The Problem with Zombies

VA Angels’ CEO Randy Thompson writes a column for the Calgary Herald. Here is one of the articles.

July 19, 2013. 4:44 pm • Section: Business, Opinion, Technology, Technology

I’ve been asked a lot recently about why an Angel or Private Equity (PE) portfolio is so binary. Unlike the public markets, it is truly a one or the other outcome with regard to returns; in the private markets you win or you lose. Previously I discussed ways that private investors can mitigate the risk reward continuum, but on average returns are either great, or not so great.

Some of you have seen the “VC Math” before. This portfolio approach is becoming common for angels as well. The math works like this:

Invest in 10-12 companies

  • 2-4 give you between 3x and 10x return on your invested capital
  • 4-6 remain as companies, but don’t provide substantial return
  • 2-4 completely burnout and no return happens

In this scenario, after all your investing expenses (finding deals, legal, accounting, due diligence, etc.) two to four deals carry the entire weight of the ten original deals. To give you a reference, when I was in telecom policy the government had a term called cross subsidization, which was a fancy way of saying that cities paid more so the rural areas could have the same service level. “VC Math” is a form of deal cross subsidization.

If private investors want to start to realize better returns, they are going to be found in the middle part of a portfolio with the companies we un-affectionately refer to as zombie companies.  Zombie companies are great for the founder and the staff as they pay their bills, are either slightly profitable, or more likely, break even on aggregate over a number of years. Furthermore, the founder gets to tell all of his friends about his successful company and how he/she has been running it for X number of years. The problem for the investor is that this cute little entity would not operate if the investor was to take their initial capital out, let alone any dividends or profits. And every year that this happens is another year that affects the return on investment (ROI).  As an example, I just forced a return in a company that I’d been invested in  for eight years. The company was living off of investor capital, and recently asked the founding investors if they would escrow their shares (i.e. promise not to sell their stock)  for another six years so that the company could raise more capital. In other words, we were asked to wait 13 years before we MIGHT see a liquidity event, but the founder salary remained intact. You can appreciate why the investor group said no.

There are two major issues that come up if you happen to be fundraising as well as running a breakeven but VC funded business. First, when you try to raise money as a breakeven company and investors don’t see the opportunity for a lift, you will be left scratching your head as to why your profitable company can’t raise any capital. It’s probably because investors see you landing in the middle section of their portfolio. It’s the reason the VC community will frequently attempt to “kill the zombies” as early as possible in the deal-flow continuum by either cutting off their capital source or trying to sell-off the company as early as possible. The hope in doing this is that they can drive a sense of urgency into the break-even company and ideally the zombie will drive towards an investor friendly conclusion at a faster pace. But more often than not, a zombie’s end point is pre-determined.

The other unfortunate outcome of the “ rise of the zombie” is that investors  add clauses into Term Sheets to motivate companies to look after their investors ahead of the founders and employees. Some of the clauses you will see include:

  1.      Tying founder compensation to revenues,
  2.      Tying investor dividends to gross revenue numbers
  3.      Creating debentures with interest that are not tied to revenue or compensation
  4.      Creating a Preferred Share structure where the founder is forced to repurchase the shares

The reality is none of these clauses matter when the company is moving towards a bitter finish, but they do help when the company is caught between success and failure.  When a company does actually fail the investor at least can write-off the investment, use a tax loss strategy or other types of compensatory strategies made possible by the lawyers, accountants, and governments to protect the investor class.

As an entrepreneur, the information I outlined above is why you will be encouraged to succeed or fail as quickly as possible. There is no upside for anyone other than you if you are hanging around without a payout. Of course the way to avoid being a zombie would be to avoid the investor game completely. Build a solid company on cash flow and your own capital. But, if you do need to use other people’s money- understand why you are being pushed to get that return as quickly as possible. And truthfully, as the founder, you make far more money as a shareholder than you do as an employee.

Besides, nobody likes zombies, except in movies…

–Randy Thompson

Link to article

The Problem with Zombies _ Calgary Herald – PDF Version of the article