Don't Build a Zombie

We all agree that valuations in 2020 and 2021 were… let’s say overly optimistic, right?

Interest rates were near 0%, the public markets were booming, and a naturally disruptive moment like COVID all came together to make investors willing to take risky bets early. It was more important for them to land the deal in that competitive landscape than to worry about the price.

Fast forward two years though and those same startups need to raise again but in a vastly different climate with lower valuations available, despite many not yet finding product-market fit or meaningful revenue.

This week I outlined the options founders have, and put them in order of when to explore each one.

5 Paths For Startups Considering a Down Round

Founders in this position have 5 options:

1. Try to grow

2. Recapitalize the company

3. Build a zombie

4. Pursue an acquisition

5. Give the money back

Let’s break each one down…

Try to Grow

Your first option should be to just simply find ways to grow the company. You can either:

• Make no major changes → If you’re nearing product-market fit then look for ways to get leaner. Reduce expenses where you can. Focus on the high leverage things only.

• Lay the team off → If you’re not near PMF then you’ll need to make drastic cuts and hard decisions while finding ways to do more with less.

• Go back to first principles → Grow the “company” doesn’t necessarily mean grow your existing product. Explore pivots.

Regardless, set a time-boxed milestone for yourself that you’ll take action if you don’t hit it. For example: “We will hit $1 million ARR within the next 6 months.” Set this based on your most realistic projection.

Then, if that doesn’t happen, you know when to start considering other options including shutting down the company.

If you go this route make sure you have a clear plan and that your investors are onboard with it. Even if they’ve already written off their investment you’ll be better positioned to raise successfully for a future startup if you maintain good relationships with them.

And whatever you do, don’t just burn all the money and let the business go to 0. There’s likely no reason to go down with the ship other than your ego.

Recapitalize the Company

Chances are you won’t be able to raise at a meaningfully higher valuation than you did in the bull market. In fact you may need to take a significant down round if you want to raise money at all.

This may cause concern among existing investors. Raising a down round introduces substantial dilution for all existing investors. Quick example:

If a venture firm invested $10 million at a $100 million post-money valuation then they own 10% of your startup. They expect this to go down over time as you raise more capital, but only as the valuation increases.

But if you then later raise another $10 million from other investors at a $50 million post-money valuation, the new investors get 20% of the company and the original venture firm is diluted down to 8% of a company that’s worth half as much — meaning their $10 million investment is worth only $4 million.

All of a sudden that original firm is below their ownership target for the startup at half the valuation they invested in.

This means they see the investment they made as considerably less likely to be able to return their fund eventually and that may translate into them being less excited about your startup.

With that said, a down round can be smart for the company if there’s a clear path to growing again.

Build a Zombie

If a cash infusion isn’t an option, then you can run the startup as a zombie.

A zombie has given up on its dreams of being fast-tracked to unicorn status via the venture treadmill. In most cases it means a venture-scale exit is essentially off the table. Instead it focuses on building a sustainable, cash-flowing business.

There’s, of course, nothing wrong with that. It’s your company and your decision, assuming you have majority voting rights.

But if you sold investors on those initial dreams and are now saying the company is no longer pursuing them, expect some pushback.

Your investors won’t love it because in most cases it means you keep whatever remains of the money in the business rather than returning it to them. Historically this has meant they write the investment down to basically 0, though Flexile may be changing that by making dividends cool again.

Note that it may be much harder to recruit and retain top talent at a zombie since the equity upside is so much more limited than other startups they could join.

Pursue an Acquisition

If you don’t think a zombie sounds exciting, then you should look to exit the business. The first path to explore is an acquisition.

You likely won’t have unanimous investor support for this. This might sound surprising. Isn’t an acquisition the best remaining possible outcome for everyone at this stage?

The answer is typically no.

For the founder, an acquisition means you get to say you’re an exited founder when you go to build something new in the future — which sounds a lot better than shutting down your company.

But some investors would rather have whatever remains of their capital back so that they can re-invest it in other startups. Others will defer entirely to you and your cofounder(s). Many will be in the middle.

At the end of the day the decision is made by the board of directors.

If you and the rest of the board decide to look for an acquirer, temper your expectations. Unless you find a perfect match where the merged entity of the two companies is greater than the sum of its parts, you will have no leverage in this deal and your acquirer will know that.

Give the Money Back

If you’re unable to find an acquirer or the board decides to not pursue one then your only remaining option is to call it a day, shut things down, and return the remaining capital to your investors.

This is hard for any founder to do. It marks a failure. And all founders know that your startup inevitably becomes closely tied to your self-identity, even if you consciously work to keep them separate.

But remember that, if things are at this point, this is the best way to ensure continued good relationships with your investors and a better shot at raising money again in the future.

Even Justin Kan did it after raising $75 million for his legal startup, Atrium:

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