Ask an Investor: How do I raise venture capital after a pivot?

pivot

Welcome to a BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors Roger Chabra and Katherine Hague tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.


A pivot means that a startup has decided to change their business model. This can be a drastic change (a completely new business model in a different sector) or a slight change (usually a major change in the company’s product to address a larger market opportunity in the same sector).

Pivots are quite commonplace in the startup world. We see and hear about them all the time. Startups are tumultuous by nature, disrupting the status quo by design and led by smart, entrepreneurs with “never say die” attitudes. It’s no wonder that we see business model changes a lot, particularly at the pre-seed and seed stage. Some incredibly successful startups were pivots. PayPal, Twitter, Instagram, and Flickr all changed their business models quite drastically and successfully.

Personally, some of my most successful investments were pivots. Chango, a programmatic adtech platform, started out as a very different company than what was scaled and eventually sold for a handsome return. Frank & Oak, a vertically-integrated, omnichannel men’s and women’s apparel company, started life as a made-to-measure online service for men.

A pivot will not only alter your business model, but will also alter your capital path and prospects for raising money. The more traction you have post-pivot, the easier it will be for you to raise money from new investors. However, in many situations, you will need to raise money to get said traction.

Stretching your current runway is your best and least expensive solution. Once you have your investors and board on side with your new business model, discuss with them a plan to lengthen your cash on hand. Cut expenses and headcount wherever you can to achieve this. If your older business has significant technological intellectual property (IP), sales, or a decent customer/email list, perhaps look at selling off that business in order to generate cash for your pivot. Recognize that running a sale process will distract you from focusing on your new business, so tread carefully, but recognize that this can be a great source of non-dilutive capital.

Your next best option is to raise additional money from your existing investor(s). This will take significantly less time than raising from new investors. The quicker you can raise your money, the quicker you can get back to building your new business. Approach your lead investor with your new idea. Get them bought into your go-forward plan and work on your capital needs plan together. Easier said than done, of course.

However, your lead investors should be all ears. They are probably not as excited about your business as the day they invested and their return goals are probably not being met by your current business model. They have a vested interest in getting their investment on the right path. They will want to get excited about a better path for your business.

It’s important to recognize, however, that your current investor will view their past investment in you as a “sunk” cost. Put simply, this means they won’t want to throw good money after bad money. Their past investment won’t obligate or drive them to write another cheque. Most good investors will listen to your new plan and help you work on it – but, ultimately, they will evaluate an investment in your new business almost as stringently as they would any new investment that comes across their desk.

Investors know that momentum is hard to gain, but even harder to regain. Some investors won’t be willing to take a chance on your new business model at such an early-stage of proof.

Because of this lens, you can expect to get very little value ascribed to your old business. Instead, investors will view you as a seed stage startup and value you accordingly, even if you were past this stage with your old business. You may get credit for having more market knowledge and a better team than other seed stage startups, but recognize that this round of financing is going to be very dilutive compared to your last round. Existing investors may want to do a flat round (the same valuation as your last round) or even a down round (a lower valuation than your last round of financing).

You may also see something that is referred to as a “pay-to-play” financing term. This means that one (or more) of your existing investors is willing to write a cheque into your company but that they expect all other material investors to also write a cheque that mirrors said investors current ownership level in the business (the investor’s “pro rata”). The thinking here goes that the company is in dire need of money (or else it faces bankruptcy) and one investor alone shouldn’t have to “carry the bag” for all other investors and give them a free ride going forward.

Investors that don’t pony up more money into the round are typically faced with punitive terms such as having their preferred shares converted into common shares on top of any dilution they will experience from not participating.

Once you have an existing investor willing to lead your post-pivot round, you may want to think about a few new smaller investors to bring into the round. This will breathe new air into your business and perhaps give you more potential follow-on capital in the future. Tread carefully, here, though. Approach these new investors only after you have an existing lead and be sure not to get too distracted from focusing on building up your new business. The best advice is to close your round quickly and get back to work!

company pivot

If your existing investors are tapped out, or are unwilling to invest in your pivot, you have little choice than to seek out a new lead investor. This is a very time-consuming task, and truthfully, the odds are against you. Great entrepreneurs, however, follow Han Solo’s mantra: “Never tell me the odds!”

Investors know that momentum is hard to gain, but that it is even harder to regain. Some investors won’t be willing to take a chance on your new business model at such an early-stage of proof. It doesn’t help that your company has the “baggage” of having a failed business model on their hands.

However, it can be done and I have seen it done. Again, recognize that this will be a very expensive round of financing. Your new lead will be quite punitive towards existing investors in your company. They know that your existing investors are unwilling to give you enough money to capitalize your business properly and will take advantage of this. You can expect to see a down round and perhaps even a recapitalization of your company altogether.

So there you have it. Raising money after a pivot is harder than raising money for a new company, but there are options available to you. Happy pivoting!


Katherine’s take:

Katherine Hague

I totally agree with Roger’s advice here. One thing I would add is that startups that pivot after raising money generally feel obligated to pivot under the same company/cap table that they started with, bringing their old shareholders along for the ride. This is generally quite noble. Founders are recognizing the role that their original investors played in getting the company to where it is today, and are trying to avoid those investors losing their investment in a failed concept.

While pivoting within the same corporate structure is well-intentioned, I just want to remind founders that you are not obligated to pivot under the same company. You could wrap up the current business, return any remaining capital to investors, and then reincorporate a new business to pursue the new idea. Doing so leaves you with a clean cap table and a blank slate to bring in new investors.

And, as Roger mentioned, raising money for a new company is often easier than for a failing or pivoted company with no traction. When your pivot is completely different to the original concept, none of the IP from the original company is needed, and much of the team will change in order to build the new product, this might be the right approach. The risk here is that you’d be starting from scratch, giving up an remaining cash in the bank, and there could be some reputational damage from losing money for your original investors.

Depending on how related your new idea is to your original company, your investor may also feel ripped off – like they funded your knowledge and are then cut out of the upside. On the other hand, some investors might appreciate your candour, and your willingness to return capital after the concept didn’t play out as expected.

My advice on navigating this situation would be to have open and honest conversations with your team, board members, and shareholders. When planning a pivot, explore all options, including shutting down and reincorporating.

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Roger Chabra

Roger Chabra

Roger Chabra is the CIO at TribalScale, a global provider of digital products & companies for mobile & emerging technology platforms with offices in Toronto, Los Angeles, Dubai, San Francisco and New York City. You can follow Roger on Twitter at @rchabra