Startup investors: What to look for, what to avoid and how to due to diligence
Many first-time founders have grand dreams that only some money can make them a reality. To achieve it they set their goals by their success to fundraise and they are happy with any type of money raised in any form. They go about the entrepreneurial echo-system impressed by check numbers of their peers and believe this is a great metric for success.
This mindset exposes founders to taking money that can have a negative affect on their journey.
In this blog I’ll review what to look for in investors and what to be careful of. Hopefully, finding the right investor for you will enable you to build a strong partnership with those investors that will lead you to success and generate great returns for them.
If too busy or just can’t be bothered - just scroll to the TL;DR section.
Why are you fundraising, to begin with?
Let’s start with the trivial motivation for you being in the market, looking for money.
Even if you and your team are all on Raman now, history shows it won’t last forever. You will all need salaries to eat and live, but moreover, the company will need money to move forward.
The most efficient planning of your ideas testing scheme will require some money to test them out. Without money you are always stuck in the “chicken and the egg” scenario: I can’ test and develop my ideas if I don’t have money. I won’t have any money until I have some proof of my ideas. You can always bootstrap some parts, and you should always be as smart and frugal in managing your efforts, but keep in mind that time is always of the essence, so using money to move faster is not only logical but many times smarter. With that understanding in place, you can plan how much money you need and how you plan to use it. The most important part is what would be the next step if your plan succeeds. Will you raise another round of funding? If so from who and how much? If not, will you use the cash generated from revenues to drive growth?
What about the investors? What are their motivations?
A simple viewpoint will assume investors invest to make money or generate favorable returns.
While that is always the case, this answer is very lacking. Many angel investors are actively looking to help entrepreneurs as part of their ideology. They might view it as their social responsibility - not only to provide capital to young companies but also guidance and support.
Others might view startup investment as an asset class for diversification, and some corporate invest in startups using their corporate VC’s to keep their fingers with the pulse in the industry, rather than relying on analysts and 3rd party reports.
Setting investor founder expectations
Many founders are pitching like car dealers. Life is seen through pink glasses, and the future is rosy. That is all well as an initial hook, but it's best to have an honest discussion about what each side expects in the long run and why they make the investment.
Some investors love to be involved, others are looking for a passive investment. Some expect their investment to be paid in full with some nice return in the next round of funding. Others plan to go “the full monty”. Some investors expect the company to stick to its “vision” while others expect it to pivot often in search of a business model. Some investors are happy with a small exit, while others will consider nothing but a NASDAQ IPO.
These differences in expectations will create differences in strategic thinking, which will lead to tension. Sometimes this tension can be mitigated, and sometimes it may cause the founder and CEO to be ousted. In general - the company’s CEO is perceived as the one who knows the company and industry best and thus will set the tone. Losing the faith of the investors may cause the loss of the CEO title. Here are some examples:
- It’s best to list in advance each sides thoughts about the near future as well as the vision
- Does the company aim for IPO/M&A/evergreen?
- How fast should the company recruit and grow the team?
- Which function do we grow at a priority? Sales? Marketing? Product and engineering?
- What does an expected budget look like for the company? E.g. Many early-stage investors are surprised the founder is expecting a salary after two years of bootstrapping.
- How is the company expected to grow?
- In what level of “days to live” do we start to fundraise?
- What level of involvement does the investor have? In what capacity? Is there a compensation as part of that expectation going to the investor?
“Hey, I hope you don't mind, I got up a little early, so I took the liberty of milking your cow for you. Yeah, it took a little while to get her warmed up, she sure is a stubborn one, whew.”
“We don't have a cow. We have a bull.”
“I'm gonna brush my teeth.”
Industry experts provide information on industry benchmarks and connect with vendors, partners, and distribution channels. They can provide feedback on the progress as well as help to set the right goals. All these make an investor who comes with a strong industry experience worth more than their dollar investment. To sell their value, many investors will claim they have expertise in an industry, and since some experience in one industry has some carry over to another, this is true in the board sense. Having said that, the further the distance between the industries, the less likely that advice will be applicable in all cases.
When trying to evaluate how helpful the investor will be, try to evaluate the similarities and differences in his experience. Example of items to look for:
- Industry - the more specific the better.
For example, “this investor is great for us as they have B2B experience” is much too broad. A much better fit would be “we are a company that develops quality control solutions for the metal manufacturer and this investor was the head of biz dev for a public company selling to quality managers in manufacturers”
- Size of company - If the investor is inexperienced with large corporates, many of his advice will be hard to implement. “You want market awareness. Get the biggest booth in the show”
- Business model
- Company stage - if they’ve never been involved with a company that has not fully proved their product-market fit - they would not even know what the search process looks like.
