What Sherlock Holmes, Mother Teresa and Sun Tzu Can Teach You About Becoming a Startup Investor
Three traits every truly great startup investor needs to have.
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As an entrepreneur who has struggled for resources and an analyst who has investigated startups, I have an urgent message for investors: With great wealth comes great responsibility.
It's relatively easy to become a good investor if you follow others before you or join an investor group to share risks and rewards. However, to become a great investor, you must develop insight as sharp as a detective, nurture and mentor like a hands-off parent and advance like a military strategist. Here are the three stages of investing, and whom you should be emulating at each stage.
Stage 1: Sherlock Holmes and Hercule Poirot (the detective)
Yes, you heard it right. It is not enough to be either Sherlock Holmes or Hercule Poirot, two of the greatest fictional detectives. To be a great investor, you must combine your scientific study of clues with your brain power. In other words, meticulous due diligence involves both the rational investigation of the business plan and the psychological and intuitive process of assessing the people involved in it. You have maximum control over your decisions before signing the contract with the startup, so use this opportunity wisely.
First impressions do matter. Your intuition is fueled by your experience; respect it. My mentor, a successful angel investor, has a favorite tactic, which is to provoke the interviewee to elicit spontaneous reactions. It's impressive how instinctive responses such as anger can reveal the true character of a person. One red flag to watch for is rookie mistakes by CEOs who claim they are "serial entrepreneurs." These mistakes might be expected from first-time founders, but they're inexcusable in seasoned players. Reject if you find red flags at this step. Your time is precious. An ideal startup CEO is sharp and honest but coachable. However, do not just jump to positive conclusions at this step. When interviewed, Theranos board members described Elizabeth Holmes as a person who embodied "integrity" and "competence."
To confirm your positive impressions, you need to do a deep dive into the company's business plan — cue Sherlock Holmes. Here are just a few of the areas you should focus your due diligence.
- Background search: Research the history of the company. Name changes are a favorite ploy of zombie companies. Look for any past legal issues under alternate names. Interview any early investors or employees, who can provide critical insights.
- Market analysis/commercialization strategy: How valid is the value proposition? Is there a real market? Examine the customers and the customer contracts: Are they credible? No competition often means a lack of business potential. Too many and the market is crowded. Don't forget to check in with a few competitors and subject matter experts.
- Finances: If the company is early stage, take all projections with a grain of salt. Do the projections line up with the market? A billion-dollar forecast of revenues in a $100 million market is a red flag. Most sophisticated VCs have a team of analysts formulating cash flow projections to value the company. The finance document you must focus on is called the cap table. It shows the distribution of equity holders. You can find a treasure trove of information about the company history from this document itself.
- Team composition: Check the background of each critical team member. Do they have relevant experience? Remember, the team also includes the board of directors and, if applicable, the board of advisors. The Theranos board was composed of influential government dignitaries such as Henry Kissinger, George Shultz and James Mattis, who had no prior business experience. It should have been a huge red flag.
- Technology: Is the technology solving a real problem? What does the timeline for the concept-to-market look like?
- Intellectual Property: Does the company have any IP strategy? Do not fall for the "quantity" of patents but the "quality" of its portfolio. Does it even have freedom to operate (FTO)?
Are you intimidated by all the aspects of due diligence? You can make your task easier by either joining an angel group or hiring an analyst. Getting this right is essential, as any investment in due diligence will pay for itself many times over.
Related: Want to Invest in a Startup? Here's What You Need to Know.
Stage 2: Mother Teresa (the nurturer)
Welcome to the next role of an investor. A board seat is a privilege, because most minor investors walk away after the term sheet is signed and wait for their capital to "cook" till done. However, an astute investor knows that it takes a team to conjure a grand feast. And that "team" also includes the investor network involved with the organization. Traditionally, the board of a startup acts like its strategic headquarters. Engaged board members help coach the CEO/founder make calculated decisions. Many founders have a tech background; lend them your business experience. Extend your network power to find managers, investors, board of advisors and customers. Commit yourself to regularly attending meetings and asking incisive questions.
There is a rare breed of investors who are known as patient investors. They understand that a startup needs time to reach commercialization. They expect the company to hit roadblocks on its way to milestones, so they open their deep pockets for bridge rounds, which act as a lifeline for struggling startups. From a founder's perspective, a patient investor feels like nothing short of the blessings of a saint. Beware of too many bridge rounds, though; it often means gaps in timeline planning and execution.
One vital point to remember is to balance between mentoring and micromanaging. Follow the dictum of, "Nose in, fingers out!" Allow for autonomy in operations. Curb their freedom too much, and you might end up hurting the team's morale. Moreover, if the company is at a stage where investors must step in to help operations, you are dealing with an ailing organization.
Related: Who Would Invest in Your Startup, and Why?
Stage 3: Sun Tzu (the military strategist)
Congratulations! You are lucky to enter this stage. Very rarely does an early investor get to keep their board position until the exit. Assuming you are a long-haul player in the startup's life cycle, do not forget to negotiate your terms on the contract at each funding round. It is prudent to invest in a lawyer. When a company exits through an M&A, IPO or bankruptcy, what matters is not only the quantity of stock you own in the company but also the type of equity you hold. Common stock, preferred stock or convertible loans each follow a hierarchy of payment schedules. Plan accordingly.
You must have heard about diversifying your investment portfolio to minimize risk. However, a smart investor also enhances their odds through milestone payments; it is a type of vertical risk mitigation. Proactive financing should be your investment mantra. Invest smaller initial tranches; keep the larger tranches for later funding rounds. The latter players have more control over the final exit contracts, so explore that option.
Anticipate board politics. In my experience, boards work best when there is a separation of power between the chairman and the CEO. This arrangement separates board oversight from management. Guard against asymmetrical information distribution by fostering relationships with other board members and investors to focus on the common goal of a successful exit. A united board keeps the management honest and accountable. Being on good terms with other investors in the domain ensures that you have a friend on the board to safeguard your interests if you are ousted.
A shrewd investor knows how to balance self-interest with company interest. Sometimes the founder is not the best fit to be CEO of a growing company. It is a delicate situation that only nuanced board members can handle due to emotions and history. If you are an early investor, you are more likely to have the longest-running relationship with the founder. It makes you an ideal candidate to navigate the challenging but sometimes necessary process of replacing a CEO. Beware that creators have the power to destroy; tread cautiously.
Another critical factor to consider is the timing of exit. Too long to get to an exit means your shares are over diluted; exits are also market-sensitive, especially if you take the IPO route. Most outsiders would say that a company shutting down is the worst outcome for an investor. They are wrong. If a company folds down, it often means tax write-off for investors. The actual worst outcome that most investors dread is a self-sustaining company that limps towards a zombie existence. What would Sun Tsu advise in such a case? Act proactively and guide the company to a better end than dragging a limping animal along. Move on to better enterprises that could use your time and dedication. There are plenty of deserving ventures that need you.