Zechariah J. Dean
In this article Mr. Dean introduces six of the most important factors when deciding to take money from the investor. The feeling of extreme relief and happiness engulfed me as I put the phone down and punched the air, I was so excited that I couldn’t even muster the courage to shout. The past 12 weeks were exhausting, and I mean literally exhausting. I felt like I just ran non-stop across the Sahara Desert with no rest and no water breaks. My days were consumed attending meetings and conference calls, answering questions, and delivering bite-size presentations; whilst my evenings and nights were used to refine my strategy, business plan and financial model. I’d lost count of the number of memos I had compiled, formally documenting answers for lawyers and representatives who were tasked to undertake their commercial, legal, financial, and technical due diligence. I look at my data room, once more, which has grown to over 3GB of data, and I marvel at my tenacity and silently give myself a pat on the back as it sinks in that the investor has decided to invest £2m into my venture.
Little did I know that this phone call was just the beginning of a long, challenging and (at times) frustrating relationship. I had spent three years in stealth mode. By some accounts, too long but I had my reasons. For now, I needed to buckle up and get the equity documents in place and set a day for the completion and for those investment funds to hit our corporate account. Only then can I safely exhale and more importantly celebrate.
Over the next four years, I was able to experience some highs and many lows working with this investor. It was clear that our mindset was on different wavelengths and our spiritual outlook on how a venture should be designed, developed and taken to market was different.
In this article, I outline six essential factors which every entrepreneur must be curious about prior to committing to an investor. I write having gone through this journey a number of times with varying results. Of course, with each new opportunity I was able to draw on my past experience and see the hyperboles and deliberate meandering of the investment dialogue to downplay my achievements and ensure the investor was setting themselves up to secure a better deal.
Do they actually have the funds?
I was once seeking to raise £2m with another investor who we will name Bob Capital. It’s a ludicrous name I know, but let’s carry on. The dialogue progressed and upon completion the representatives of Bob Capital informed me that they wished to stagger their investment. They wrote out a cheque of £350,000 (which gave us a 6-month runway) and then they defaulted on follow up payments. Over a passage of time, I have learnt to weave in penalty clauses for defaults, but legally these penalties are very cumbersome and time consuming to enforce. The £2m, was, as you can imagine, very exciting for me and Bob Capital used this as leverage to drive down the pre-valuation of the venture. With monotonous regularity, I would often hear statements such as, “…look we are investing £2m…” or “…your cap table requires an investor like us who is able to pump in £2m to get this business to where it needs to be!”
Within a few months, despite regular meetings the follow-on payments did not ensue. We were back talking to another investor. As passionate entrepreneurs, my team and I pressed forward. The intrinsic value of the company had risen, and we were back around the negotiating table (again) with other similar sized investors. We tried to have a parallel discussion with Bob Capital, but it was clear that discord between the founders and Bob Capital is not ideal when you are encouraging new investors to invest. I felt bitter, I felt as though Bob Capital manoeuvred and manipulated the situation knowing that in the future, we wouldn’t be in a position to clawback our shares, as it genuinely would run the risk of jeopardising any incoming investment.
In hindsight, it is vitally important to pose the question of how does the investor plan on funding this investment? Ask them whether the funds will be arriving 100% in a single instalment or whether the investment will be staged in line with milestones or other metrics. It is vitally important that this is documented and shared as an official memo and referenced into any Term sheet and equity documents. Finally, do not be hesitant in expressing your concerns of potential slippages or defaults on payments and what penalties would they suggest if a default took place. I have noticed that genuine investors do not flutter when a sensitive question of this nature is posed. If the investor begins to dither or begins to become indecisive, then light bulbs should begin to flash in your head.
What are their recent or past investments?
Take time out to understand the investors existing portfolio. You should do this to ensure they are not involved in any conflicting enterprise or are politically exposed or have any negative media which could impact the image of your venture in the future. There have been situations, where some investors will initiate a dialogue solely to unpick your business. Regardless of a Non-Disclosure Agreement (“NDA”), it is always sensible to send an investor an Investor Screening Sheet which explicitly asks them to address whether they hold investments in any venture which is in a similar industry. Having some background information about your investor provides a rain check as to how much information you can release and when. If matters do progress, then it allows you to undertake your own due diligence by reaching out to such companies and asking them for a reference.
