The VC trap and the mad CEO

Have you ever noticed how some start-ups raise huge amounts of capital and end up going down? This issue explores the causes behind that phenomenon.

I’ve been part of the start-up scene for over a decade now, a couple of times as a founder, most times as a consultant and a few as an employee. Having worked with companies of all sizes, colors and types, I found an interesting pattern in companies that obsess with raising capital: they have a great start, with enormous potential and bit after getting huge investments, they close operations. I may have an explanation for that: some CEOs go mad as a result of what I call the Vicious Cycle of Overconfidence.

Let me explain: At its core, the success of start-ups has been wrongly measured for years. People think that news of a company raising millions is a sign of healthy and promising growth; but it couldn’t be more mistaken. Let’s start by agreeing that getting money from investors is not free, conceptually its closer to a loan than just ‘borrowing’ it. If that money isn’t used correctly, it ends up being very costly to the shareholders and, as we’ll talk later, to everyone in the company.

Being a CEO is a lonely and difficult job and many boost their self-confidence through external sources, for example: raising obscene sums of cash from investors, which is the easiest way for journalists and world to take notice and applaud the milestone (the heavier the money bag, the bigger the cheering, but, consequentially, the more far-reaching promises to investors). Thing is, this public praise inflates the ego of the CEO, convincing them that they’re doing a great job; sadly, investors never get the full picture of a company’s performance because, let’s be honest: figures can be massaged, metrics can be manipulated, milestones can be faked; and the company’s performance might not be the same as the investors or the public imagine.

A ‘win’-at-all-costs mindset in concert with a CEO’s trapped in this cycle is a recipe for disaster. Once the company gets the money: lavish parties are thrown, lots of people are hired, motivational speeches are given and copies of “The Lean Startup” are thrown out the window. A new era of crazy spending starts and the company forgets what it was doing right before getting the money; people concerned by the excesses are told to “chill, we’re doing great! Did you hear all the praise the world sent our way?”. This results in a start-up, likely unprofitable, that becomes bloated with an excessive cost structure and huge dependencies on external sources of financing.

Public praise is a very addictive drug for start-up CEOs and when combined with the effect of “brain damage” caused by positions of power, the skills and good judgement of that person start to weaken. Suddenly, the CEO knows better than anyone and those who dare criticize the approach become “pessimists”, “traitors to the vision” and/or “non-believers in their supernatural abilities to raise more money”. These executives start to isolate from the company, focusing entirely on convincing more investors, growing deaf to those that ask for restrain, frugality, profitability and objectivity. Sadly, most of the promises made to investors are so far from reality that end up becoming a huge issue to the company.

Let me give you a concrete example of malpractice, based on what I’ve experienced in over a decade of working with mexican start-ups: Raising money too soon for international expansion. Why? Simple, companies that are not properly consolidated in their home market (think of profitability, standardized processes, market share, loyal customer base) end up dying because of an overly complex and distracting operation and burning up resources faster than expected. Nevertheless, expanding to other countries is one of the sexiest things a company can do and CEOs continue to fail to distinguish when is the right time; especially because of overconfidence in their judgement that keeps them far away for the operational reality and the pulse of the market.

Is there a solution for this problem? Yes several, for instance:

1) Better VC oversight and due diligence: This seems obvious but I think some VCs are way too relaxed on some startups (I’ll cover this in a future issue) and tend to trust very easily on CEOs with flashy credentials without properly contrasting the plan they’re investing in and the reality of the company. I think a lot of bad investments could be avoided if you just talk to the employees or the customers.

2) Separation of powers: This is the easiest one; stop concentrating the decision power and public relations of the company in a single person. Enforce a more active participation of the board, give more power and influence to other C-Levels and/or get rid of the CEO role (open question for the industry: why do we insist that monarchies/feudalism work well for companies?)

3) Stop sycophant culture: Put a stop to the yes-men, the bootlickers, the flatterers, the doormats, the self-seekers. There are two types: the active and the passive. The former is the one we all know and hate (except people in power); the latter is people that witness and enable the sycophancy, the ones that say nothing and don’t neutralize the lies and half-truths (these are most people, sadly). I’ve seen strong companies with great leaders go down because of sycophants and manipulators. Advice to CEOs: find ways to keep them away from your organization, they’ll push you into the overconfidence cycle and blind you from reality. Everyone else: Disable them by speaking up and using hard data against their claims, document everything and expose their manipulation.

4) CEO transparency and collaboration with the company: a CEO is not a leader if they are isolated from the operations or the concerns and ideas of the employees, and defining the strategy of a company without facts and hard data is likely to be unrealistic and prone to failure. CEOs: don’t become moths to the media’s reflectors, remember that the company relies on your hard-work as well.

5) Focus on consolidation: this is a difficult one but CEOs need to get better at determining when it’s right time to jump to new geographies, start new business units or doing mergers/acquisitions. These are risky endeavors and a company without a solid foundation is likely to crash and burn with these initiatives. This analogy might help: imagine a tree, if the tree grows too tall or with too many branches faster than it can grow roots and attach to the ground, the tree will topple and die. Market-share is worth sh*t if the company can’t keep up with it.

6) Publicly measuring startup success differently: This is a cultural issue that ecosystem needs to fix, especially journalists, raising money is risky (for all parties involved) so let’s stop talking about it like it’s a sign of unequivocal success. Ironically and counter-intuitively, too much money can kill companies and we should stop romanticizing it, let’s talk about the caveats and risks. Let’s measure success differently and pay attention to other types of startups as well; by inflating the reality of a startup you might be putting it at risk.