All too often, early-stage founders try and over optimize their valuation when they´re fundraising. This often manifests in the form of chasing valuation versus chasing quality. Rather, what founders should be looking at is who is the best investor for the company overall. Of course many founders don’t have many term sheets, but when there are multiple ones, founders in which case you need weigh juggle out the highest valuation versus the highest quality investor.
Founders need to look at which investor is going to be there in the long term considering both follow-on rounds and signaling. Some founders believe in having more investors the better, since it creates multiple sources of help for the company. The reality is that similarly it can often to become a tragedy of the commons – , when the company needs something specific or if things head the wrong way, no one’s investor is incentivized to hold the bag and step up to take the lead. In a party-round scenario of 3+ investors, not any one of them has enough skin in the game that they may be willing to go the extra mile to pitch in. Some founders like the idea of not having one lead investor to push or even having a board. However it’s often better to build the a tighter relationship with a specific lead.
In a world where reputation matters the VCs with the best reputation don’t have to always pay the highest prices. On the converse, those who have no reputation or bad reputation are compelled to offer higher valuations. If a founder is optimizing solely around valuation that often doesn’t lead to the best outcome.
Founders should feel empowered to perform thorough due diligence on prospective investors. Doing reference checks, and figuring out how the investor has behaved in good times and bad times. It sounds great to optimize and get the absolute lowest dilution possible, but when it means an investor could be difficult down the road it’s not worth it. It´s a case of short- versus long-term thinking, and founders are much better off having someone in their corner even if it’s at a slightly more dilutive valuation. Particularly in less frothy-times, founders need to trust their investor is going to be around and be able to invest from their reserves, as in the case of a bridge scenario, and likewise be a useful signal in the next round of funding both from a brand perspective as well as individual introductions to follow-on funders.
So, the natural question is, what makes a great investor partner? First and foremost, founders need to be introspective about what they really need from an investor. As a founder, you might think you need nothing outside of the cash, but at a minimum the founder is probably going to need fundraising help in the next round. Good investors can bring domain expertise, help with hiring or help with certain parts of the business such as high-level business development and partnerships. Founders need to look at the investor and think about a) what they´re promising and b) how real are their promises?
Some founders just want investors to leave them alone and let them get on with the business. For example, Travis Kalanick at Uber was quite self-sufficient, and was known for his view, ¨I want my investors to mostly just let me do the driving, I know what I’m going to do and how I’m going to do it.¨ And he found investors that were generally helpful in that way who let him run the show. Most of the time though, founders can benefit tremendously from having and involving the right investor partner onboard as a sounding board and sometime coach.
There are no shortcuts around doing a full background and references checks to figure out what a particular individual investor or investment firm is really like. Founders have to talk to fellow founders that have been in longer relationships with this investor, both with the firm and with this partner to see they are like when things go well; and when things go poorly as when the company fails to hit a milestone or face money problems, which often happens in the early-stage. How do they behave then? Do they step up and are useful? Do they help figure out the problem or do they wash their hands or walk away?
These are a few of the different factors founders need to be looking at in addition to if they have the capital to keep funding your company in the first place. There will always be a lot of lovely people who are well-intentioned, but unfortunately have very small funds or funds that aren’t growing for whatever reason such as prior funds’ poor performance or lack of deep LP base. In some cases, founders may choose to go with a small fund if it’s not capital that they especially really need, but where they are seeking more of a strategic partner or someone with domain expertise or credibility in the sector.
Sometime investors exaggerate their fund size or at least their liquidity. Nevertheless founders can get a sense if they are a $20 million, $100 million, or $1 billion fund. You can always get kind of an order of magnitude sensibility. Founders should also look at how active the funds are on sites like Crunchbase or Pitchbook. There are plenty of free resources that will tell how active the fund is in deploying capital and at high level, how successful have they been in the past.
A firm that’s doing three or four deals a year or with a pace that is noticeably slowing is probably a signal that they’re nearly out of capital or can’t raise more. Likewise, if the fund been around for ten years and don’t have much of a track record, at some point, they’re going to have a hard time raising more capital themselves.
So, there is no perfect heuristic, as there’s no real database except for the public data of what investors and startups announce and publicize what they’ve raised.
Finally, founders should talk with other founders within the fund’s portfolio companies. Figure out who worked with them directly, and put the question to them, is this firm well capitalized and useful or going dry? Most of the existing portfolio founders will have a good sense of liquidity of a given investor they worked with. This gives extra assurance that it’s a well-capitalized firm and able to support the company over the long term. They should be evident when you look at Crunchbase or if you look at the number and frequency of deals they´re doing. If it’s been five years since a fund’s last raise, that’s a red flag that they’re probably out of capital.
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