Entrepreneurs tend to fund companies a variety of ways in the early portion of a startup. Entrepreneurs may elect to use their own funds, obtain support from family and friends, or seek grants. As the company develops, there is an ever-increasing need for additional capital to grow the business. This need causes the entrepreneur to go on the road to meet with fund managers that make such investments.
Not all funds are the same. Some are easier to deal with while others are sharks! The nature of the fund depends on the people running it and the nature of those that invested in the fund. The terms of an investment can vary widely from fund to fund. Some require special liquidation preferences, board seats, liens, ability to select new senior management, anti-dilution provisions, and other considerations. The final terms become part of a negotiation, which includes the valuation of the company. The valuation forms the basis on which the investors identify their percent ownership after they invest.
Diligence becomes a significant part of the process. The investors seek to verify the investment is sound and that it meets their investment criteria; Managing risk is critical to their success. Entrepreneurs usually turn over all the documentation and answer numerous questions in this part of the process. In the end, the fund will decide to invest or not.
Entrepreneurs have the right to ask questions as well. They may decide to eliminate this step but questioning can help obtain a better understanding of the fund. Remember that those investing are becoming your future partners! Learning about their personalities is important because you will have to live with them. Working with people where personalities clash can create much more complexity to your growing company. The following questions are a few additional areas that will help you understand whether you are starting down the diligence path with the right people or interacting with a fund not likely to invest in your company.
1. How big is your fund and where are you in its lifecycle? The lifecycle is important because it identifies a time in which the fund must return the funds to their investors. A fund with 7 years to go is more likely to make a riskier bet than one with 2 years remaining. The size of the funds remaining is also important. If you are seeking more than the amount remaining, you are in the wrong place for the current round. They may invest later, but not have the funds for the current round.
2. Do you lead, follow, or do both? Funds often do not like to go it alone. They seek other funds that will invest with them. The diligence process is time consuming and costly and the fund must desire to engage in the process. Some funds will do the diligence and share it with others they wish to co-invest in the deal. The funds that conduct the diligence and help pull together a syndicate lead a transaction. The syndicate formation allows for sharing of risk. Those that are not part of the diligence, follow along in the investment. The followers review the shared diligence materials. Many funds never lead and only follow. A common trap is that the entrepreneur finds many funds willing to follow a lead investor, but no lead will step forward. It is important to find the lead in order to finalize the investments!
3. What is your appetite for investment? Funds have typical ranges for their investments. Finding funds that fit your needs is a critical part of deciding which groups to visit. Funds that invest $50K-500K may be the wrong ones for you if the need is $20M. You would need to have an extremely large syndicate to put the total together. Likewise, some funds only invest in a higher range like $20M -100M. If you only need $2M, you may not want to speak the higher limit funds.
4. How long does your review take? There is no fixed answer since this process depends on the diligence required. Some groups are very fast and others are extremely slow. The answer may help you set your expectations on timings.
5. How many investments do you make a year? Funds have a desire to invest in a certain number of companies a year. They also will diversify their portfolio. They may never get the number of investments they wish to make. Do not be surprised to see a fund that desires to make 6-9 investments only complete only 2 per year. They may see hundreds of companies and select from those. You may have fantastic technology and business prospects, but if you do not match their criteria, they will pass on the investment.
6. What investment structures do you prefer? The nature of the investment and the terms the fund requires are important to your future. The deal structure will alter your ability to make money as well as raise future capital. Some deals are not worth doing if they limit your future prospects too much. Your attorney is critical to helping you finalize a deal that will not be too painful. They all hurt, but some hurt much more than others.
7. How long before you expect to exit? A fund requiring an exit in 2 years is not likely to invest in a company needing 7 years before an exit occurs. A company with securities trading on an exchange may not want an investor seeking a 1 year holding period.
It is important to understand the parameters and expectations of your investors. It is hard to manage expectations if you have no idea where their starting point is. These questions cover a few areas for your consideration. What are your thoughts on this subject?
You can follow Taffy Williams on Twitter by @twilli2861 and you can email him with questions at firstname.lastname@example.org or contact him via company contact info in the website. More Startup information is contained in his personal blog.