3 Red Flags That You Can't Ignore When Working With Investors
Raising capital is one of the hardest parts of being an entrepreneur. It is often a delicate dance where both parties must determine if they can be the closest of partners over the life of the business
It’s stressful for both sides, but entrepreneurs face a unique pressure. The relationship between company and investor is rarely symmetrical. Investors hold the key to the life-giving capital that young companies need to reach their potential, leaving most entrepreneurs with little to no leverage in the process.
The good news is that most investors are in the value-creation business. They’ve been entrepreneurs themselves and understand what it takes to build something of substance. Others, however, lack these skills entirely and can cause significant harm to your business.
The “do no harm” principle
It goes without saying that investors are due a certain latitude when it comes to finalizing their decisions; after all, it is their money at risk. However, the most important thing for any professional investor is to “do no harm.”
The unfortunate reality, however, is that inept, inexperienced, or incompetent investment groups can do tremendous harm to their prospective portfolio companies.
I know from experience. I just narrowly dodged a bullet with a venture fund that had committed to invest in BodeTree, only to drop out at the 11th hour.
The red flags appeared early, but I willingly ignored them. I wanted to finalize our round and turned a blind eye to their behavior.
Fortunately, things fell apart before it was too late. While certainly painful, I learned quite a bit from the experience. Here are a few red flags that every entrepreneur should look for when working with potential investors.
They perform excessive ‘due diligence'
The dirty secret about venture investing is that it’s a painfully simple process. Professionals would have you think that it’s nothing short of rocket science, but the truth is that it comes down to four things:
Does the product or service address a large need in a differentiated and valuable way?
Does the business model make sense?
Do you trust and respect the management team?
Does the investment fit inside of your wheelhouse?
Of course, there’s no question that a certain amount of due diligence must be done before investing. It’s the old “trust but verify” adage, and it only makes sense. However, there is only so much digging that is required for a small, non-controlling investment in a young company.
This particular investment group, however, after months of analysis, insisted on even more months of additional ‘due diligence,’ during which they did absolutely nothing. I know this because we set up a virtual data room inside that contained all of the information they needed. Unfortunately, it was accessed only twice.
The stalling should have sent me running for the hills, but it didn’t. Unfortunately, things only got stranger from there.
They’re unable to deliver deadlines
Before I knew it, their initial 60-day ‘due diligence’ period was over, and I was ready to receive the funds. To my dismay, however, they were still not ready. Whether they didn’t have the money or wanted to wait it out to de-risk their investment is unknown. The fact of the matter was that they couldn’t give us a hard deadline.
I gave them an additional month because I know that unavoidable delays can happen. I enter into partnerships with the assumption of trust, and that is a two-way street. Unfortunately, that month turned into two, then three. No matter how hard I pressed them, they refused to commit to a date.
Eventually, as the year drew to a close, I decided to impose a deadline of my own. I needed a commitment by the end of the year, or the valuation went up. It was only fair to my other investors.
They gave me their word that we would fund by the end of 2016. However, December arrived, and they were back to their old habits.
They don’t honor their word
I learned that during this back and forth, the team brought on more experienced fund managers to head up operations, and naturally, the new senior manager wanted to revisit all of the investments the fund had sourced.
At first, I was pleased to see that they were bringing in new, seasoned management for the fund. After all, these new team members were apparently heavy-hitters who could bring a lot of value to the table.
The problem, of course, was that the managing partner of the fund had already given a documented commitment to invest and was now claiming that he was not the one making the final decision.
This posed two problems for me, and all of the other companies they planned on investing in. First, it showed that their word meant very little. Investments are partnerships, and partnerships are based on trust. Obviously, that trust was shaken.
Second, it showed me that they lacked the sophistication to recognize the tremendous reputational risk associated with their actions. I knew that even if they did manage to come in as investors, they wouldn’t be the types of partners I could trust, respect, or admire.
The lesson? Always listen to your gut
To be honest, I’m embarrassed by the whole situation. I knew six months ago that these investors didn't have the skills to add value beyond their cash investment. However, I let my impatience get the best of me and allowed them to give us the runaround.
The silver lining in all of this is that I learned a valuable lesson I can now share with my fellow entrepreneurs. Never, under any circumstances, ignore red flags with potential investors.
It’s better to stretch an investment round than partner with people who simply cannot deliver. It might be painful in the short-term, but I promise you that it will be the right move for your organization.
While I waited too long, I'm ultimately grateful that the deal fell through. If you’re in a similar situation, feel free to email me at firstname.lastname@example.org. I’m always happy to share my experience and offer guidance to fellow entrepreneurs in need.
Chris Myers, the Cofounder and CEO of BodeTree and the author of Enlightened Entrepreneurship
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