Pivoting into a new corporate structure

This hasn’t happened to me, but I keep hearing stories about situations like the following: 1) startup raises a seed financing round while working on a preliminary idea, 2) founders later “pivot” into a new idea that looks more promising and/or gains traction, 3) founders decide to raise a new round of financing, 4) founders argue that the new idea is so different from the original one that it should be part of a new company, and that the original seed investors shouldn’t own any part of it.

At Founder Collective, we think of ourselves as investing primarily in people, and only secondarily in ideas or products. I have to admit that until I heard about these situations happening, I hadn’t even conceived of the possibility of “pivots into new corporate structures”. In retrospect, I suppose it was inevitable given the founder-friendly market and the rapidly evolving venture environment.

As a legal matter, assuming the founders worked on the idea on the original company’s time and/or money, the seed investors probably have a strong claim. Founders and employees normally sign “invention assignment” agreements that would make the new ideas and products property of the original company (again, these aren’t situations I’m personally involved in so I am just speculating on the specifics). The reality is that most professional seed investors aren’t going to sue founders and will likely instead try to work out some compromise.

This is not to suggest, by the way, that founders are indentured servants to investors. It is perfectly fine, if an idea isn’t working out, to wind down the company, return the remaining capital, and go off and work on new ideas. If one of those new ideas shows promise, the founders are then (legally and morally) free to form a new corporate entity and raise new financing from whomever they choose. From news reports, it sounds like this is what the Odeo team did before they pivoted to Twitter. It’s the conventional and, in my view, correct way to handle these situations.

Here’s what really worries me. If it becomes a norm for founders to jettison seed investors when their company’s focus changes, seed investors who invest “primarily in people” will stop doing so. I think that would be a real shame: we’d lose an important source of capital and a lot of innovative startups wouldn’t get funded.

http://benmetcalfe.com/blog/ Ben Metcalfe @dotBen

“As a legal matter, assuming the founders worked on the idea on the original company’s time and/or money, the seed investors probably have a strong claim.”
…
“It is perfectly fine, if an idea isn’t working out, to wind down the company, return the remaining capital, and go off and work on new ideas. If one of those new ideas shows promise, the founders are then (legally and morally) free to form a new corporate entity and raise new financing”

I don’t mean to be pedantic but I think what Ev did was realize that the IP + work done to invent Twitter *was* done with the original Odeo investor’s money and so rather than have them lay claim to potentially a much bigger ball-park company, he bought the original investors out (ie returned their capital, and presumably made good on the short fall).

That’s not quite the clean break you are describing in your piece – but I raise it because it is more likely that as entrepreneurs who have ideas buzzing all the time we’re not going to decide a venture isn’t working out, return the money and *then* discover a new idea in that strict succession.

Back to Ev’s predicament with Odeo’s employees inventing Twitter under company time, is did he disclose to the investors he was buying out exactly what IP had been invented? I remember when he bought back Odeo, at the time it was kind of made out that he was ‘doing the right thing’ and buying back a failed company so that his investors were not left high-and-dry (which is rather odd given the nature of ‘risk capital’).

I don’t know what happened, I wasn’t there – but it still leads me to wonder whether this was (to use your words) “the correct way to handle [this] situation”

http://www.cdixon.org chris dixon

Maybe I shouldn’t have used the Odeo/Twitter example because I don’t know what happened there beyond news reports. It might not represent the situation I meant to describe. In any case seems to me that offering to buy out your investors (with full disclosure and giving them the option to keep their capital in the company) seems like a very fair way to handle things.

http://benmetcalfe.com/blog/ Ben Metcalfe @dotBen

Yes, I would certainly agree with your sentiment that offering to buy the investors out – full disclosures in place, etc – is the fairest way.

This is an important post because like you said, investors invest in people first and foremost and in “the era of pivot” entrepreneurs need to tread carefully and play fairly.

http://www.dogster.com Ted Rheingold

Related: I’ve had no choice but to wonder the alst couple of years, if all entrepreneurs had the ability and courage to make investors whole from their own holdings, I wonder how many more Twitters might have been able to grow.

I don’t think a company should travel (love that term), and I don’t think a company should jettison well-meaning investors because they wanted to give up working how they said they would. Pacta Sunt Servanda “agreements must be kept”

However, I do think investors should be more willing to structure exits for investments that founders are left boxed in. The reality is that the average seed investor would rather a company completely exhaust all opportunities, then say return a fraction of the money.

But I’m pretty sure you wrote this piece Chris in response to companies that aren’t living up to their part of the agreement. Which I’d love to talk about more in another comment

http://twitter.com/dttg diegogomes

Chris, how do you handle spin offs in your portfolio companies? And how “legally” should a startup and a investor deal with these kinds of situations?

http://www.cdixon.org chris dixon

So you mean a true spin off where company A spins off company B while Company A continues operating and you end up with 2 companies? I’ve seen it once and what the founder did was structure it so company A owned, say, 40% of company B (the rest was allocated to new investor & management) and then the founder dividended those company B shares out to Company A investors. That seamed like a very fair structure. Since the founders owned a decent chunk of company A, they also ended up with a decent chunk of company B.

http://twitter.com/bap Brian Paul

Maybe i’m just a bit sentimental but when an angel invests in you they are allowing you to pursue a dream you have; an idea. Yes there’s a business arrangement. Yes, there are legalities. Regardless, at some level, ethics, basic human decency and gratitude demand that you not screw the people who aided you in this opportunity.

