What Happens When A Startup Fails – Do The Founders Go Broke or Go Home Rich?

What Happens When A Startup Fails – Do The Founders Go Broke or Go Home Rich?

Chioma Ifeanyi-Eze asked a question on her wall, wanting to know what happens when a StartUp fails. I wrote a response on her wall and I’ll share it here

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So, What happens when a StartUp Fails

Let me attempt to give a detailed explanation:

Note: Investors here do not refer to “Crowdfunding investors” who invested for tenured ROI, but rather institutional investors.

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1. 
   Whether the founder will go broke or not, is dependent on the stage of the business

And this is the reason:

When a Founder raises money, he sells out equity in his business

At the Pre-seed stage, he’s still expected to not yet be compensated for all his efforts thus far

So if the business dies at Pre-seed… he may also end up broke

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But at the Seed stage (second round funding), there are possibilities (if the shareholder’s agreement allows) of selling off some of his own equity on a “Secondary Market”. This makes them have “his own money” aside from the business money

On the other hand, since most founders invest their own money at the start, it’s often recorded as debt

They get paid back some or all of the debt

Also, at the Seed to Series A Stage and beyond, the Salaries of the Founders eventually set At something close to an Industry standard of if they had hired a CEO

If ideally, a hired CEO for that level of business should earn 4m per month… the Founder can earn about 50 – 80% of that.., basically as high as the Board Agrees

Remember that investors actually want their investees to earn high enough to focus on the business and not look towards side hustles

Also
The Founder, if wise, would likely have started putting some parts of their liquid into other investments like Real Estate, other startups, etc

All these factors… make it almost impossible for the Founder to go broke especially from Seed Stage

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Now, what happens when a funded business goes down?

During investment, the investment thesis, term sheets, and agreements often show the “Rights of First Refusal”

and the Shares sold are not often “Ordinary shares”.

The shares sold to investors are called “Preference Shares”

Which means if anything happened to the business and it had to wind down… the Preference shares holders have to get paid from the Money Recovered from sales of assets etc

And this will start from the earliest investors who are yet to exit, to the last investors in that order

Often times also, in the case of winding down, a certain level of the losses of customers are expected to be covered before investors pull out their funds

In all this… no matter what happens… the Founder gets paid last – and investors may lose money

And oftentimes, they ideally should end up with “nothing” from that pool

However, if it’s the case where it’s really not the Founder’s fault as such.. the Board (of which the Founder should have a board seat nominee) can decide to make the Founders have some portion from the wind-down

But if the Shareholders agreement originally ensures that the Founder would hold some shares as Preference shares (which isn’t ideal), the founder may also end up rich

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Lastly

Had it been the Business has already gone on IPO or listed on a Stock exchange – like WeWork

The Founder will ALWAYS end up rich cos they’ve already cashed out from A large chunk of Sales of their Equity and they’ve got money In the bank

This scenario might not work for Africa cos we don’t have lots of IPOs yet… though we have a good volume of publicly listed companies on NGX

So I’ll say the first few scenarios hold true

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Fundraising and winding down of a company is more complex than what I wrote here

However, this should provide some insights

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Bibliography:

Pre-seed Investment:
Money raised at the ideation stage to prove the idea

Seed:
Money raised to push the validated idea to Product Market Fit and large adoption

Series A:
First large funding Attempt at very Fast Growth and scale

Ordinary Shares:
These are shares of a company that is issued, to give shareholders the right to vote in the company’s meeting and also earn income in the form of dividends from the corporation’s profits. (Adapted from Google)

Preference Shares/stock:
Preference shares, more commonly referred to as preferred stock, are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders. (Investopedia)

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Read through these, find some lessons, and of course, Share with reference.

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© Olatunde Victor Adeoluwa
The Growth Hub/ Tribinnov Africa