When an entrepreneur's total focus
is on raising the money they desperately need to survive, few give
any thought to the possibility that some investments might actually
hurt them. The phrase "Not all money is created equal" is
a truism most entrepreneurs just don't want to face. Yet by
knowing how to evaluate an investment and its potential negative
impact, an entrepreneur may just decide not to take the
money offered. Here are some of the common mistakes made in this
arena:
- Taking too much money
- Taking money from the wrong
source
- Taking money at the wrong
time
- Taking money in the wrong
way
Each of the above situations has their
own unique, potential problems. Some may just be unnecessary
blunders that cost the business founders excess dilution, while
others may turn out to be fatal mistakes. Here's a rundown on
each of the mistakes noted above:
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1. Taking too much money. Most
entrepreneurs don't see this as a potentially fatal flaw, but
selling too much of your company too soon will surely cost you
premature dilution of your ownership. In fact, one strategy used by
professional investors is to first negotiate a favorable valuation
and then offer to-graciously--increase the amount of money they
invest. And yes, we realize you may have to accept the money if
you're desperate for cash and have only one offer on the table,
but the price may be more expensive than you think. First, you lose
control of your company before your vision is realized. Worse,
future investors may be less inclined to invest when they don't
see one clear person in control. Thus, the wise entrepreneur will
at least try to structure the deal so the investor can see an
acceptable upside while the entrepreneur remains in
control.
2. Taking money from the wrong
source. Can there be a wrong source of money? Of course, it
wouldn't be smart to get your "A" round from the
mafia. But other than that, how could there be a wrong source of
capital? What many entrepreneurs don't realize is that most
institutional investors only invest with other investors they know.
For example, if you take an investment from a group that's
unknown in your market niche and you think you'll need to raise
another investment round in nine months, good luck! Many investors
won't even talk to you, and if, by some miracle, you manage to
capture their attention, you'll most likely pay a high price
for coming from an "unknown" investor.
3. Taking money at the wrong
time. Again, this is probably never a fatal flaw; it's just
one that creates unnecessary dilution. For example, if you think
you can close a deal with a major first customer or finish a
demonstrable working prototype in the next one to two months, your
valuation will soar with these types of accomplishments. And if you
were to accept an investment just prior to achieving these
milestones, your valuation would be much less. Clearly, if the
milestones can't be achieved without the money, you have no
choice. But whenever possible, tough it out and do it on your own.
You'll keep more of your company, and you'll make it more
attractive--and valuable--to your next round of
investors.
4. Taking money in the wrong way.
How can you take money incorrectly? That's easy. (And seasoned
investors know every trick in the book to protect themselves at the
expense of the entrepreneurs.) Below are just two of the more
common methods:
- A bridge loan is a "cover
your bet" way of making a non-investment. The investor is
acting like a loan shark where you, in your desperate need for
cash, are willing to accept almost any terms to get your hands on
the money. Bridge loans usually come with a high interest rate,
extra stock warrants and, if the company fails, a huge, expensive
debt for the entrepreneur.
- Any time an investor is allowed to
purchase common stock at a price below the preferred stock
rate--except when it's the founder's stock--the company is
robbing their employees. Common stock should be reserved for
employees as an incentive for them to help the company
succeed.
In some cases, the only way to avoid
these mistakes is to know what you're doing and what price
you're willing to pay. If you have a legitimate offer on the
table and can't see another coming your way soon enough to give
you options, then the general rule of thumb is to take the money.
Before doing so, however, make sure you understand your options and
exercise them wherever possible. Here are the solutions to these
four situations:
1. Taking too much money. The
best option here is to bargain. If the investors want to place $1
million into your company and you feel that $500,000 will be enough
to reach some significant milestones, then offer a
counter-proposal. Ask if they'll agree to invest the first
$500,000 at your current agreed valuation. Then, if you make the
targeted milestones within budget, the investor will have the
exclusive right to invest at a pre-determined new valuation, less a
nice discount. If they choose not to invest within a set timeframe,
then you may raise money at the higher valuation. This type of
negotiation sets a true partnership mindset between the
entrepreneur and the investor where each is rewarded for their
respective contribution.
2. Taking money from the wrong
source. The best way to avoid this trap is to . . .
- Research all your potential investors
to see who they've invested with in the past and how those
investments have done. Partners who've made successful
investments in the past will likely invest together
again.
- Research who's come into their
investments in secondary rounds. If they have any major players
picking up on their deals, such as Mayfield, Kleiner Perkins or
Goldman Sachs, that's a good sign.
- Ask them for a listing of their past
investments and see how they've done.
3. Taking money at the wrong
time. This is a tough one for several reasons. First, no matter
how good we think we are at predicting when that all-important
customer will decide to buy, they'll almost always disappoint
us. And despite all the best intentions of finishing a prototype on
time and on budget, need I mention Murphy's Law? Who really
knows how long your current cash needs to last and whether you
could make one more important milestone to boost your
valuation?
It all boils down to your gut call. Most
of the books say take the money. But then, most of the books were
written by investors. Ultimately, the call will be yours. I just
recommend you think it through carefully. One possible strategy
would be to ask the investor if they'll provide management with
an added incentive to achieve certain pre-agreed-to goals. At least
that would allow them to earn back some of their
dilution.
4. Taking money in the wrong way.
The simple solution is, just don't do it. Understand the pros
and cons of taking money in a way that's neither onerous nor
likely to scare away future investors. Not all bridge loans are
bad; however you do need to understand how they work. Make sure
your legal counsel has had plenty of experience with them and can
help you structure them properly. Never, ever allow an outside
investor to buy common stock, except as a founder. And be careful
how any warrants or options are priced--you may have to live with
that price for a long time.
There's both a right way and a wrong
way to accept an investment in your company. If your attitude is
simply "take the money and run," you'll pay a heavy
price and commit a costly mistake. If you take the time to get
educated, listen to the advice of a good lawyer, and have the guts
and poker face to negotiate with your investors, however, then
everyone will come out of the experience better off.
Jim Casparie is "Raising
Money" coach at Entrepreneur.com and the founder and CEO of
The Venture
Alliance, a national firm based in Newport Beach, California,
that's dedicated to getting companies funded.
- Best Businesses
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