By Benjamin Chong
You’re a founder with a great idea and you’ve got some early customers. Now you need money to build your team and scale.
You’ve probably received overtures from potential investors. They seem nice and knowledgeable, but how do you know if they’re the right fit?
Here are five warning signs for founders when dealing with investors:
1. Little to no value provided:
Many investors like to say that they take a “founder-friendly” approach and offer more than just money for your business. Test this by asking how they’ve added value to previous investments. Have they connected founders to their network, opening the door for potential collaborators, customers and employees across the world?
2. Lack of clarity:
Investors who send mixed signals while completing a deal are likely playing for time, creating optionality for themselves at the expense of founders. Good investors are clear and decisive about what they seek from a start-up, the process they take to make an investment decision, and how much assistance they offer after investing.
Investors should be clear about the amount of funding they can provide and the type and amount of equity required in exchange. They should outline the decision-making gates, due diligence requirements and completion measures so founders can follow every stage towards closing the deal. Strong and consistent communication at crucial points of the process is a good sign that the investor is not only cognisant of your needs but can provide future value to your business.
3. Weird term sheets:
Some investors are notorious for micro-managing their founders. I’ve seen terms which provide investors an undue amount of control over the business. This sends the message they don’t trust the founders to run and grow their own business. Other whacky terms include investor ownership of the intellectual property of the business and investors placing undue restrictions on the stage, source and value of future investments to the business. These types of terms can create an albatross around the neck of the start-up, serving to stymie the business’s future.
The Australian Private Equity and Venture Capital Association has a set of open-source seed financing documents that can be used as a guide to what’s conventional or not.
4. Too high or low a valuation:
An investor’s valuation of your business can also be a warning sign. A very high valuation sets up equally high expectations for the business and its next round of funding. If the business doesn’t reach key milestones with a very high valuation, it’ll make it difficult for the business to raise money in its next round. If the valuation is too low, the founders may be unnecessarily diluted, capping their future upside.
While a high valuation is often music to a founder’s ears, in the long run it’s important for the founder (and investor) to do their homework to assess the amount of funding required over the life of the business along with the business’s potential.
5. Inappropriate board structure:
Most term sheets set out the structure of board members and shareholders. If you are a founder of a seed-stage business and the investor requests your business assemble a board of five directors, you can be sure they aren’t experienced investors.
Board composition should be commensurate to the stage of the business and amount of investment. During a business’s early stages, a formal board shouldn’t be required. Founders should be prioritising the growth of their business instead of preparing endless board packs. As the business grows, its board should grow too, both in size and formality.
View the original article on the Australian Financial Review. Twiddle your thumbs at Benjamin on Twitter(@benjaminchong)
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