Instagram was famously a pivot from Burbn, a failed check-in app. Twitter was a pivot from Odeo, a failing podcasting platform. Slack was a pivot out of a failing game company.
The successful pivot is revered in Silicon Valley. But, while some entrepreneurs snatch victory from the jaws of defeat, I think the Valley would be a far healthier ecosystem if more companies naturally failed and then restarted, and fewer pivoted.
When companies pivot, they are effectively deciding to keep their corporate structure, team, and cap table in place and try something new. If you have a well-functioning team and a new idea, you can maintain some momentum. Pivoting vs. starting over allows entrepreneurs to skip the hassle and expense of winding down the company and incorporating again. And if the founders have some money left in the bank, they don’t immediately have to fundraise.
But there are hidden costs to the approach that become apparent later on.
First, and probably most harmfully, almost all companies that pivot end up with fairly awkward cap tables that frequently advantage investors over the team. That frequently makes future financing difficult and almost always leaves the founders and team overly diluted and without control quickly.
When companies make a dramatic pivot what they are effectively doing is resetting the value of the company to zero. But unlike a clean startup, they already are carrying investors on their cap table. In effect, the team is acknowledging that the money and time they spent to date is worth nothing.
That means that rather than the team starting with 100 percent of the company, the team is now starting with around 70 percent of the company or less based on how much of the former company they had given away. It means they are basically writing their own value down to zero but not that of their investors. So if things work, they are instantly getting 70 cents on each dollar of value they create going forward.
When a team starts with 70 percent of the equity of a company rather than 100 percent, it becomes extremely hard for the founders to maintain control through more than one more round of financing. The greatest companies are built by founding teams that are deeply in control, and even with very supportive capital, when founders lose the ability to outvote everyone else I believe they make worse decisions out of fear for their safety and position.
The upshot is that in a pivot, the team pays the full price of their first idea failing, while the VCs get an almost free position in the next thing based on capital that they invested into something that didn’t work. This is extremely friendly for capital, but not so friendly for teams.
Bad for Teams
The second issue with pivots concerns teams themselves. This issue takes two forms. The first is that when you change dramatically what you are doing, not everyone on the team is going to be right for what comes next. At least part of the team might not be the right people, which causes transition turmoil.
Further, for those who are right, pivots create equity and vesting challenges. Building successful startups—even the rocketships—takes an enormous amount of work and time. The general convention around people vesting equity on a four year basis with a one year cliff was based on the notion it took four years for a company to go public if things worked out. That’s just not the case anymore.
When teams pivot rather than restart, employees are already well into vesting their original grants, which may truncate their anticipated tenure.
Rather than vesting out an original grant over four years, employees could be left with three or two years. This, like the cap table issues, might not burn a company on day one. But a few years later, if the business is doing well and founders and team members start leaving earlier than expected, things can get ugly.
To be sure, there are myriad variants on the pivot, and teams and investors can and do structure them to mitigate pitfalls. Sophisticated teams might impose equity rebalancing deals or new option pools to refresh the most important employees. If the second business is very different from the first, founders almost always offer financiers their money back. But investors rarely take them up on it because they would rather roll the dice on another lottery ticket and avoid a write down.
But the problems are hard to completely avoid.
Many years ago, pivots may have made more sense because startup costs were high. If you had to buy servers rather than rent access on Amazon.com, you could argue that the old investment than went into buying those assets really should carry over to the new company and be compensated. When it was simply harder, more time-consuming, and more expensive to set up things like payroll, finance and accounting, the capital and labor that went into starting a company was truly valuable.
But, at this point, when almost everything is turnkey, and there are even wind-down specialists who help companies dissolve, a clean start is generally the best way to go.
I expect this column will get some negative reaction from venture capitalists who believe that they back “people not ideas.” They pride themselves on not backing out when the going gets tough and they want to maintain relationships. In my career, some wonderful people have supported me this way, and I’ve appreciated it deeply.
That said, I believe that investors taking that approach is unfair to the entrepreneur and lacks rigor. It is unfair for the entrepreneur because it effectively puts them in the position of taking care of the investor, even if the thesis everyone is betting on together turns out to be wrong. It also allows investors to be far more sloppy with their actual analysis of a business opportunity.
As an investor you are using capital to buy a percentage of a specific effort—a team, and an idea, and an approach. If those three things don’t come together to create something that is working, investors should accept that they made a mistake along with the team. The team wasted time; the investor wasted money.
If everyone wants to try again together, that is wonderful. But to entrepreneurs I say, if something isn’t working, don’t give investors a piece of what is next simply for having backed your first effort. And to investors I say, you don’t have a duty to a person; you have a duty to back people following a specific thing you believe in.
If people operated more often this way, and were truly willing to let things fail and try again, the ecosystem would be a more efficient place for deploying time and money.