The downside of accelerated investment decisions

There has been a lot of talk about how early-stage valuations have risen dramatically over the past few years. Financially, this is probably good for founders and bad for investors. But a side effect of this frothy market is that financings are occurring much faster. It is very common for investors to get introduced to founders with the proviso that a term sheet will be signed in the next few days. As a result, founders and investors are spending very little time getting to know each other before entering into long-term business contracts.

This is bad news for everyone. Most significantly, founders often give up significant control to people they won’t get along with or even might end up hating. Having bad investors might not matter if the company executes flawlessly and the financing market stays frothy. But most companies have difficult episodes, and the financing market will eventually return to normal. Sadly, founders with bad investors will likely face punishing down rounds, key employees being indiscriminately fired, and elaborate financial shenanigans engineered to dilute founders and seed investors.

“It’s only when the tide goes out that you know who’s been swimming naked.” Warren Buffet likes to say this about investors, but it applies to founders as well. Taking on a new major investor should be treated with the same gravitas as taking on a new cofounder. You can’t do it in less time than it takes to really get to know someone, which is usually weeks or months. Quick financings might seem attractive but are actually fraught with risks.

http://twitter.com/amikegreen2 Mike Green

Thanks Chris. We’ve heard your wise caution. But you leave both investor and entrepreneur dancing at dinners with founders looking at their watches and calendars while the burn rate continues unabated. What’s your advice on best seed stage investment practices? Founders, like beggars, often can’t be choosy.

http://www.cdixon.org chris dixon

very fair point. I think simply extending the process a few weeks can make a huge difference. Also doing as much up front work as possible (face to face and also calling around to get other opinions) to get to know the people you might be dealing with can help a lot.

Anonymous

Making sure the both parties have good references/performance is one thing which is often a very quick process. However, whether you can personally work with them is another entirely different kettle of fish as everyone has their own style, especially when the pressure is on. Takes more than a first date to make a reasoned judgement call on that.

Robin Klein

Chris is spot-on here. A few DD calls can confirm our instincts – or otherwise. Investors are very clear about other’s they’ve backed. Just call them and get the low down on how they acted as Directors, shareholders.
http://www.websterisk.com Josh Webb

A little dating is rarely a bad idea. The marriage analogy isn’t bad here. If you are gonna consummate the thing, at least go out to dinner first. The whole “til death do us part” thing and the “for better or for worse” part deserves at least a little dating. Maybe you decide that you can’t be choosy and you have to take the evil money, at least you will do so with the knowledge and term foresight to not end up being the one on the wrong end of the post-threshold romp.
http://twitter.com/drew23 Andy Kim

I double Mike’s POV: @Chris, Extremely wise advice but as much as I do understand the marriage analogy, not sure it quite works here. Timing doesn’t have much to do w/ a successful marriage. People aren’t crunched for time to get married (unless you’re from a orthodox asian family but that’s another story). But with startups, especially given today’s climate, timing is nearly everything. I completely agree that its important to know your potential investors to minimize risk but timing is huge: successful startups = execution + timing. Even giving it an extra few weeks, could put any startup in a hole. I’m in the same situation where there’s a $hitty deal in front of me but there hasn’t been much interest elsewhere and at the same time, the space I’m in is nearly doubling everyday. I’m leaning on taking this deal because I need a bone to throw our team.
http://www.priforce.me Kalimah Priforce

Very good point Mike about founders looking at their watches. One of my co-founders asked me the other day, “is this a game that only young kids from upper middle class backgrounds can play in? Because they can always go back to living with their parents or relying on their trust funds while waiting for the cash to roll in,” and I can see his point. Seed investment is definitely a patient capital process, but as an adviser once told me, “adults don’t work for free”. Some founders have fifty bucks in their bank accounts others have fifty cents. Can they wait any longer?
http://www.facebook.com/people/Paul-G-Richardson/1214881324 Paul G. Richardson

Remember some of this is driven by the go-go nature of the tech industry, at least the software portion of it. Hardware (you remember that dinosaur of technology that all this new-fangled software runs on) takes far longer to develop and thus naturally lends itself to more deliberation in general. That being said, the capital to run a HW company is much greater.