Do they wish to sit on the Board?
Most investors have a desire to sit on the board, but do they actually add value? Ensure you have a clear understanding of what you require from any board member. There is nothing more frustrating than a cosmetic board. In the past, I was pressured by an investor who demanded that they had to sit on the board and wanted a small fee. I had little choice. If I refused, then the investment was lost. Overtime, their monthly management fee was akin to a stealth tax. I was hammered into a corner and was left to lick my wounds working with a board member who had polarising views as to how the company should be run. A difference of opinion is healthy, but this was a fundamentally fractured relationship. The investor was happy to cut corners and skirt around the edges of what was legal; something I venomously pushed back on and eventually led to many heated discussions, and we would hear the ultimate relationship breaker comment, “…I put money into this business, you listen to what I have to say!”
If you are compelled and the incoming investor is crowbarring their way in, then ensure your Shareholders Agreement has a provision in place that an investor must maintain at least 10% shares in the company in order to maintain a seat on the Board or have the Board refreshed every three years where all shareholders are allowed to vote. This is often a legitimate way of easing them out when the next round of investment comes through or when their time expires.
Understand that your incoming investor is not your best friend
This is controversial, I know. It appears as though I am presenting a discourse that you shouldn’t trust any incoming investor. That’s not the case. Most investors are not emotionally bound to the company like the founder is. Of course, you will frequently hear statements like, “…I want to be with you on this journey…” or “…I love your passion and it resonates with me on many levels…” but most often these are misaligned statements. I have always advised entrepreneurs, to be realistic and remember that most (most being the operative word) investors are dispassionate and have an investment horizon with pre-defined targets. Your role is to help them achieve their investment returns. During this process, if you hit their investment targets and fulfil your dream then that’s a win-win situation.
How is the investment being structured?
Debt versus equity is very important – the devil is in the detail. Remember, any loan – especially those which are defined as convertible – can really come back to haunt you. Investors proposing Convertible Loan Notes (“CLN”) will most often put forward vague terms which in effect means they are minimising their downside whilst benefiting if the company succeeds. Take time to really understand the milestones or the trigger points for conversion of the loan. If you are able to afford it, always ask a lawyer to cast an eye over the content. If there are no funds available, reach out to someone who has experience, its always worth discussing the loans. From my experience, Loan Holders control your business especially if there are provisions in the agreement for veto rights. It’s important to carefully consider the real benefits of taking on debt as opposed to equity.
Term Sheet signed you can politely say no to other investors
It is good practice to present your venture to a range of investors, and if you are lucky, you will be managing many dialogues simultaneously. Eventually, you will get to a point where one of the investors will ask for disclosure relating to the identity of other investors. Some investors have in the past, have proposed forming a syndicate. Whilst in principle this may sound plausible, be careful! On a few occasions, I have witnessed exclusive investors coming together to cut out a deal which strongly favoured them. They knew they held the cards as they were the only investors that had shown interest. I have seen the valuation drop knowing that beyond these investors there were no options.
Another major issue is when a particular investor signs your Term sheet and asks you to terminate dialogues with other investors and then asks for written confirmation. I have seen how such investors will frustrate and delay the final stages of completion to ensure your bank runs close to dry and then to come in with a vicious strike by devaluing the business. In such instances, these investors are mindful that you have terminated dialogues with other prospective investors and the likelihood of you returning back to the negotiation table is slim, especially when you have very little funds in your bank account.
It is important to stay firm and inform investors that you will not terminate any discussions until your equity documents have been signed and the cash hits your account. In some instances, some investors may ask for exclusivity. This can be granted but only for a few weeks to ensure momentum on their side remains positive. However, in no such instances should you terminate discussions with any investor until funds hit your account.
(Zechariah J. Dean is the Chief Dreamer of Dean Venture Studio. Zechariah is a social impact technology entrepreneur who believes technology entrepreneurs have the potential of solving many of the issues facing our world, whilst also providing a superior return to shareholders.)
Zechariah J. Dean