Don’t Take Money From Me!

By Eric Dobson

Every year 600,000 – 700,000 companies form.  An estimated 90% of them will seek some form of financing.  Only 10% of those get angel funding.  Only 20% of those funded will likely return capital and only 10% of them will get venture capital funding.  So, why are the successful ones so few?  The deck is already stacked against the startup company.  For a startup company to be successful, it must have timing and luck on its side AND the vast majority of decisions be sound.  That is a tall order.

There are numerous avenues of failure: team (leading vector for crashing and burning), IP (rarely the true cause of failure), market acceptance, business planning, etc.  Few people think of INVESTORS as a mode of failure.  I am here to tell you taking the wrong money is a fast path to destruction of an otherwise great company.  Friction with your investor wastes time, expends unnecessary energy, and erodes the morale of the team.  So, chose wisely and make sure your investor has a track record of success!  You are going to need it.

First, if you don’t need investment capital, don’t take it.  Investors require a LOT of work and come with a LOT of strings!  I know.  I have been on both sides of the table.  As an entrepreneur, I knew that getting a round of capital would take six months of full-time work.  So, I had to know my financial outlook for at least six  months with certainty, which is a very difficult proposition for a startup under the best of circumstances.  I knew I would be neglecting my leadership role for that period of time because there are only so many hours in the day (if you wish to stay married and have a relationship with your children) and investors demand your full time and attention to reach an investment decision.  Most importantly, I had to expect a vast amount of redundant effort to create a ”syndicate” investment for my company amongst angel groups and venture capital firms.  I learned to pick a strong operations lead in addition to the me, the CEO, because my job quickly became capital, investor relations, and sales.  The numbers work out over time to a 1 in 15 close-to-angel-investor-pitch ratio in my experience (one in five angels will show interest and one in three interested angels will close).  That is why angel groups and funds have largely replaced the lone angel for organized capital investment.  You can meet with 10 – 20 angels at a time greatly improving your odds of closing…..assuming you have an investable deal!  So, if you can bootstrap, do so.  Avoid this effort and the strings that come attached needlessly.

Second, once you sell shares in your company, it is no longer your company.  You have signed an implied agreement that you work for your investors.  They now own your company even if they don’t own controlling interest.  This is why selecting the right investor is so critical.  They exert control over you by how they put money into your company, bring others to invest in your company alongside them, and influence your operations through executive/leadership participation.  So, you better know and love the investors you bring into the family.  You better do as much diligence on them as they do on you.

The strings that come with professional investors:

1.       Board of Directors Seat(s) with monthly BOD meetings

2.       Quarterly reporting

3.       Annual reporting

4.       Tax reporting

5.       Investors have preferential rights meaning they are paid back first

6.       Investors rights including covenants on management actions requiring investor approval

7.       Rights to future investing

8.       Voting rights

9.       If your plan doesn’t go as planned, expect investors will force additional reporting requirements and possibly human resources upon you

10.   If your plan does continues not to succeed, investors will act to replace the leadership team

Why is this the case?  Why can’t investors just trust an entrepreneur knows what he/she is doing and give them room to prove their mettle?  The short version is we all know entrepreneurs are consummate optimists.  They rarely comprehend the jeopardy they are in and find pride in eking out ways to live-to-fight-another-day on an ongoing basis.  Truth be told, you can’t be an entrepreneur without it this type of psychosis.  No one would willing submit to this kind of financial and personal liability and exertion (torture!) unless they live a “reality distortion field” (RDF).  So, angels have to be intimately involved in the business to understand the positive and negative effects of the RDF, which varies with each leadership team.

The positive parts are an entrepreneur will willingly tackle a problem others would not dare….and frequently succeed!  An entrepreneur will work 80 hours per week to avoid a 40 hour a week job (Credit: Lori Greener).  An entrepreneur is willing to take extreme personal and financial risk to create something important and lasting.  Another popular analogy is entrepreneurs are willing to jump out of a perfectly good airplane and build a parachute on the way down.  And, finally, entrepreneur is word derived from the French meaning “lousy employee.”  They are not right in the head, but we love and NEED these people.  They are the bedrock of our economic system.