http://twitter.com/flotype Flotype

“Taking on a new major investor should be treated with the same gravitas as taking on a new cofounder”
So what qualifies as a new major investor? An investment over $100k?

http://www.cdixon.org chris dixon

I would define it more by control. Board seat and/or control provisions that are generally contractually agreed to with venture-style investments.

http://twitter.com/chartio chart.io

I’d also say that the emergence of tools like Angel List (they have instituted reviews (and might display bad reviews as well at some point) is a great data point for vetting investors. The issue is that the recent high times in early stage financing have brought in a whole new population of previously unknown investors to the fray. It’s hard to know who’se who. I wonder if your point is as equally applicable to later stage financing as early where the reputation of various firms is pretty well known.
http://twitter.com/ivanfarneti Ivan Farneti

Recirpocal due diligence is a practice that helps reducing the risk of any partnership. rushing a decision, on either side may be something both sides come to regret by the second board meeting. Those who have made that mistake once know better. In our 15 years as a venture investors we offered entrepreneurs time to talk to any of our portfolio companies every time we asked to talk to their customers (which normally follows a term shet for us). I can only remember one case of reciprocal due diligence, and it was one call to one founder.
http://twitter.com/rreichmann Robert Reichmann

This lack of foresight or understanding seems also to point to the lack of experience these founders have. I think this is indicative of a larger problem to come, where companies as a whole, with very inexperienced teams will face challenges they do not yet know how to tackle…

http://www.cdixon.org chris dixon

Probably true.

http://giffconstable.com giffc

Wise advice chris. Not every entrepreneur can be choosy but one who can sign a term sheet in a weekend probably can. I’ve been in a startup once before which turned from hot to challenged when the winds changed and the investors basically put a straightjacket on the business, killing future potential. I would have others avoid that heartache.
http://sisyph.us/ ErikSchwartz

The first time I raised outside VC money (a previous company a few years back). We had some geographic challenges so I was happy to get it and didn’t do dili on the lead investor.

That was a mistake. We were basically on plan, but we needed to raise money in September of 2008 (a tough environment). Not only was this guy not any help, he said misleading things to investors we were trying to bring in. He had also put a lot of non standard terms in our original docs. The best way to find out how an investor acts when things are not going well is to speak to founders of the partner’s portfolio companies that have failed.

http://www.cdixon.org chris dixon

Yeah, sounds like situations I’ve seen too.

http://www.asoftwarestartupguy.com David Miller

I’ve raised capital and know that you’re likely to work with your investors a lot longer than you probably expect to, so you should spend extra time up-front trying to determine whether you’re compatible. The last thing you need is an investor around the Board table stirring up dust without having a personal rapport, developed over a period of time, to fall back on.

Great practical advice.
http://reecepacheco.com reecepacheco

i had a FIRST meeting with an angel investor recently in which they realized that our round is already closed…
their suggestion? take $25k in cash, personally, in exchange for $25k worth of my shares.haha… needless to say i’m passing on the offer.FWIW: this person’s made 21 investments since 2010! funny, i thought you still need a license for a shotgun wedding? [cross commented from AVC]
http://www.twitter.com/stevenkane Steven Kane

amen.
http://twitter.com/Volnado Volnado

Learned this the hard way!
http://twitter.com/chrisyeh Chris Yeh

Completely agree. I try to remind entrepreneurs all the time, “you can’t fire your investors.” I actually did a post on this topic back in March:

http://chrisyeh.blogspot.com/2011/01/investors-are-job-applicants.html

Things have just gotten crazier since then. I’ve seen some complaints that I like to meet multiple times, rather than making a invest/don’t invest decision after the first meeting, but in my view, that’s helpful for both parties. The last thing an entrepreneur should want is to jump in bed with an investor on the first date.
http://florianfeder.org Florian Feder

The post illustrates to me how unsophisticated the venture capital market still is. Normally you assume that both sides do a deal that is in their best interest. So for example, there should be no danger of “punishing down rounds, key employees being indiscriminately fired, and elaborate financial shenanigans engineered to dilute founders and seed investors”, because the sophisticated or well-advised founder can protect herself against all these hazards with well drafted deal documentation.

