The Founder’s Trap: Perfect Product and Huge Market Potential Destroyed by Owner’s Fear

Enterprise Value Accelerator

(Blending Marketing and Finance)

Story #4

(6-minute read)

It is late Friday afternoon after a long week.  I get a call.  The area code suggests “Phoenix”.  Then the cell phone lights up with “TOM”, and I know it is action time.  A hot investment deal must be on the table.  I take the call.  Tom quickly reports that, based on the known information, the company and its market are in perfect harmony, and it should be a “BIG WIN” for investors.  But time is short as it always is, and the race is on to finish the project.  What will we miss, and what mistakes will be made in the rush?

This is our 20^th year; Tom is a brilliant lawyer who helps early growth companies find needed capital. He works with owners, the company’s board, and investors to create super enterprise value for the founders.  He did it for me as the founder of a new company, which is now the largest in its niche in the world.  We have been working on similar projects ever since and now a new one.

We are still in COVID protocol.  The phone call turns into a ZOOM call where Tom shares the details.  He needs an Interim CFO to:

1. Clean up the books. They must follow GAAP.  The books are a problem today.  Investor due diligence is next.
2. Work with the Founder and top management to create a detailed data-driven strategic plan that flows neatly into a business plan.
3. Assist with the capital raising by preparing the financial sections of the investor presentations and addressing detailed investor questions.

For me, the goal is to become a permanent part of the management team after we raise the capital for the launch.  I report to the Board, but work primarily under Tom’s direction.  Tom is Corporate Secretary and attends and records all meetings.  The Founder controls all aspects of the company and as of today, his Amex Black Card is the only source of cash.  With the constant use of his credit card, his fingers are in every pie.  The company is out of cash relying on phone calls to the Founder to personally approve and fund even the tiniest expense.  With this level of involvement, it begs the question, is the Founder’s involvement more than just wisely controlling cash? Whatever the answer to this question, the pressure is on Tom to raise the $5 million of convertible debt before the end of next month.

Tom and I focus on the precise financial and legal details of closing the convertible debt.  We privately ask ourselves, “Are we too narrowly focused?  Will we get blindsided?”  With 20 years of working together, the emotional complications of a Founder should have been on our radar screen.  In our race to the finish, what will we miss and what mistakes will we make?

Based on the known information, things look great.  The product had been created, tested, and patented over the last 5 years.  The large Indiana based pharmaceutical firm, Eli Lilly and Company, signed an agreement to purchase the product, once it had been thoroughly tested in their labs.  This month, the company needs to be in full production and make 250 sample products to supply Eli Lilly.

The heart of my work, as Interim CFO, is the 5-year strategic plan, preceded by the accounting cleanup, and followed by communicating the plans to investors.

The big FedEx truck stops at my front door with a huge box of legal, financial, and accounting documents from Tom.  The accounting cleanup starts with a review of each asset to establish its basis.  Then, I interview all parties creating detailed files on all liabilities.  It is quite common with early-stage companies to have agreements between owners, investors, partners, and vendors that are not fully reflected in the accounting records.  It does not take me long to see the unknowns.

The problems jump out.  The new CEO employment agreement, the Founder’s loan agreement, and the Board actions are out of sync.  We must immediately link them together or the wheels will fall off before this company starts.

As the financials are cleaned up, the Founder and Board team work together to create an analytically based strategic plan.  My detailed approach of converting the strategic ideas into a plan makes sense to all.  In the end, consensus building creates the best plan and allows all management to talk to investors with the same voice.

The Board meeting is just a few days away.  Tom works on sorting out the Board actions.  The plans require a new CEO and $5 million of new investor capital.

My computer is printing all the documents, and I prepare big white overnight FedEx boxes with all the plans and drafted Board actions.  As the FedEx driver picks up the boxes, I call each board member alerting them to the arrival time and emphasizing the importance of a decision at the Board meeting.  I tell them specifically,

“No agreement at the Board meeting means no new investors”.

Sharing the information early gives each Board member a few days to review and ask questions before the Board meeting. In addition, Tom shares his 3 investors who have orally committed to investing the needed capital.

The company is highly in debt with no operating cash, but the investment bankers put the company’s value at a $15 million due to the patents.  With the new investment of $5 million and the Ely Lilly contract, the plan shows an increase in an enterprise value to $200 million in 5 years.  If the CEO is hired, the investor’s capital comes in, and the company goals are achieved, the Founder has a huge financial win.

The Board meeting starts at 1:00 pm on Tuesday.  The agenda is:  approval of the strategic plan, approval the $5 million of convertible debt terms, and the signing of the new CEO’s contract.  All members had seen the details and the goal is to sign the investor letter of intent.

On Tuesday at 1:50 pm the deal explodes.

The pain buried in the unknowns of the Founder’s mind is out in front now. After months of work by Tom, Board members, investment bankers, and investors, the deal explodes.  The Founder, who controls the company with 79% ownership, says clearly,

“I will not give up any equity!”

After the annihilation of the deal, it is important to ask the question:

“Are the Founder’s fears of loss of control and dilution rational or irrational?”

Today’s valuation of $15 million is based on having new investment and new management in order to fulfill the obligations of the Ely Lilly agreement.  With the new management team and the new investors, the Founder’s ownership is reduced to 61%.  He maintains the position of Chairman of the Board.  In 5 years, his shares will be worth $122 million.  Not seeing this future, his fears of loss of control overwhelm him, and he walks away.

Without the experienced management team, the investors have no interest.  The future of the Founder’s invention, the contract with Eli Lilly, and the product’s role in the market place is left in a vacuum.

I call the fear of ownership dilution and loss of operational control: THE FOUNDER’S TRAP.  The Founder has managed the company for 5 years but cannot see the company’s future without being in control and managing the details.

Because of THE FOUNDER’S TRAP, the crisis and the pain are permanent.  When the Board meeting ends, there is no management, no investors, and the Board and the Corporate Secretary resign the next day.

Details: How to Avoid The Founder’s Trap:

By not “reading” the Founder’s emotions, and the Founder’s lack of commitment to the strategic direction requiring new management, many months of time is wasted by Tom, Board members, and potential investors.  The questions remain:

1. How do we assess the Founder’s preparation to move forward?
2. How do we nurture and guide the process along a successful strategic path?

1. How do we prepare early to pull out, if the Founder’s commitment is in question?

As an investor, and as a professional working to develop a company, you must understand a Founder’s thinking and emotional commitment before you invest your time.  In this case, because the company lacked the funds to proceed, there was only one true economic and business direction.  It was so clear to us; we could not see or envision an alternative direction.  We were blind-sided by our own narrowed vision.

Each situation is different. However, there are tools I have successfully used, early in relationships, to document realistic organizational and financial strategies.  These are the sharing of ideas and getting agreements, hopefully in writing, regarding the strategic direction. It is important to never assume the Founder thinks like you do.  With this early preparation, the professional and the investor can gain confidence in the future or, lacking comfort with the Founder’s comment, elect to walk away early.