The negative parts of the RDF are they don’t perceive catastrophes nearly early enough and are loath to admit when there is a problem, or God forbid they make a mistake.  They walk a fine-line between confidence and arrogance making them difficult to coach.  Entrepreneurs will always expect a favorable outcome for any action by default.  They will expect that they can find and utilize resources at unrealistic efficiency rates.  They will expect people around them to work as hard as they do with the same selfless dedication.  So, we must have “canaries in the coal mine” to catch problems before an entrepreneur runs down the “rabbit hole” so far we can’t save them.  They are so busy building a “buzz” and brand that they avoid showing any weakness, which if left unchecked can be their undoing.  Thus, we ALWAYS take a Board of Directors seat, and sometimes seats.  On rare occasions, we will accept a Board Observer seat instead, but even more rarely for startups.  We want to know what is NOT working so we can help in non-intrusive ways, but are willing to be intrusive if need be.

Entrepreneurs must be exceptional nonessentialists.  They must create a work environment that is the very antithesis of McKeown’s Essentialism doctrine  and be great at managing that chaos to the point they use it to their advantage.  The entrepreneur that can successfully transition from a exceptional nonessentialist to an exceptional essentialist as the company grows is truly a rare critter.  Most “starters” become painfully bored with the drudgery of actually running a business!  Entrepreneurs find it hard to let go, but also feel constrained in the roles required of a high growth company when the proverbial ship-comes-in.  Most transition to some other position on the management team or are eventually forced out (sadly for both parties).  Managing that transition is a delicate issue because entrepreneurs rarely understand their own limitations.  Within the RDF, there are no limitations, just opportunities for growth and most ultimately want to be remembered for disrupting some industry, which is hard to do from the “cheap seats.”

People invest in people in markets they like and understand.  Investors demand detailed regular reporting.  And, that is non-negotiable.  We write it into all our term sheets and closing documents.  We demand to see your detailed quarterly and annual financials, tax filings, metrics, milestones (achieved and projected on a quarterly basis), and failures in detail.  We want to know what you learned from these failures because it defines the true potential of you as an entrepreneur.  We expect a written update quarterly and a meaningful annual narrative on your past year and future year every January.  That is how we judge your ability to adapt, overcome, and learn from your mistakes.  How you execute this requirement figures heavily into how we decide if additional capital is to be made available to you!  If you are communicative, own your mistakes, demonstrate learning and growth, and are coachable, then we have a vastly easier time deciding to invest in you again. In short, we are inside your company always and we expect that information will flow regularly to us showing an honest assessment of the business at each of these points in time.  We will hold you accountable.

Once upon a time, angels followed a spray-and-pray strategy as largely passive investors.  They invested money in a large number of companies and then waited for them to mature without heavy handed participation.  That model failed miserably and has largely died for professional investors.  The market has continually shown “active” investors in the angel market are more successful in reaping rewards.  Entrepreneurs are fundamentally hardworking, well-meaning, dedicated folks.  But, unfortunately, we can’t simply trust them to avoid making big mistakes that become catastrophes and take our cash with them despite the entrepreneur’s best intentions.

Professional angels are active investors.  They have to be!  We still make a lot of investments, but we monitor and get involved when we decide it is needed.  That is why it is challenging to become a great, successful angel.  It takes time, resources, and dedication.  That is why most angels live on the spectrum from wanting to “give back” to their community to making better-than-market returns.  In my experience, most are squarely in the middle.  They love the game.  They want to help other entrepreneurs achieve the success they have enjoyed (largely through hard work and the grace of mentors and investors!), but they justify the time spent because they can make meaningful returns above the market.  Angels want you to succeed and to create live changing wealth for you and your team!

What should an investor take away from this?  Entrepreneurs are optimist, and must be so.  You need to allot time in your weekly schedule to be active in the process of investing in and counseling / mentoring startups.  The good news is this is big game of legal insider trading and it is fun to work with great people on building great companies.

What should an entrepreneur take away?

1. If you don’t need my money don’t take it.
2. A strong operations lead is critical in a startup if you want to continue to grow the company while the CEO is on-the-road begging for capital.  No one can do both at the same time.
3. Be diligent in selecting your investors based on your chemistry and alignment with them and their track record of success.
4. If you do take investment capital, you better understand the obligations you are assuming!
5. Understand your own RDF, what problems it presents, and how to use it to your advantage.
6. We want to help in ways that do not constrain or distract you.  You have to help us do that.
7. We expect that we will be included in the decision-making process for big decisions.  You are wise to embrace that.

If you don’t like the level of intimacy that comes with a professional angel investment, don’t take our capital.  If you do, we can build great things together