Dysfunctional Investors Are Real

Private high-potential startups often need to raise capital to fund the development and commercialization of their visions. Yet, too often, what causes the disappointingly large failure rate for such startups is not the technology, the market, or the need but dysfunctional investor behavior.

Of course, many excellent, ethical, and effective investors are out there. Yet, one of the advantages of having worked in the entrepreneurial space for over twenty-five years as a fundraising startup CEO for multiple startups, as a coach and mentor for other startups, as a limited partner in venture capital funds with whole portfolios of high-potential startups, and beyond is the experience base I have developed. I have seen and heard of some truly astounding examples of investor dysfunction with dire consequences for the startups, their teams, and their other investors.

Dysfunctional investor behavior is seldom talked about, but it is a real and unfortunate secret of the venture and private equity capital marketplaces. Because investors often refer deals to one another and co-invest alongside each other, it is in their interest to have at least cordial relationships with others in the entrepreneurial ecosystem, so, on the surface, it looks like they all get along. This pattern can lead to unpleasant surprises for new entrepreneurs, who can lack awareness about how dysfunctional investors can potentially impact their businesses. A few representative examples might provide a sense of what I am talking about:

• An investor managed to “helpfully” maneuver a startup team into a position where he would fund payroll only every week – and he blocked their every attempt to improve their funding position. That meant the team spent untold hours trying to manage an incredibly cash-constrained business amid constant negotiation to get the next trickle of funding to keep going for another week. Then, one day, he decided not to fund the startup any longer, and it folded.
  
  
• Another VC-Board Member’s partner inappropriately insisted that the board of one of their portfolio companies abruptly replace the high-performing CEO in a business that was accelerating with a new CEO who had just become available with total disregard for the disruption of the business growth and R&D progress that resulted. Months of progress evaporated as the team lost their focus and commitment as they were distracted by the turmoil and began to leave.
  
  
• Misalignments between large investors in different rounds resulted in the boardroom turning into a battleground. Investors refused to work together, resulting in a fundraising failure that tanked the company.
  
  
• One co-investor ran out of capital to deploy in their fund and ended up yielding all the control and decision-making to the other VC on the board, who still had deployable capital. Ultimately, a series of missteps driven by the lead investor, including forcing a pivot to another commercial approach and a change in leadership, resulted in the loss of early customers, wasted capital on ineffective strategies, and the failure of the business when the controlling VC eventually opted to stop supporting the company.
   
• An investor who got in early but had a bad reputation as a bully amongst other investors scared off many other potential investors, resulting in worse terms and fundraising difficulties for an attractive early-stage startup. Once in, it was hard to overcome the presence of an investor others had decided to no longer invest alongside him because of his past abuse of previous companies and other co-investors.
  
  
• A few investors openly refuse to collaborate and co-invest with others with the goal of being in a controlling position. They position this as a simplifying advantage to the startups they funded (we will fully fund your round). Yet, once they were on the cap table, they leveraged their control to force particular strategies and prevent others from supporting the company. The friction often resulted in startup failure.
  
  
• When a startup CEO was fundraising, a “knife fight” broke out between existing investors who wanted bigger stakes in the next round and wanted to squeeze out other investors. This caused endless bad blood, poor cooperation, and destructive chaos for the startup team.

Why Does This Happen

The venture capital industry operates under immense pressure and competition as different investors seek to deliver extraordinary, top-quartile returns year after year and fund after fund. That means that they are constantly seeking an advantage, whether that is the attractive-for-them terms they can push for, the controlling positions they can engineer, or the ability to get a bigger slice of the cap table as they double down on emerging winners. 

• Investors’ interests are not always aligned with their portfolio companies or each other. These conflicts can be handled ethically and collaboratively or viciously underhanded, as well as in many places in between.

• Big investors both compete with one another and diversify their investment commitment by co-investing alongside others. Over time and through hard-won experience across many portfolio companies, they learn who they align well with as well as who some of the bad actors are. These investor relationships are often hard for entrepreneurs to discern and can mean that there are incentives beyond just what is best for this startup for investors to collaborate in deciding where to put their finite resources and when to pull the rug out from under a particular company.
  
  
• Investors’ funds have a timeline and limited partner expectations they must fulfill. A particular powerful fund’s need to show liquidity events can drive premature exit action for a portfolio company whose value is still accelerating, to the detriment of the other investors and startup team.
  
  
• Investors who run out of money to deploy from their fund either because it is taking longer than expected to achieve success or because a fund under-reserved or reached the end of its fund life at an awkward time for the startup can find themselves sidelined in the board room or investor power struggles, resulting in unexpected imbalances.
  
  
• Power plays by later investors can result in control provisions that give some investors undue power, which is sometimes misused, especially when the startup hits a rocky patch, as they commonly do at one point or another.
  
  
• Some board members are not as disciplined as they should be about their fiduciary responsibilities to the startup when the interest of their funds diverges from the interests of the startup or other investors. Often, a startup can do little when these roles get fuzzy because suing your investor is a resource-intensive and fraught path to a quick loss of support.
  
  
• Personality conflicts, systemic bias, relational breakdowns elsewhere, and other human foibles can also be causes of strife amongst the investor group, with the portfolio company suffering the consequences.

Undoubtedly, I have only scratched the surface of all the ways the humans involved in investing in startups can get into conflict with one another. Plus, it is often the case that these problems escalate in times of difficult or sometimes even times of extreme success. The consequences of these human conflicts can be abrupt, severe, and completely unexpected. It can feel like the most illogical things are happening when the senseless destruction begins to roll.

The most important takeaway is that plenty of startups fail because the investors failed, not because the startup, the team, or the technology failed. This is one of the potential risks you take on when you raise capital, and it can mean the loss of your dream. Yet, it can also be the rocket fuel that propels success for all. Hopefully, this post gives you a bit of a heads-up about the range of craziness that can happen – and being aware and forearmed as much as possible helps you try to navigate your way out of the mess if it occurs.