An Actual Case Study Where I Could Have Done a Better Job

Paul Haley, the founder a company that we backed, Haley Systems, posted a comment to my last posting.  I contacted Paul and asked him if he would mind if I created a post in my Bill of Rights.  He kindly agreed.  Here’s his question:

“Larry, I literally hear you on the last sentence! I most enjoy how this post reinforces the title of your blog. I would appreciate more of your thoughts on the board/VC’s challenge in guiding versus terminating a CEO struggling with the challenges you enumerate here, perhaps after you’re done with the Bills of Rights. More specifically, how do you assess how much to influence operations versus waiting for abject failure before acting? How active do you think a founder/entrepreneur or CEO should expect the board or VC to be? What are your thoughts on being an active VC? Under what circumstance do you think a VC should be as patient as this post might allow? (Perhaps you should write a book?-)”

Haley Systems had a very interesting rules engine that was a perfect fit with an investment thesis we were exploring around the next generation of code development.  We looked at a number of companies and found that Paul’s company was the best match.  We wanted them to attack the low-end of the market with a new table-driven product (our vision, not theirs).  The company had revenue and had been bootstrapped by Paul since inception.  We felt Paul was a brilliant technologist (I still think that – he’s one of the best) but we felt that with a more experienced CEO, the company would grow faster.

Replacing the entrepreneur/Founder/CEO was the first mistake we made.  Hiring a new, great CEO was not an easy prospect because the company was located in Pittsburgh, not a mecca for experienced software company leadership (but not devoid by any means – there are several very successful companies in this area and the number is growing).  The guy we hired had been successful in a prior company (although not as CEO) and he seemed to have the business skills that would enable Haley to grow rapidly.  We introduced him to Paul who agreed and Paul hired him.  We closed our investment and set out to build the business.

From the start, Paul and the CEO diverged on strategy.  We encouraged Paul to wait and let the CEO execute.  In typical “hired gun” style, the new CEO hired a couple of other execs in various functional roles who, also, were apparently successful in prior companies.  He added other staff as well.  We did less with more people, we lost track of our customer needs, we got caught up in big deals that went nowhere and, in the end, we fired the new CEO and his team.  Paul lost faith in the board and his investors, tried to right the ship, might have done more damage, maybe not.  Paul, who was in charge of developing the product, never launched a low-end product because it did not fit HIS vision.  A board member stepped in to run the company and we sold for a discount of the amount of capital we put into it.  Paul and his investors managed to come to an agreement on the split on proceeds that left everyone miserable.  Lots of fun.

For me, this was an important learning experience.  This happened in 2003 or so, but it was apparent already that the development of companies was changing.  The guys who cut their teeth on growing the typical client server company (big dev teams, salesforce, etc) could not make a change to the new business models that were developing (software-as-a-service, low cost sales, lower cost development, rapid iterations).  Watching these types of guys was like watching someone putting square pegs in round holes using big hammers that shattered everything!  Moreover, the CEO was a hired gun.  He could never garner the passion that Paul could for this business.  He had 10% of the business (if anything, he was a great negotiator), but truthfully, he viewed himself as more of an employee than the business leader.  He did not care all that much about dilution (he would go on to the next opportunity or get re-upped with more equity if he spent too much money) and his employees followed his lead.  It must have been devastating for Paul to watch this man run his company into the ground.  This investment was one of the final straws that made us change our investment criteria to backing only companies where we thought the Founder/CEO could go the whole way.  We have strayed from this on occasion and we have needed to bring in CEO’s in companies where WE were the founders, but, in general, this has been our modus operandi.

So on to Paul’s question.  Yes, we changed our investment criteria, but that does not mean we have been successful with every founder CEO since – we haven’t.  So, what do we do when we encounter this this situation?  The first step to solving any problem is recognizing that you have a problem!  This is easier said than done.  Typically, we like the CEO.  He or she might be a terrific person.  They have families.  They are trying really hard.  We believe in the company.  It’s actually really hard to recognize that you have a problem with your own company.  I would liken this situation to trying to believe that your child is not really the kind, wonderful, genius super model that you thought he is.   I don’t have this problem though, since my kids are just like that…

Discovery of the problem can come in several ways.  The best is to have sat down with your Founder/CEO prior to financing to discuss specific milestones against which success is measured.  But, as I said in the last post, companies never develop in a straight line.  However, the milestones do provide an opportunity to understand how the company is performing and what are the causes of the variance: Market? Product? Customer? Team? CEO?  The milestones provide a great framework to assess how the company is doing without being a binary (go/no-go) gate for the company’s future.

