Board should be discussing the company's runway and agreeing a funding plan. But there is not yet a sense of real urgency to address the many unknowns about how this might come together. 12 months seems an eternity away and the investor directors don't yet want to get drawn into what role they will play:

  • Will this be an internal round, or will new investors be required? i.e. Will existing investors participate and to what extent?
  • Could a non-dilutive cash generation event relieve the time pressure to raise equity? For example, could a major customer contract or a grant extend the runway - and is this likely?
  • Might funding market conditions improve? i.e. Would it be better to delay a little longer?
  • Will the investment story improve if we just give it a bit more time? i.e. Perhaps some good news is imminent?

Result: With many difficult questions to resolve, days turn into weeks, turn into months. The funding timeline starts to get squeezed as the cash out date remains stubbornly fixed.

Experienced founders don't wait. They drive the funding discussion at the Board. They press on with preparing the funding plan and use this as a forcing function to make decisions. In particular they:

  • Set a clear timeline for the campaign
  • Identify a target list of well qualified investors
  • Nail down an investment proposition that should resonate with this target audience (note this is NOT the pitch deck - that comes next)
  • Build or update their financial model
  • Are very cautious about incorporating any uncertain upside into the short-term cash flow
  • Have the Board approve this outline plan (which is then minuted)

This all builds a sense of urgency. Experienced founders use this process to harry current investors into revealing their intentions. Understanding insider participation is a critical component in any funding strategy.

[Founders - if you would like to know more about how Duet helps startups develop their funding plans in the Zone of Uncertainty, please reach out.]


Zone of Misplaced Belief (6-9 months out)

Common scenario: If the actions required in the Zone of Uncertainty did not happen, they now just get rolled forward.

On top of this the CEO needs to be in pitch creation mode. The belief is that by creating the pitch deck this will help answer all the preparatory questions. But pitch deck creation always seems to raise a plethora of additional questions about the proposition itself.

For example, for early-stage companies, this might be the first time they have tried to elaborate the go to market strategy or the business model. Answering these questions - which should have been addressed months ago - now takes up precious time.

Meanwhile, current investors are starting to consider their options. Are they going to follow their money or stand back? Will they hold off committing until they can gauge external interest? From a founder's perspective, no news is good news, so the assumption is that they will likely stump up again this time.

Result: There is a belief that the creation of the pitch deck will galvanise the entire company - especially the current investors - into action. But thorny questions about the business are now taking priority and the deck (as well as the associated financial model) gets delayed.

Experienced founders: Working from the outline plan approved months ago, all the investor materials have now been finalised. Current investors have been cajoled into declaring their interest. The Board has approved the pitch deck and financial model projections. All associated decisions have been minuted. Investor outreach has started.


Zone of False Hope (3 - 6 months out)

Common scenario: Now inside the 6-month window the atmosphere starts to change. Investor outreach started late, and none are biting yet. The weeks tick by and there seems to be little serious interest. The major investors demand more regular Board meetings to monitor progress. One or two indicate that they might be able to step in if all other options fail.

The temptation is to cling to the original funding strategy in the false hope that a new investor will materialise.

Eventually, when it looks like external options are fading with only a few months to go, the existing investors finally declare their hands:

  • Those that still have faith in the company make a last ditch offer to save the business, but this is now a down round. This will likely include punitive terms, such as 'Pay to Play', on the back of a recapitalisation (for example, holders of preferred shares might get demoted to ordinaries if they don't take their pro-rata. They might even end up with fewer shares overall). This can be a brutal shakedown.
  • Those investors that have already written the investment off (although they never told you at the time!) now decide to quit their director roles. The next few months will be arduous for the Board and as they are unlikely to see any return, they simply lose motivation to continue.

Result: Forced into a recapitalisation by an existing investor, the company survives but many relationships are damaged. Last ditch rounds rarely work out, so are very high risk for investors. That's why they demand extreme terms.

But when they do work out (the company recovers and builds value) then there is a risk that investors that did not agree to or participate in the recap take action against the company to recover their 'loss'.

Experienced founders (i) based on investor feedback do not hesitate to adjust the funding strategy and realign with a revised target audience before it is too late, and (ii) make sure that they (and the other directors) are following a robust process: They have documented the outreach plan, who was targeted, who they spoke to, what they said etc.

In the case of an adjusted strategy, this could include bridge financing (usually in the form of a convertible loan note) from existing investors if there is appetite. This will depend on the prospect of concluding an externally supported round a little further down the line when the proposition has improved.

In the case of a recap, they have been clear that this is a 'financing of last resort'. They have spoken with all shareholders about their option to participate. Boards should ensure that all investors sign off on the recap. Every step of the process should be captured in the Board minutes.


Zone of Insolvency (0-3 months out)

Common scenario: If a last-ditch funding offer is not forthcoming the company will likely find itself in the "zone of insolvency". The company's financial health is now precarious, and it is on the verge of being insolvent - meaning it may not be able to meet its debt obligations as they fall due.

The "zone of insolvency" is the grey area leading up to formal insolvency where directors must be particularly cautious as they have heightened legal responsibilities.

Result: When a company enters this zone, directors' obligations shift from acting in the best interests of shareholders to prioritizing the interests of creditors.

Key responsibilities include:

  1. Avoiding wrongful trading: Directors must not continue trading if they know, or ought to know, that the company cannot avoid insolvency. Continuing to trade in these circumstances can result in personal liability for company debts.
  2. Maximizing creditor interests: Directors should prioritize actions that protect or maximize returns to creditors. This may involve a sale of the company (if this has not already been investigated earlier), halting trading, seeking professional insolvency advice, or entering into formal insolvency procedures like administration or liquidation.
  3. Filing for insolvency if necessary: Directors may need to enter into formal insolvency procedures if they believe the company cannot recover. Failure to take appropriate steps can result in accusations of wrongful trading or other misconduct.
  4. Seeking professional advice: It’s essential for directors to get expert financial and legal advice to ensure compliance with their duties during this critical period. This can begin with informal advice from an insolvency practitioner as soon as they believe they may be entering the zone of insolvency.

Failure to act appropriately in the zone of insolvency can lead to personal liability, director disqualification, or other legal consequences.

Again, having a detailed set of Board minutes can prove invaluable to directors should they need to demonstrate that the right decisions were taken at the appropriate points.


In summary

Some of the risks that might prevent a startup securing funding can be neutralised if they are dealt with early enough. Time is always the founder's greatest enemy.

To help assess typical risk scenarios in the 'default dead' timeline, founders can use a simple framework: 'The Four Zones of Risk'.

If founders don't proactively handle the risks in each zone they will get carried forward to the next. They then compound until founders eventually face an almost insurmountable challenge.

Experienced founders drive the funding discussion at the Board. They press on with preparing the funding plan and use this as a forcing function to make decisions. They don't hesitate to modify the funding strategy mid-campaign if required.

The funding process and all key findings should be communicated to the Board. Together with all related decisions, these should be documented in the Board minutes.

If all funding options fade and the company enters the Zone of Insolvency, directors' obligations shift from acting in the best interests of shareholders to prioritizing the interests of creditors. Professional advice should be sought.



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