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Startups need to do due diligence, too

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I hear a lot of horror stories about investors. Many are misunderstandings. Some are just outright false. Then there are those that are true. Sadly, there are a lot of those.

There’s the alleged angel in the Baltic region who committed (in an email) to leading a round and then refused to talk to the other investors and eventually seemed to bury his head in the sand and disappear. There are countless stories of mysterious Middle Eastern angels who put teams through painful pitch, due diligence and negotiation processes only to bail (post-term sheet) after months of promises and B.S. about the money being delayed/lost/stolen/on the way.

This kills companies. I’ve watched great entrepreneurs with brilliant ideas sink because they’ve been fucked around and because they made poor choices. Many of the so-called “investors” involved are odious individuals. I wanted to write something that will help people avoid having to deal with them, so here are some tips.

Financial institutions are bound by a regulation called KYC (know your customer). It’s time we created KYI for investors. You should want (and probably need) to know who’s investing, why they’re investing, who they are, how they made their money, what else they’re up to, what they’re like to work with, what’s their temperament and risk appetite and other such useful tidbits.

Do some digging on the people you’re going to target — creep on their AngelList, CrunchBase, LinkedIn and other profiles. Check to see if they blog, tweet, judge at Startup Weekends, mentor at accelerators, speak at conferences or do things that the vast majority of other investors do. Are they talking about their existing investments? Do they add value to industry conversations? Do they seem credible? Do they appear mostly sane?

Red flag No. 1. If they don’t have an online profile of any description, be a little wary. There are some super-wealthy people who obviously don’t want to be on LinkedIn, Facebook, Twitter and other such platforms as they’re too busy in their walk-in humidors. But in general terms, someone who has zero online profile makes my spidey senses tingle.

Red flag No. 2. If you’re constantly dealing through an intermediary, be wary. When you get into Series A/B/C, etc., it’s more natural for this to happen. This is what venture capital is, to a certain extent. In angel rounds, if you’re not regularly dealing directly with the angel, this is likely a pattern that will repeat. Also, you run the risk of Chinese whispers and subsequent misunderstandings.

If someone’s going to give you anything between $5,000 and $500,000 that they could otherwise spend on a holiday, a car or a buy-to-let flat in Walthamstow, they should probably want to look you in the eye and talk face to face. Likewise, if you’re giving someone a single- or double-digit percentage of your company, you’ll want to spend time with them. If you ask to meet an investor and that never happens for various spurious reasons, don’t take their money.

Ask to talk to companies that the investor has previously put money into. This leads us to red flag No.3. If they refuse this, or are sketchy about it, you should be very, very wary. Talking to companies that your investor has previously put money into is pretty normal due diligence for a startup. You should be asking what the investor is like to work with; are they pushy, obnoxious, needy, anxious, cool, useful or just good/bad/indifferent to work with.

Appear smarter than your lawyer. Also, get a lawyer.

The right investors should be happy to share this info with you. The bad ones won’t want you to find out that they are secretly tools. Incidentally, you don’t need an investor’s permission to do this — if they have investments listed on LinkedIn, AngelList and other places, just connect directly with the founder/CEO and ask.

Red flag No. 4. Watch out for loonie valuations. The less sophisticated the investor, the more of your company they’ll want. The classic instance is where the investor wants 51 percent of your business. In most funding rounds, you should be aiming to give away 10-25 percent of your company. The lower end implies you’re a hot deal or you’re doing something really well. The higher end implies it’s riskier or perhaps the traction isn’t that great. In early rounds, my personal feeling is that anything more than 25 percent is too high and can create a disincentive for founders, staff and current/future investors. Anyone who wants anything north of 25 percent is worth spending some more due diligence time on.

Red flag No. 5. Watch out for people who aren’t at least reasonably amenable to standardized term sheets. Seedsummit, YC and many others have produced great templates that are pretty standard. Watch out for things like participating liquidity preferences (1x liquidity preference is probably ok, others would argue it’s pretty standard). Watch out for warrants, vesting clauses that are overly punitive, full-ratchet anti-dilution clauses and stuff like that. If you don’t understand these terms, you need to. Do yourself a favor and buy Venture Deals and appear smarter than your lawyer. Also, get a lawyer.

Red flag No.6. Watch out for people who only bring cash to the table. Introductions, advice, connections and guidance are the most useful things that early-stage companies can get. The right type of angel — usually one who’s been there and done that — is worth 10x their investment in this regard. They’ll shill for you at conferences, introduce you to people, act as an additional BD/sales/HR person and generally add way more than just cash to the equation. Ask not what you can do for your investors (you should know the answer to this already — make them a fuck ton of money), ask what your investors can do for you.

If you’re feeling cheeky, send them this. But seriously — be upfront about asking what else they’re bringing outside of cash — can they introduce you to potential clients or useful contacts? Can they help with hiring or international growth? Do they know the reporter covering your area at the biggest trade publication or at the FT? Can they connect you with bigger investors when the time is right?

Red flag No. 7. Watch out for people who want overly complex financial projections (or other ludicrous requests) when you’re pre-revenue or pre-product. Anyone with a brain in their head will know that it is A) guesswork and B) producing this material is a time sink.

Do your homework. Do it early. Do it often.

Smart early-stage investors are backing the team, the market and the idea — probably in that order. If someone’s looking for five-year projections, you’d be as well off reading the tea leaves with them. Definitely have your product roadmap in your head, and some ideas about how you’re going to scale into new markets, etc. — and have an idea of what you’d like to make, but you shouldn’t have to waste your time on projections.

Red flag No. 8. Watch out for people who drop off the face of the planet after giving you a soft commitment. As a species, we’re not great at saying “no” to people, so a lot of investors will simply break off contact instead of saying no. If someone drops off the radar after saying they are in, it probably means they are out. If they’re going on holiday, having surgery or doing something else that prevents them from replying to an email/WhatsApp, etc.,they’ll probably tell you.

Red flag No. 9. If your gut feeling is bad about someone the first time you meet them, pay attention to that. You don’t have to be best mates with all of your investors — in fact, you shouldn’t be. But, you do have to at least tolerate them. If you’re lucky, you’ll be talking to and emailing them once a month for the next five to 10 years. Gut feeling is important.

I’m not saying discount an investment straight away, but if someone feels off, creepy or just not right, spend a bit more time figuring out why, and definitely do at least one more meeting to double-check that feeling. I have taken on investors in previous businesses who I really didn’t like when we first met, but they offered money. It ended like this.

These are just a small subset of the things you should be looking for when you’re talking to early-stage/angel investors. It’s equally as applicable to later-stage investments, but in the early stages of a business, this is serious stuff. The people you take on as investors at the start can be a huge predictor of the success of future funding rounds, or the company as a whole.

I’ve heard stories of people who had investors who were supposed to put in the second tranche of funding, but couldn’t because their assets had been seized by a country as a result of various nefarious deeds in the past. I’ve met companies who’ve taken investments and then did their due diligence on the investor — only to find out they were one of the leading fugitives from a European country. As you can probably imagine, having someone like that on your cap table is going to make it a lot less likely that a tier-one VC will invest in your next round.

Do your homework. Do it early. Do it often. Don’t be afraid to ask for references and more info about the person who’s investing. If they’re sufficiently motivated and interested in you, they should be happy to do it. If they’re sufficiently smart, they’ll respect you asking. If they’re sufficiently sketchy, you need to think about casting a wider net.

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