How to check for founder-investor alignment before you start fundraising

As the flood of pandemic-era venture capital recedes, startups need to avoid the scarcity trap that accompanies the chase for dwindling investor dollars. And as the markets turn, founders should remember the fundamentals they learned during times of plenty.

Investors are pulling back as fears of a recession grow. In the first quarter of 2022, global venture funding declined 19% to $143.9 billion from the previous quarter’s record-breaking peak, according to CB Insights.

Whether you’re looking for angel investors to seed your business or later-stage backers to help you scale, the partners you choose today will affect your company’s future — from how you run your company day to day to your exit strategy. That’s why it’s important to pick investors who are a good fit and have track records that show how they might act when the chips are down.

It’s crucial to understand who your partners are before you let them in the tent. Below, we’ll discuss key factors that startups should consider when evaluating investors in a changing landscape.

Kick the tires and get references

Check in with a potential investor’s portfolio companies, both current and past, to see what their experience has been. You’ll need to do this without violating any non-disclosure agreements, but a key question is how investors behaved in previous downturns. For example, in the second quarter of 2020, when COVID-19 upended the global economy, did they provide portfolio companies with a bridge through uncertain times or tell them to find their own money?

Early in the pandemic, investors at a venture-backed technology company we worked with helped the business manage expenses but initially refused to write checks. They also attempted to use their blocking rights to prevent other investors from backing the company and then offered it a term sheet that was substantially lower than the offer they blocked, attempting to take control of the company.

Choosing the right partner for the right stage of your business can make the difference between building a billion-dollar company and losing control of the business.

We were able to work with the company to prevent that from happening. But these were people with sharp elbows, and the company had been aware of information in the public domain involving those same investors that should have been noted. Heed such signs if you come across them during your due diligence.

So, what can you do? Ask around your network (including your attorneys) and the investor’s existing portfolio to see what kind of reputation an investor or fund generally has and what kind of value they’ve added to the companies they’ve backed. You can also ask funds for a reference to a portfolio company where their investment didn’t work out.

Talking to the CEO of a company where things didn’t go as planned can shed light on how an investor behaves in challenging circumstances. Just like anyone else, investors have reputations and tendencies, and this is information that’s available to founders, if they’re inclined to look.

Make sure you understand how much money an investor has under management and how likely they are to participate in subsequent funding rounds. If a fund is just going to make an investment and then move on, that could make your next round of financing significantly more difficult, particularly if today’s constrained capital environment persists.

Right now, many startups are trying to gather money from the investors they already have to stay afloat. The ones that took money from funds that can provide later-stage capital are better positioned to survive and thrive.

Critically, get to know potential investors personally to understand what your working relationship may be like. Investors who are difficult when you’re negotiating aren’t likely to be any less difficult once you’ve taken their money. Are they trying to micromanage before the relationship even formally starts? For example, are they saying that as a condition of the funding, you need to get rid of a person who you consider a valuable team member or demanding that you relocate your corporate headquarters?

Investor pros, cons and pitfalls

Different investors will be appropriate at different moments in a company’s lifecycle, but partners that can open doors to future financing or make valuable industry connections will be a boon at any stage.

There’s no “best” type of investor for all companies and each class of investors typically comes with pros and cons.

Friends and family

It can be fun to go into business with the people who know you and the money they provide tends to be light on conditions, giving founders a fair amount of control. But what’s easy money now could prove more challenging down the road.

One company we’re working with raised money early on from as many as 50 people, ultimately bringing in tens of millions of dollars. Now, the economy has turned, and we’re looking to raise more money under terms that are complicated because of the broad range of early funders.

That financing could penalize these friends and family if they don’t participate in the round, which likely means putting in more money than they expected to when they initially invested.

In such situations, friends and family investors could see their shares get diluted if they don’t invest more or even lose their rights to dividends. Sometimes, the company could get sold out from under them or reconstituted elsewhere and recapitalized.

Meanwhile, the founder is trying to save their company, their employees and make good by their investors, while still being able to show up at the Thanksgiving table with some of their friends and family.

Angel investors

Angel investors can also help get a business off the ground and may open the doors to other capital sources. Often high-net-worth individuals, they tend to be professional investors. Some can even become trusted advisers, especially if they have valuable industry contacts or expertise in your space.

However, angels tend to have strong opinions about how their money is spent, and the checks may be smaller than what a generous family backer might write. You could wind up juggling multiple angels with competing opinions about how a business should be run. And, you shouldn’t expect their support across the lifetime of a business, even though some may negotiate to participate in later funding rounds.

Institutional investors

Institutional money from venture capital firms, private equity firms and family offices can provide many of the same benefits that angel investors bring to the table but with more muscle.

These partners tend to be seasoned and can provide guidance on building a company, recruiting advisers to sit on your board and — through the funds that watch their moves carefully — expanding your access to capital for later rounds.

If you’re looking for the big exit, that road often runs close by a venture capital firm whose investment in you will be highly structured. The right institutional partner can be the key that unlocks your company’s ultimate potential.

Remember, though, that institutional sources of capital are ultimately responsible to their limited partners and their investors not to your employees or your business.

Strategic investors

Strategic investors are typically bigger companies looking to acquire a strategic advantage in a particular sector. They can provide valuable industry connections and can help put a startup on the map through affiliation with a well-known name.

Strategics have deep pockets and different objectives than institutional investors, which means that, frequently, investment terms will be more favorable to your company.

But having one strategic investor could scare off others in the same space, and if companies don’t tread carefully, investment terms may potentially limit the upside of that company’s potential.

Also, if times become tough and resources are scarce, at the end of the day, you’re probably not core to the strategic investor’s business, which means your funding may be cut as part of their own belt tightening.

Other sources

In recent years, big players like hedge funds and institutional investors have forayed into earlier stages of venture funding, opening additional prospects for growth-stage companies. The ultra-wealthy also got into the game, as family offices and celebrities poured millions into a range of startups.

But backers who showed up at the party when times were good may not stick around to guide companies through rockier periods, so track records matter.

An aligned vision is key

Being able to recognize the motivations of your investors is key. Whether the drive is to bring a product to market, expand personal wealth or grow a company to a size where it can be acquired, it’s best when founder and investor interests are aligned.

For example, one early-round investor in a startup we worked with helped shift the founders’ mindset from looking for a quick exit to a much bigger picture. Now, the company is on the verge of reaching unicorn status and is set up for success in a way that would have been unimaginable to anyone involved with it five years ago.

On the other hand, a life sciences company we worked with at a time when capital wasn’t easy to find took money from people who looked good on the surface but turned out to be a complete mismatch in terms of future vision.

The investors worked to keep valuations low for the rounds in which they invested and then pushed hard for higher valuations in later rounds, knowing that it would scare off other investors and push the company to an earlier than expected exit event, which met their investment requirements but not those of the founders. That made it harder to grow the company even in good times. In hindsight, the founders wish they had taken an alternate route, like a bridge round from value-add angel investors.

Investors whose interests aren’t aligned with yours — or with those of subsequent investors — can inhibit growth or hold a company hostage by exerting their rights to block new financing rounds or even a sale. If one party is looking for a $50 million exit, and the other wants a $5 billion exit, that sets the company up for serious issues down the road. The key to avoiding this in any good investor-investee relationship is aligning on interests before the partnership begins.

Choosing the right partner for the right stage of your business can make the difference between building a billion-dollar company and losing control of that business or even having to shut it down entirely. Making the right decision is as vital now, when access to capital is getting tighter, as it was a year ago — perhaps even more.

As funding gets harder to come by, your risk tolerance may change, but your process for evaluating investors should not.