By David Siegel, Grellas Shah
As a lawyer representing early-stage companies, it is common for me to receive an email from a client with an executed $100,000 note or SAFE of which I had no knowledge. But with the rise in unicorns and competition among investors, what frightens me is seeing multi-million dollar investments come in just as casually. And while rarer than their smaller counterparts, the increasing frequency is notable.
It was through that lens that I watched the Theranos documentary, “The Inventor: Out for Blood in Silicon Valley,” recently. Though extreme, the documentary is a cautionary tale that provides valuable lessons to startup investors.
First, do your diligence, whether it be technical, legal, financial and business.
We’ve seen in-demand companies resist investor diligence and investors accept that because they are so keen to invest. The result is that investors sometimes fall for smoke and mirrors, which can be avoided through diligence.
No matter how charismatic a founder or founding team is, they are unlikely to be good at everything or know what they don’t know. This is what diligence can suss out.
I had one client who was able to bring in many millions of dollars in investment funds (including from prominent investors) with no diligence whatsoever. But it did have to go through diligence in the context of a potential acquisition. And that deal fell apart because of what the prospective acquiror uncovered.
But that didn’t stop the company from raising more money after the failed acquisition, again because investors didn’t do any diligence. In the end, the company had an unfavorable exit and investors all but lost their money.
There’s no excuse to skip diligence. Throw money at the problem and you can have a team as large as you want conduct any type of diligence within days. It might not be cheap, but it’s likely a small price compared to the size of your investment.
Second, rapidly scaling startups need adult supervision. This includes investor board seats and audited financials after closing a sizeable investment round. Theranos, for example, did not get a seasoned Silicon Valley board member until late 2016.
What makes for success at the initial, chaotic stages of a startup company does not necessarily translate into knowing how to manage a rapidly growing company with numerous employees and millions of dollars. Boring stuff like financial controls might not matter on day one, but they matter when a startup has millions of dollars to spend. But if you don’t insist on things like audited financials, what is the likelihood a founding team will focus on something like this?
This assumes a trustworthy founding team. Even people you consider trustworthy might exhibit questionable judgment when first faced with millions of dollars at their disposal, as well as the pressures of investor, and perhaps media, expectations.
For example, one particularly hot company I interacted with which operated with lots of investor money, but no investor oversight. They managed to dupe investors through fictitious sales and a complete shell game to give the appearance of adequate cash flow. Even limited oversight would have exposed much of this before it happened.
Third, try to find something else to give in negotiations other than the ability to do real diligence and provide oversight.
Perhaps you can up your pre-money valuation or the amount of your investment. With the confidence you can gain from the first two tips above, those economic gives are likely more palatable.
Or, particularly at the earlier stages, you can offer founder protections and incentives to distinguish you from other investors. For example, you can give founders some early liquidity, offer founder protective provisions similar to what investors receive, or even consider providing founders a liquidation preference or other downside protection.
These types of terms may fly in the typical model where investment rounds are all about what rights and preferences are built in for the investors, not the founders. But creative thinking might give you the ability to invest in a particularly sought-after startup, without throwing away your money blindly.
To put it succinctly: as exciting as it is to have the opportunity to invest in the hottest startup du jour, the boring stuff matters. This might sound predictable coming from a lawyer. But as a lawyer who has seen investors lose millions of dollars based on not following this advice, it is worth considering.
David Siegel is a partner at Grellas Shah, a Silicon Valley-based firm, where he specializes in helping startups. He can be reached at [email protected].