If I was a founder, the constant paternalism expressed by VCs would get enormously on my nerves. It is also very hard to gauge whether it is genuine, since VCs are in the middle of a conflict of interests: They have a mandate to produce above market returns, and every dollar that the founder receives is a dollar less in the VC’s pocket.

Looking at both sides objectively, I think there is no doubt that quick financings pose more risks for VCs than for founders. Any investor would rather have more than less due diligence. But in a frothy market investment discipline is often loosened and the risk of a bad investments therefore increases.

Founders, on the other hand, are the clear winners of quick financings. This can be easily shown if you walk through the possible outcomes:

Take a “bad” founder, who would not get any investment at all if the VC had more time for due diligence. In this case, he might end up facing “punishing down rounds, key employees being indiscriminately fired, and
elaborate financial shenanigans engineered to dilute founders and
seed investors” once his incompetence is revealed, but that is still better than getting no financing at all, isn’t it?

The “good” founder, on the other hand, won’t face such a scenario whether he takes hastily arranged financing or not. And after the VC concludes his due diligence, he would get the financing anyway. But he will lose time he could have spent doing what he is good at, instead of spending lots of time courting VCs.

http://www.cdixon.org chris dixon

I lost you on your last paragraph. Plenty of talented entrepreneurs have gotten screwed by investors. Are you arguing that doesn’t happen?

http://florianfeder.org Florian Feder

My argument is that the “bad” (less talented) founder will more likely find herself in a situation where she needs a cooperating VC. The “good” founder is less likely to end up in such a situation, and since she would get financing no matter how long it takes, it is in her best interest to take it today rather than tomorrow.

I agree that “good” founders can get screwed as well. But I think a founder would be better advised to protect against getting screwed by insisting on protective provisions in the deal documentation than to hope that the guy who was so nice over dinner will end up acting against his own interest once the s*t hits the fan.

http://www.cdixon.org chris dixon

I also don’t think good investors see venture investments as zero-sum between founders and investors (to your point: “and every dollar that the founder receives is a dollar less in the VC’s pocket. ”)

http://rickcolosimo.com Rick Colosimo

The best investors see that if the pie is big enough, everyone can have more than they can eat. But payouts to investors are based on liquidation preferences in acquisitions and conversion price (~~ pre-money valuation decisions) in IPOs. There is only 100% of the pie; the money can only go into one pocket.

The phrase my partner and I hit on when investing is that “we don’t want to be greedy, but we don’t want to be foolish.” That’s a good model for both companies and investors. Good deals work for everyone.

http://unystartups.com Julian Baldwin

Nice post Chris. Earlier today I was having a conversation with a founder who is starting to raise money for the first time. I made a suggestion to him that he approach the entire process similar to any new relationship. While it might be tempting to jump right into things, one should try to remember the earliest of encounters are often filled with such great optimism that a great deal of individual character remains hidden. Since it can take a fair amount of time before the nuances of any person are revealed, it just makes intuitive sense to give investors and founders enough time to really learn about each other.
http://venturehacks.com nivi

Chris, we’ve released investor reviews on AngelList to accelerate the “getting to know your VC” process. It’s not a substitute for getting to know your investor, but a tool to expedite the process.

It’s pretty cool: only startups that an investor has invested in, advised, or taken an intro to can review the investor. And all reviews are anonymous so there’s no pressure to leave positive reviews.

Here are a few examples:

http://angel.co/chrisyeh
http://angel.co/drorberman
http://angel.co/jackherrick

This is a new feature and we are iterating on it. We’ve got some cool ideas on how to improve this for both startups and investors. We’ve got about 1000 reviews of 500 investors so far. Feedback and suggestions would be lovely.
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http://www.robdkelly.com Rob Kelly

I’m glad you shared this advice, Chris — I’ve heard of some entrepreneurs taking money from people they’ve only met for a couple of hours.

I just covered this in tip # 7 (“Investor Relationships Are Best Measured In Years (Not Weeks Or Months) in “The 7 Unusual Fundraising Lessons I learned While Raising $1 Million+” at http://robdkelly.com/blog/fundraising/how-to-raise-money/
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http://twitter.com/AndySack Andy Sack

Great advice Chris!
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Chris Dixon