Managing Liquidity in Risky Markets — 5 Mistakes Investors Make

Managing Liquidity in Risky Markets — 5 Mistakes Investors Make

by John Kogan
April 09, 2021

None of us has a crystal ball, but we can all acknowledge the current metrics indicating an overvalued equity market. With prices high, portfolio companies needy and limited partners’ backing at risk, how do venture capital and private equity investors limit unexpected cash outflows and preserve dry powder?

Following are five mistakes investors often make. Most of them arise from not following guiding principles, and not imposing guidelines on the CEO.

  1. FOMO Part 1 – Auction Mentality. Another investor’s bid should not be a factor in determining the highest price you are willing to pay. Fear of missing out (FOMO) is not a reason to buy at inflated value. Are you following written investment guidelines? Do metrics inform whether or not you feed or starve a company?

    No dashboard will give a definitive answer on what to buy at what price, but if you are not taking an apples-to-apples view of your portfolio companies based on KPIs, and following your written investment policies, you will be more vulnerable to unconscious biases and emotional attachment when term sheets are played against each other by smart sellers. Stick to your diligence, stick to your process, and don’t chase overheated deals.
  2. FOMO Part 2 – RIF Avoidance. The most daring of CEOs often will do anything to avoid facing a reduction in force (RIF). They fear loss of morale and institutional knowledge, and a sense of failure. They display uncharacteristic conflict avoidance behavior when terminations are discussed. In most situations, however, serious problems are already known to employees. Taking definitive action, including a layoff, with a well-articulated plan for the future can reduce the anxiety that drives better performers to look for an exit.

    Institutional knowledge is often overrated. Rarely do we wish for the knowledge held by underperforming team members we let go. High performers’ morale always suffers when they see the cost of keeping weak players. Pruning exposes costly hidden issues and opens space for key players to advance more quickly. Assistance from the board and outside advisors helps rationalize decisions and preserve relationships. They play bad cop, and the CEO gets to keep their white hat.
  3. Failure to Force Prioritization. Founders are often brilliant visionaries who see possibilities in many places. So many ideas are too good to pass up! Management and avid online fans are demanding attention to pet deliverables — never mind that most of the customer base is not even aware of the issue. You aren’t in business to micro-manage, but too many boards are hands-off until runway becomes an issue.

    The CFO can be your advocate here. They are closest to the numbers and know the CEO’s blind spots and where the beef is versus the fat. CFOs are often torn between loyalty to the CEO and frustration in efforts to course-correct to benefit the bottom line. They may argue vehemently against out-of-budget expenditures and mission scope creep with the CEO, but not in front of the investors.

    Good CFOs want to be asked the hard questions – but they usually won’t volunteer bad news against the wishes of the optimistic or desperate CEO. Forced ranking of projects, differentiating between must have and nice to have, and acknowledging what most users require to make a purchase decision are critical. Ask them.
  4. Starving Marketing. (This is the corollary to FOMO Part 2 and also impacts prioritization.) Labor and marketing are usually two of the biggest expenses a growth company has. Most senior management has a mindset that employees are a fixed cost, and advertising is a discretionary expense to be dialed back when there is a budget shortfall. Those of us who have been around for a few decades have all seen companies with superior products lose market share due to a competitor’s superior marketing. Considering what drives revenue is critical to prioritization.
  5. Tax Allergy. The latest scheme to save hundreds of thousands or millions in tax dollars is irresistible to many founders, who balk at the thought of their hard-earned gains being diminished, as well as to investors imagining the impact on fund ROI. Many investors and management teams fail to consider: 1) the opportunity cost of significant diversion of management focus and back-office support; 2) the hit to company value when due diligence proves complex or makes the buyer uneasy; and 3) regulations often change and the millions in expected savings evaporates.

    If it sounds convoluted or too good to be true, get a second opinion and a third. Unnatural acts for tax savings frequently backfire and can easily reduce value.

Stay Focused on Value

There's an old audit saying about corporate culture that “a fish stinks from the head.” The right tone from the top can reduce liquidity risks in markets like we face today.

The moral of this short story is to stick to your well-considered investing process, ensure your leaders make the tough decisions in tough times, remember what drives value, and don’t look to tax schemes. Value comes through great product, well marketed, at companies that are run by a steady hand.

To learn more about driving value by strengthening the corporate finance function, contact our Strategic Finance Outsourcing experts.

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Chief Financial Officer (CFO)
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