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.

Pivoting

My Hunch cofounders and I frequently ask ourselves: “If we were to start over today, would we build our product the same way we had so far?” This exercise is meant to counter a number of common cognitive biases, such as:

1. The sunk costs trap.  People tend to overvalue past investments when making forward-looking investment decisions. From the rumors I’ve heard, Joost was a company that fell into the sunk costs trap. In the beginning, their p2p architecture was their main differentiator. Thus they invested a lot in building p2p infrastructure and required users to download a software client. When browser-based web video companies like Hulu and YouTube surpassed them, Joost switched to a browser-based client but still required a special plugin so they could maintain their p2p architecture. In fact, the problem the p2p architecture was solving – reducing bandwidth costs – had, in the meantime, become a secondary basis of competition.  By the time Joost finally discarded the p2p model, it was too late.

2. The Bridge on the River Kwai syndrome.  This is when entrepreneurs fall so in love with their engineering project qua engineering project that they lose site of the larger mission.  Former engineers (like me) are particularly susceptible to this as we often get excited about technology for its own sake. Many products can be built much more quickly and cheaply by settling for good technology plus a bunch of hacks – human editing, partnerships, using 3rd party software – versus creating a perfect technology from scratch. At my last company, SiteAdvisor, we made the decision up front to build a non-perfect system that did 99% of what a much more expensive, “perfect” technological solution would have done.  The software wasn’t always pretty – to the annoyance of some of our engineers – but it worked.

3. Solving the wrong problem. Location-based social networks have been around for years. Foursquare came along just a year ago and has seemingly surpassed its predecessors. The other companies built elaborate infrastructures: e.g they partnered with wireless carriers so that users’ locations could be tracked in the background without having to “check-in”.  Foursquare built a relatively simple app that added some entertaining features like badges and mayorships. It turned out that requiring users to manually check in was not only easier to build but also appealing as users got more control over their privacy. Foursquare’s competitors were solving the wrong problem.

Ask yourself: if you started over today, would you build the same product?  If not, consider significant changes to what you are building. The popular word for this today is “pivoting” and I think it is apropos. You aren’t throwing away what you’ve learned or the good things you’ve built. You are keeping your strong leg grounded and adjusting your weak leg to move in a new direction.