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:
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.
Solutions to These Mistakes
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.