- Company funding background and vision
- Company long term goals
Every investor will claim they have a lot of value add that exceeds their check size. This claim is easy to make but very hard to prove or validate. Having said that, some large investment firms not only talk the talk.
Traditional investors were focused on investing their own money, or money they have raised for their fund. The primary role of the investor was to achieve superior returns by deploying money to the best opportunities in the market. Sure, they took board seats and gave valuable advice when needed, but this is it.
Andreessen-Horowitz was the first VC that changed that model Started in 2009, this fund actively works for its portfolio companies, by providing them with high-quality services such as recruiting, digital marketing, branding, training, and more. Many VC’s claims to follow the model, but very few actually do. A VC might show a public relations person as part of the team, but the only PRs that person will ever actively drive is related to the fund itself, giving you no value whatsoever.
Many investors would claim they can bring value to you via “operational expertise”. That is absolutely true, but it’s best to both understand what that means as well as to set the expectations between the parties going forward.
When the founder hears the investor brags about operational expertise, it is important to understand how relevant it is to your company. First, go through the same questions as reviewed in the industry expert section. Then try to understand which organizational function these investors are most experienced with and whether it fits your needs. Were they headhunters in your industry or chief marketing officers? Did they manage the sales organization or made the first sales for a startup. If they were CEO’s they’ll bring the broadest viewpoint, but also the least function-specific expertise.
The last thing is to understand the expected level of involvement you should expect from that investor and if it comes with additional cost. The founder might expect an ongoing heavy engagement while the investor is OK with a short advice phone call once every couple of weeks.
Some people say that if the investor is expecting the company to pay them anything for their services, it’s a bad sign. I do not hold this position but rather the opposite. In my humble opinion, if the investment is substantial compared with the services provided, it’s actually a good thing. For example, an angle that invests $50K in a company, and also has a marketing agency that provides hourly training for $100/hr. If they sell the company a full day of training every week, it would take the investor more than a year to “recover” their investment, which suggests the structure was not set to drink all the funds in the company using a straw.
In these cases, it is useful to limit the paid engagement in advance to a limited project or timeframe. This would allow a softer “breakup” in case the company doesn’t need the services any longer or chooses a different vendor.
“Money does not stink”, or does it?
Many entrepreneurs, especially in the early stages, are happy to raise any money from any source. In the long run, this can prove to be problematic. First of all, in the US as well as other countries, the selling party (e.g. a startup raising A round) is responsible to make sure all investors are accredited or handle the exceptions. But even if all your investors are accredited, it doesn’t mean it’s a match made in heaven.
Different investors have different expectations - about the level of involvement in the company, how quickly they should see a return, how volatile the business is, as well as the capital requirement for a business in this industry. Many inexperienced angels are wooed by dreams of huge exits, but when the time comes to raise the next round of funding, be it an A round, a B round or later rounds, they are surprised by how much capital is required to get to those dreams. They will be diluted, they will lose their rights and in some vicious cases, they might be exposed to a “pay-to-play” scenario where they will be diluted faster than expected. All these will guarantee to create tension between the founder and those investors, and in many cases, it can derail into a legal conflict between the investors and the company.
In order to avoid all these, make sure the investor you bring on board either has a lot of experience in the specific field, or you help them understand what is expected, even at the risk of losing the investment. For example, an investor in the restaurant business may be OK with the initial investment check, but they might expect a hefty dividend after the 3rd year. Since tech startups seldom pay dividends before they IPO, this is a tension point that needs to be cleared out before the partnership is signed.
Some investors might “block” future investment. For example, raising money from investors who’s money source is shady or investors from non-democratic countries. While it’s not “fair”, some non-democratic countries are getting waived as “its OK to take their money”, while others will paint your company as untouchable. In doubt, it’s best to avoid even seemingly legitimate sources of funding if those risk pushing away institutional investors down the road.
Future round participation
It is also important to understand what sort of monetary (money) support this investor is expected to provide down the line. Will they participate in follow-on rounds?
Many angel investors are active in the pre-seed and seed stages but do not keep their pro-rata in more advanced rounds. This is an accepted behavior. But if a VC participated in a previous round and does not participate in future rounds - it sends a very bad signal, regardless if this is a small VC.
Monetary support in hard times
What happens if you fail to raise a round and strapped on cash? Will they bridge you until you are in a better position? How easy it is for them to make that decision? Is it a decision they can make on their own or is there a committee and process they are bound by (in the case of many corporate VC’s for example.
Avoid the Hans Westergaard investor
During her sister’s crowning, Princess Anna gets to waltz with Hans, a handsome foreign prince she recently met. The dance leads to an entire date that lasts the entire night. The conversation flows naturally, the night is beautiful and the couple seems so compatible. Hans works up the courage to propose, and Anna immediately agrees. A beautiful love story begins.