Sometimes these relationships go sideways and there is a certain amount of temptation to ‘get yours.’ This is exactly the moment when your actions will broadcast to every other potential investor (as well as the rest of the planet) exactly the kind of person you are. People have long memories.
http://hdemott.wordpress.com Harry DeMott

Good post. Amid the clamor of all the “founder friendly” posts and the entrepreneur as rock star commentary we have these days – it’s good to see people realize that without capital – none of this early stage stuff really works. There can be extraordinarily bad behavior from all sides of the equation – and what you describe is pretty bad
http://www.sixstringcpa.com Geoffrey

Great post Chris. I have been more than a little concerned with the overuse of ‘Pivot’ for quite some time now. NOT because a course correction is bad or wrong (you offer a fair and mature suggestion on how to handle this approach in your post) but because the overuse of a thought/idea/term can really hyper-charge a culture and system. And in this supercharged atmosphere unfortunate things can happen. It is why I started using the term Pivotophobia and sharing and mentioning it on Fred Wilson’s blog and March Birch’s blog and even on Micah Baldwin’s blog. I am unfamiliar with any specific examples of what you sight happening – I will take you at your word that they are. I would not be surprised if this is the case though.

Again, great post to share with the investing and startup community at large.
http://www.kellblog.com Dave Kellogg

While some pivots are valid, frequent pivoting can be a sign of a simple lack of corporate strategy. To extend the pivot metaphor (i.e., one foot stationary), I think VCs and boards should call companies for “traveling” when both feet move — e.g., pivoting into a new corporate structure.

I blogged about this here a few weeks back: http://kellblog.com/2011/07/13/the-silicon-valley-strategic-pivot/

http://www.cdixon.org chris dixon

traveling – good concept.

Anonymous

Chris, the only reason I could accept for a “pivot into a
new corporate structure” would be the case where the new entity is a completely
different market that the investors can’t help in or might even be a hindrance
in when it comes to raising additional funds.

That said I find it funny that most bloggers keep using
examples of startups that have “raised funds to work on their ideas”. No
offense but even in this frothy investor market that doesn’t happen on
AngelList, and if it doesn’t happen on the hottest investor “club” in town then
I doubts it.
http://www.echolouder.com Bruce Warila

Great post Chris. In the music industry, in a 360 deal, artists (founders) are sometimes asked to sign rights and services agreements whereby all intellectual property created during a term is pledged to an entity that they also share ownership in.
http://www.dogster.com Ted Rheingold

Great and very timely post Chris. As someone who took the commitment of my investors very seriously (even when they became mostly uninvolved) I’ve been closely watching others that seem to have no concern about shaking off their investor because they decided they wanted to do something else. As you say, investors are unlikely to publicly go after said entrepreneurs which leads them to think it’s fine to walk away.

But they will learn not long after when they go to raise money on their next round how most every qualified investor will have dozens of questions about their commitment length. Their reputation will be tarnished and they better have an amazing jaw dropping idea to get new investors over the hurdle of their feckless past.

When it goes back to being an investors market (something most of them have never experienced in their < 4 year fundraising experience) they'll have even more they have to prove.

(But do see my comment in the thread with dotben about the problem of investors preferring some businesses to run themselves to exhaustion, rather then give them any sort exit to fight again sooner than later)
http://www.upnext.com Danny Moon

Perhaps the founders are getting pressure from the new money to get the seed investors out? Purely conjecture on my part but it would not surprise me.
Anonymous

Seems that reputational concerns would weigh more heavily in the equation than legalities. Not sure how much protectable IP your average startup has. Non-competes, even if agreed to in a state that enforces them, may not be enforced as drafted. Maybe in an egregious case the investors could go after a startup’s founders for fraud and unwind the original transaction. But that will not often be the case.
http://danspinosa.com/ Dan Spinosa

When you invest in people, it is the responsibility of those entrepreneurs to produce for and do right by the investors.

We recently traveled into a new corporate structure and essentially mirrored the angel equity from the previous company. It was the right thing to do. Not only for the companies and the angels, but for ourselves. I hope to be a lifelong entrepreneur and know I’m standing on the shoulders of our angles; I’m not going to kick them in the teeth.
Anonymous

Why can’t this be caught by the “work-for-hire” clause most companies have? Did Odeo have anything like that?

http://www.cdixon.org chris dixon

It’s not really a question of whether it’s covered by legal agreements (it usually is), it’s more that (good) investors are very unlikely to sue their investments.

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Chris Dixon

Pivoting into a new corporate structure