FOR ANGEL INVESTORS: THE CHALLENGE OF WORKING WITH FOUNDERS

By Eric Dobson

Sometimes when you see a great idea, it is easy to be captivated into believing all aspects of the venture are equally as well organized. However, you can’t take this at face value.  If you do not validate your assumptions, you stand to earn a learning experience…and usually an expensive one!  This is especially true of the management team.  Several years ago, the Angel Capital Group, now a part of the Sheltowee Business Network, was working under its Version 2.0 business model for angel investment, setting up microfunds.  We had six cities up and running and we traveled with the favored company of the month to ALL six cities to do a live presentation, which we called the “Road Show.”  And, we accepted dealflow from all over the country. So, our challenge was two-fold with these companies.  We had only 30 – 60 days to perform a deep diligence dive on them, understand their team dynamics, and travel with them to six cities.  We focused less on investor- lead diligence in those days, which lead us to our Version 3.0 business model for investment from our microfunds, which focuses almost entirely on investor-led diligence.

We met a company with a great idea from one of our groups.  The company was recommended to apply by a trusted source -- who was one of our angels in the group.  The deal seemed like a “no-brainer.”  They had a great, unique idea.  They believed they had filed the seminal patent in the space.  They had a rock-solid plan for building the device that would give them essentially a monopoly on a municipal market that was in dire straits and desperately in need of a solution on a national scale. And, this solution looked like a lock.  The cost was right and the model naturally lent itself well to project-based financing or franchising avoiding the need for substantial further investment.  In short, it had all the makings of a “baby unicorn.”

So, we dove in with verve.  The local folks provided context for the deal and there was high praise for the charismatic new CEO.  Only one report came back that hinted at problems between the founding team and their first outside CEO, forcing his departure.  But, we largely dismissed it because that is not an uncommon occurrence with startups.  If there is not a natural CEO on the founding team, a recruited one is difficult to shoe-horn in.  But, the founding team had clearly found a brilliant and very well-informed replacement and we placed our faith in him (Spoiler alert! Foreshadowing!).  The founders all nodded and said the right things and we moved on.  We completed our diligence work, created the diligence report, informed all the angel chapters with microfunds in our network that we were coming, and took to the road.

We took the show to all six chapters with Knoxville being the last stop for the most polished pitch, which was normally our process because we would video the last pitch as an archival record for all to review.  This is when we saw the first crack in the dam.  At the social after the meeting, we saw what we thought of as “discord” from the lead founder and the new CEO.  The CEO dismissed it as creative tension and told us not to worry about it.  So, we made the deal call and collected approximately $200k in commitments in a very short amount of time.  And, other investors also committed another $800k to the deal with us. All seemed good for a $1M closing that would get the company into market for implementing the service contracts they purported to have in hand.

We collected the deal documents and put them online for signature on a Thursday afternoon at the close of business.  We were prepared to wire as soon as the company signed the documents.  All seemed good….but the CEO did not immediately sign the deal documents as we were accustomed.  We expected to see a signed copy of the agreement waiting for us on the open of business the next morning…….

Finally, on Friday afternoon at 6:00 PM, we got a phone call from the departing CEO.  You guessed it.  He could no longer hide the fact that the founders were too difficult to work with and he had tendered his resignation minutes earlier.  To his credit he asked us to call the lead founder and talk to him before making any decisions on honoring our intent to invest.  But, sensing blood in the water, we immediately pulled the documents offline, and then made the call on Monday.

The lead founder installed himself as the CEO and said he was ready to sign and accept the wire.  But, we demanded an explanation for the CEO’s departure before we would proceed.  What we got back was an ear full of the most paranoid babbling that I have ever heard.  He basically said all the hard work was done and he was not going to let a CEO have such a large chunk of the company stock. And, he insisted that we should feel lucky that he was even letting us invest.  When we said we would have to go back to all our folks and ask if they still wanted to continue because we had predicated our investment on the CEO’s outstanding record and personal integrity, I received a personal tongue-lashing attacking my character and integrity…and eventually parentage.  We ended the conversation there, rescinded the term sheet formally, and sent all the money back to our investors.

In the postmortem deal analysis, which we do every time a proposed deal goes bad, we struggled with how we missed such a caustic influence on the founding team.  We were within minutes of signing a deal that was doomed to fail.  That deal made us change our approach to how we evaluate teams that endures even today.  That is why we ask entrepreneurs to go through certain stage-gates and hurdles to prove their commitment to be a good portfolio member.  That is why we ask for Myers-Briggs analysis on the entire team, so we can begin to understand their internal team chemistry.  And, that is why we focus on companies from our chapter cities first, where folks know these people the best.  And, we are just better at asking the right questions of the team.  We dodged a BIG bullet that day and we have never forgotten.

So, what should an entrepreneur learn from all this?

• It is really difficult to maintain the chemistry of the founding team if you add an outsider to your management team.
• Don’t be too in love with your tech. Once you take investment capital it is no longer yours alone.  The investors own a pro-rata portion of it and the future of the company.
• If a deal fails to close, let it go. Do not be defensive. Do not condescend and insult the investor(s)!  It is a very tight-knit business community in any town and word gets around quickly!

What should an investor learn from all this?

• Work with good people.  The CEO had too much integrity to allow the closing with his departure.  He could just have easily waited to resign one more day.
• Beware of inventors that are too much in love with their technology.  They generally make lousy business people.
• Always meet the entire team and ask them important questions about the chemistry of the team.  Don’t be shy about asking for personality tests to gain insight into the chemistry of the team.