Well not exactly. The queen objects to the whole thing, warning her sister it’s a very bad call to marry a stranger she just met, but Anna doesn’t heed to her sister’s warnings.
Fast forward some 30 minutes and prince Hans is revealed to be a power-thirsty psychopath that not only cares little about Anna but is willing to sacrifice her to achieve his goals. Bad prince Hans.
While Disney’s Frozen depicts the dangers of fast-moving relationships using songs and magic, you won’t feel so magical if you brought in Hans as your investor. Below we’ll list some examples you should avoid from.
The board of directors’ role is to set the company’s strategy and to overlook its activities. If things are not going well, they should definitely suggest and even force changes to how the company is managed or change executive management. But some investors hold a playbook the founder is not aware of, and when the time comes, they will try to execute their plan. While this is more related to what strategy an investor believes will grant the best return for their money, there is also a personality issue.
With some investors, you might have strong disagreements on strategic items, but strong cooperation in executing an agreed-upon strategy (by the board majority or simply acceptance of one viewpoint for a test period).
However, investors are people, and some have toxic personalities. This can be deadly to your company. A toxic investor might turn other investors against you, wearing down the company using legal tactics, giving bad PR, etc.
This is the part that is probably the hardest to learn about in advance because people don’t tend to wash their dirty laundry in the public, but you should certainly try to get an understanding of the person you’ll be working with.
Putting their interests before those of the company or the founders
This case is easiest described by an example:
A company raises seed-round funding from a micro-VC and manages to hit cash flow positive with the raised money and it’s sales. The company decides to focus on improving its current processes to provide better customer experience and is planning to raise another round of funding in a year, once it can show even more organic tracktion and get much better terms and attract better investors. As long as the management and board believe it’s the best strategy, there is no reason to question it in normal operations.
However, if the micro-VC is in fundraising mode of a new fund during that said period, it cares to show short term changes to its investors. As such, it may push the company to a less-than-optimized up-round, just to expose the hidden value created by the company in its internal IRR reports. Most often than not this motivation will be masked by arguments such as “we should grow faster”, “raise money when you can, not when you need”, “rumors talk about a blackout period in investment. Rush to get money today.”
The important takeaway here is that while the investors want the company to succeed, some of them might care for their personal success even more. As they may be active in many companies - pushing one company to do the right thing for the investor at the expense of the company.
Driving your company over a cliff
This point is more focused on VC investors and in order to understand this point, one must understand how VC’s make money, and how they operate. This is out of the scope of this blog, but I’ll just say this: contrary to the intuition, even in the most successful VC’s, most VC’s investments fail, and this is by design.
A startup taking VC money has to adopt the mentality of “go big or go home”, but founders usually have one company, and the founder’s economic future is usually tied to the success of this single company.
This creates tension between the founders and executive team appetite for risk compared with a VC investor. In most scenarios, the VC in the board of directors will be the ones pushing for the most aggressive, riskiest, moonshot strategies. This is not because they are risk lovers. It is because their risk is diversified across many companies. Moreover, if the company runs out of cash, the VC can choose to “bail” it, probably being very strong at the negotiation table both facing the founders as well as the other inventors.
Having an aggressive member on the board is not a bad thing in of itself, but it is a very bad thing if there is a misalignment between the executive team and the board, and or between the board members themselves.
Invest in a sector - including competitors
Most investors would have focus areas that reflect both their past experience as well as forecasted opportunities in the market. These investors might try to invest in many early-stage companies in a specific industry, hoping to hit a winner.
The problem is that many of these companies will have overlaps at day one, and they might also pivot to step on each-other toes in the future. The “industry investor” can try to sway a company from moving into the territory of one of his bigger investments. It can also pass general industry information to competitors e.g. “this and this trade shows don’t provide good ROI”. If the information streams in all directions, this might be a good thing. The problem is that the only party controlling the information stream is the investor, and as time goes by, streams can change direction.
To avoid this see how the investors behaved to-date.
Did they invest in indirect competitors? Did they get out of an investment if one of their companies “moved” to the territory of the other? How do they react when highlighting this problem?
Have a history of “educational” meetings or copycating.
Many first time entrepreneurs are anxious to talk about their new startup idea since they are concerned it will be copied. This concern makes them wonder what is the best way to get investors to sign an NDA before a meeting. The reality is that professional investors don’t sign an NDA for many reasons. Most of the reasons are legitimate, such as, they had already invested in a similar idea prior to meeting you so don’t want to expose their company to a lawsuit. But the the custom of allowing investors not to sign NDA’s also allowed them two bad practices:
- Educational sessions
In this case, the investor might be interested in a new field. They might even have already signed a TS with a company in the field, but before the investment goes public, they would invite other companies in the field to pitch their idea with no genuine intention to invest. They only care to get information and get educated.
