Thursday, May 29, 2014

Most Accidents Happen Close To Home - An Example of Startup Failure

In 2011, I invested in a promising gaming start-up. The promise was to license TV and movie content for related games, and get a jump start by using the brand name and co-marketing agreements to quickly build an audience. The leadership team was strong, the company attracted many experienced angel investors, and internet gaming sector was buoyed by Zynga’s impending IPO.

Yet, not even a year later, the investment ended up a complete failure.
When a company comes out a winner, everyone takes credit. When a company fails, it is like the scene of the traffic accident: Car drivers, passengers, bystanders, perpetrators, victims, police, ambulance - they all have slightly different perspectives about what happened. In this situation, one needs to peel back the onion to understand what really happened.

Research indicates that angel investors’ outcomes can be positively influenced by spending more time on due diligence, leveraging industry expertise, and frequently interacting with portfolio companies. To get a better understanding of the events, I talked to a number of board members, investors, and company executives. What were the early warning signs that something was going wrong? Was it a lack of due diligence? What actions should have been taken?  Did the board not take corrective action early enough? And would the outcome have been different?

The obvious answer is to point to a market failure. After its IPO in December 2011, Zynga’s stock price briefly rose and peaked in March 2012.  In March, Zynga acquired OMGPOP, the maker of the Words With Friends game, so there was an brief opening for gaming companies to be acquired. Even as this acquisition was consummated, Zynga’s stock fell off a cliff in April, taking with it the hopes of many start-ups to be acquired. The disappointing Facebook IPO in May further put a chill on the market. Raising funding for a gaming startup in early 2012 certainly was a challenging endeavour to say the least.

Both founders had worked together on the project part-time for two years before raising the initial funding. The energetic and talented CEO had a strong product vision and experience as a founder. The COO had a background in finance and operations, start-up experience and connections in the media business. The board consisted of several highly experienced angel investors. And yet, majority of stakeholders thought the founding team had failed. The money was wired in July of 2011 and the team started to ramp up. At the first board meeting in September, the directors had trouble getting financial and market information. It became clear that the CEO lacked business acumen. Soon after, the CEO, who also was the CFO and the chairman of the board, started behaving increasingly autocratic. By late fall, the relationship between the two founders had deteriorated to a point where the board started counselling the CEO. Checks and balances between the two founders disappeared, and the relationship became emotionally charged. To make things worse, the COO developed health issues  in November and the CEO was hit by a car, partly incapacitating both founders during a critical time. And none of the outside directors had experience in the online gaming industry.

At the end of 2011, revenue had come in short, and cash reserves were rapidly dwindling. January saw a rapid succession of board meetings where the CFO responsibilities were finally removed from the CEO and moved to the COO. At the same time, the COO faced a declining health situation and ended up having to step down at the end of January. The CEO ventured to raise more money, but the money never arrived in the bank accounts. Almost weekly board meetings continued throughout February. In late February, the CEO obtained a short term loan in exchange for company common stock and receivables to stave off immediate bankruptcy. In doing so without informing the board and without its consent, he breached the investor rights and was subsequently removed as chairman. The money that had been promised never arrived, and in early March all employees had to be laid off. Only a minimum amount of cash was left. In April, the company missed a royalty payment for the marquee game, and the game was cancelled by the content owner. The outside board members resigned.

But all the executive changes and board actions were merely too late. Coming out of the 2011 summer break, the marquee game had good metrics per user but did not get the expected traction. The company had been struggling grow the number of users, and made no progress until December. The introduction of new features during the Halloween and Thanksgiving holidays did not move the needle. And a critical co-marketing agreement and a new TV season would only kick in in April 2012. In retrospect, the product issues were apparent in the fall already. Instead of focusing on fixing the game, the team embarked on a multitude of projects such as replatforming the game for mobile, developing a second game, and taking on project work on behalf of others. Moreover, resources were diverted to build a proprietary metrics platform to save money paid to 3rd party providers.

The truth lies in the eye of the beholder. In this case, it appears that some of the best practices for a successful angel investor outcome were ignored, and that events spiraled out of control faster than anyone anticipated.