One of the worst mistakes an entrepreneur can make is to bring onboard during a round of financing a toxic investor into the cap table of the company. I always tell founders that divorcing an investor is much more difficult than divorcing your own husband or wife.
When raising capital you want to have people that believe in you and your business and people that can add value on the long term. That value could be in the form of introductions made by such investors contributing to business development deals, partnership opportunities, or additional rounds of financing. IN this regard, you can actually download for free the pitch deck template below to convince these type of investors.
Other areas in which investors can add a tremendous amount of value include the following:
- Experience with boards
- Providing support with recruiting
- Strategic advice
- Making exits happen
- Signaling effects
- Operational experience
- Risk management
However, most of the time you will encounter toxic investors that are very far away from adding the value mentioned above. This toxic individuals have the same type of patterns that repeat over time and that entrepreneurs should be aware of when fundraising. For that reason I wanted to put together this post so that you are able to see the different types of investors that you should avoid at all cost.
1) The Greedy
There is a distinct difference between conducting a profitable business and being greedy. If all the investor wants to do is take, take, take, and milk every dime from your startup, then your successes is not going to be sustainable or even enjoyable.
An investor may very well be able to rush you to an IPO or acquisition, but that doesn’t mean it will end well. Selling out your startup’s soul isn’t going to feel good if it is something you really care about. Even if all you care about is the money, someone who wants only to take will find every opportunity to do so. And don’t forget that if you plan to move on to additional business ventures, this one is going to be at the top of your resume. It’s your calling card. Even if it wasn’t your vote, your startup will tell others a lot about you. What will it tell them?
You will start to see some red flags concerning this type of behavior when you are in the negotiation process of your deal. Keep your eyes open for the addition of certain clauses that are out of market. This will tell you what type of individual you are dealing with. If this person is showing these signs at the “dating” stage, imagine how things could turn out if the company is not doing well. Some clauses on your offering documents may not mean anything today but could trigger certain catastrophic events in the future. For that reason you want to carefully read and understand what everything means on the documents of your financing.
2) The Investor with Lack of Scruples
Greed is one thing, but unscrupulous, shady individuals take things to a whole new level. If you risk colluding with people who have no values, there is really no telling how ugly it can become. And when you get even a little bit dirty it can lead to a rapid downward spiral. You can be damaged simply by association.
If there is any bad business in motion, the investor is normally going to be better insulated than the entrepreneur, leaving the founders who have their hands on the controls as easy scapegoats. This can clearly get really scary when it comes to health-care and financial startups.
No industry is off the hook. And partnerships go both ways. Savvy investors with values should be looking for good qualities in founders, too, though it isn’t always easy to discern who’s ethical. Take Mark Cuban’s investment in Motionloft as an example. The original founder ended up being hunted by the FBI for allegedly spinning tales of a secret deal to cash in on the company while taking money from individuals. That founder naturally lost his job, and the press coverage added additional pain. If your instincts tell you something isn’t right, steer clear. A bad decision can follow you forever.
3) The Takeover Type
If you know Steve Jobs’s story, you can probably empathize with the heartache and frustration of being booted from your own startup. Few entrepreneurs get as far as being funded unless they are really passionate about their startups.
Even if you don’t have the burning passion for perfection that led to the iPod, who wants all of the blood, sweat, and tears to end with getting kicked out of your own venture right before it blossoms? Getting bought out and staying on as an executive, or giving up a piece of the pie in exchange for being able to make your vision become a reality doesn’t have to be all bad.
If Facebook or Google buys in, gives you an amazing suite on their campus, and puts their teams of developers at your beck and call, it could be a dream come true. But no one wants someone else to turn his or her venture into something different, and end up being relegated to the position of a powerless pawn—or worse, shut out altogether. So watch out for term requests that appear to suggest that this may be the intention. You will typically get signals when the investor is asking you to increase the stock option pool over 15% as that means there is an intention to replace top management.
In any case, as a founder you should avoid a dilution of over 25% per round of funding. You should try to have as much control as possible for as long as you can. Especially at an early stage when that canvas needs to touch the market with the colors that you initially envisioned for your venture.
While I understand that entrepreneurs need to close the funding ASAP so that they can focus on building the business, it is critical to understand that relationships with investors are long term partnerships. For that reason, while having the capital from a toxic investor can act as a bandit in the present, it doesn’t cure a deeper wound that will be developed later which might require surgery.
One last piece of advice is that you should ask portfolio companies of that investor that have failed in the past about how the investor behaved during the tough times. That is when you see how people react during difficult times which is when you‘ll probably see the worst face of an investor. Life is all about events and how people react to them.
If your gut feeling is telling you to stay away from that money then you should keep searching for your perfect match even if it would take you longer to close the round of financing. Remember the best investors make founders feel like Gods and remain faithful in the face of uncertainty and help entrepreneurs rise to the challenge. These investors imbibe founders with an omnipotent sense that they can do anything, but, like God, they have a lot to do.