Typically, the awareness that the CEO is not performing is not discovered simultaneously by the board.  Many times, board members with close associations to the CEO don’t or won’t admit to seeing a problem.  They will defend the CEO for many reasons among them friendship, loyalty or simply trying to avoid confrontation.  Again, having pre-established milestones helps take many of the emotions out of this discussion.

Before there is agreement that the CEO must go, there is agreement that he/she should be put on notice that performance is not up to standard and the board tries to help with the situation in anyway it can.  This often falls to the VC board member along with a board member who was chosen by the entrepreneur/CEO.  With milestones, an objective conversation be held.  No accusations and counter accusations – just facts.  It gets emotional and its hard, but it’s the first step.  The board needs to tell the CEO that performance is not up to expectations and the board needs to offer the CEO all the help it can muster.  But, as I said before, the board and the VC does not run the company, the CEO does.  And in the end, the CEO needs to deliver the performance.

We strongly believe that we need to be active investors who add value.  We can certainly help, but our real ability to impact a deteriorating situation is to make changes, i.e. fire the CEO after all else fails.  We would certainly be looking to help the CEO all along the path leading up to this point in any way we can help.  But often, in these situations, the relationship between the CEO and VC has deteriorated.  Communication breaks down.  The CEO looks for other allies on the board.  So afraid of being fired, many times, the CEO seizes up and almost stops functioning.  Sometimes the best value we can provide is to just tell the CEO to go out and do the best he/she can – after all, what is the worst that can happen?  We will tell them we believe in him/her (if its true which it should be if we are all communicating about progress regularly) and to go take some chances.  Many times, failing CEO’s exacerbate the situation by becoming more conservative, ceasing to experiment, stopping learning.  Unless we can get the CEO back out there, failure is around the corner.

The real challenge though is to understand if the situation is the CEO or some other factor.  Firing the CEO must to be the last-ditch effort to save the company.  When the CEO is the founder too, firing the CEO it is like doing a heart and brain replacement surgery.  Probably with similar success rates in an early stage company.  Again, the factors behind failure can only be assessed through regular, objective dialog between both sides.

In the case of Haley Systems, we failed on several fronts.  I already mentioned that we hired the wrong CEO out of the gate.  Truthfully, we should never have invested and Paul should not have taken our investment.  He had a successful business that probably would not have gotten very big, but it would have been successful for him.  He was willing to give up the reigns, but having the founder hovering in the background with so much change is always very hard for everyone.  We hired the CEO without getting a plan out of him ahead of time (I will write about this in a future posting at some point).  We zigged, we expected him to zag.  He was  a terrible communicator and we never set up specific objectives beyond the financial plan.  We tried to counsel him, he never listened.  He had no passion or zeal for the market or the business and this lack of spirit spread everywhere else in the company.  We counseled him, we worked with him, we helped with sales, but in the end, he had to run the company.  We took a member of the board who had some time available and made him CEO.  He made as good a situation of it as he could but, by that time, we were in deep doody.   Our relationship with Paul deteriorated because he could not trust us to do the right thing since his company had gone nowhere but down since we became involved.  He worked to implement what he thought would work, often at cross-purposes to the acting CEO.  He never developed that low-end product until it was too late because he never shared OUR vision.  We initiated a sales process of the company and had interest, but the divisiveness was so apparent that either the potential buyers had no interest in getting involved in such a disaster or they knew they could get a great deal on the company. We sold the business, got some of our money back, settled with Paul and tried to make sure we learned from this situation (which we did – in spades!).

So, this is what it looks like in the real world.  It’s easy to write about it in some abstract framework like this Bill of Rights, but it is a lot harder in real life.  Like a great entrepreneur, a great VC should learn from every situation, good and bad.  We spend a lot of time with an almost forensic examination of what we did well and where we screwed-up.  With Haley, we screwed-up on many fronts.  Actually, the truth is, I did.  I think I learned from this and other situations and that is what I am trying to communicate in this blog.  Paul, thanks for letting me talk about it – please feel free to comment with your thoughts from the other side of the table.