This practice, not only wastes valuable time of startup founders for a one-sided benefit other than their own, but might also actually hurt the founder. If the “educated investor” invests in any competitor, some information might be extremely valuable down the line such as GTM strategies tested, marketing channels, distribution partners and more.
One would argue you should hold your cards close to your chest, but the reality is that you want investors to be really engaged while you are meeting them, asking many questions and trying to understand as much of the business as possible. It’s really hard to tell if they really like your company or they really like the information you provide them with only to use it in “their” company”.
This tactic is hard to defend against, but culprits of this behavior tend to repeat it as they find it fair play. Just ask around in your ecosystem if anyone was experienced any educational sessions.
- Copying your idea
Up until 2020, I would say anyone that is concerned with anyone copying their ideas is just too new to entrepreneurship. But 2020, being the fun year that it is, showed us that bad can be worse. In this article by the WSJ, Amazon’s VC, supposedly, met with startups only to launch a competing product. I’m not sure what is the best defence for this tactics, but if you are doing anything in such VC realm, better to stay away from them.
Cultural differences and the signed term sheet negotiators
A standard VC deal will usually have a major milestone which is signing a term sheet. The termsheet states the main commercial terms, puts the startup on “no-shop” for 30-60 days and allows the investor to invest more in legal and financial due diligence. Good investors will push for closing of the deal ASAP.
However, some investors would delay their progress to the end of the no-shop period, knowing very well the founder position is weakened as time goes by, due to lack of money and for not reaching to new investors in the no-shop period. When this time comes, they’ll negotiate the basic terms of the deal even if the new terms contradict those stated in the termsheet. This strategy is totally acceptable business practice in Asia, but will result in a culture clash when the investment in question is done in the US for example.
When doing your due diligence process, make sure to query how “distant” were the closed deals from the termsheet. If many new terms were introduced in the closing phase, or the commercial terms were changed in between, consider if this potential deal is worth the risk of entering a no-shop period for.
Even if a deal is closed, cultural differences may make the partnership hard down the line so make sure that both the investor has the needed flexibility as well as look deeply within yourself if you have the capacity, sensitivity and EQ to deal with these differences without them taking too much of your focus. A way to somewhat mitigate this is to accept investment by foreign investors but minimize their influence such as refusing board seats or any extreme veto rights. It is possible that without those you won’t be able to close the deal, but quite possibly with those you’ll enter a long term board clash that might not be possible to fix.
How to avoid the wrong investor? Due Diligence your potential investors
Just like investors run a due diligence process to avoid the wrong investment, the founder should run a due diligence process to avoid the wrong investors.
Before reaching out to an investor, try to understand how well they fit your company. We’ve given some background here.
You should do some secondary research which should include:
- Their LinkedIn profile and experience
- Their Crunchbase profile and activity
- Twitter activity
- Professional groups activity
- Media mentions either of them or companies they are involved with.
- Media mentions for founders who picked up investments from them.
If you decide this is a good start, engage with the investor, and try to pitch them the investment opportunity. Naturally, this is the hardest part and with a relatively low expected probability of getting a yes. This is simply a fact of life.
If the investor is showing interest to invest, before going into any binding commitment it’s best to have some primary research.
Interview the investor and try to both get as much information as well as set the right expectations.
Then try to get a reference call with founders who took investments to form that same investor.
If possible, you should aim to interview founders from different time periods, as well as try to get an interview with whoever was:
- First-time founders at the time of the investment
- Founders which companies have failed while having the investor engaged
- Founders that companies have exited while having the investor engaged.
The reason for both of the last is that both extreme scenarios introduce a lot of tension to the investors-founders discussion, and they provide the best indicators to how the investor would behave in rough times. If you get the slightest aversion for taking that investor’s money, you should dig deeper before you make the call. In addition it is good to try and get the perspective of other investors that shared the table with the potential investor on past deal. Get indications on how helpful they were, how did they behave in board meetings and how much value they added.
Due diligence investors thoroughly before taking their money
Try to find:
Real value ads
Real operational expertise in fields you are lacking
Shady money sources
Clear history of conflict of interest
Clear history of driving the company over a cliff
Ambiguous expectation on cash flow
Ambiguous expectation on involvement
Some first time founders will dismiss the above with the notion that these are “high class problems”. First you need to survive, so raising any sort of money is better than not raising at all. While I totally get this position, I would argue that is not the case and would urge them to consult more experienced entrepreneurs before taking toxic money.
Startup life is hard and the odds are against you to begin with. If you take the wrong money from the wrong investors you’ll be stuck in a bad relationship for a long time and what's more, your probability to succeed will practically become non existing. It's better to spend more time on your business, improve it in every aspect and make it more attractive to good investors. It’s also better to spend more time finding the right investors.