You can file this under investors to avoid. There are plenty of situations that I have seen where non-investor types get involved in startup funding. These range from wealthy family members and benefactors to corporations and government organizations. The reason I call them non-investors is that while they have the money to invest, they have absolutely zero experience and a complete lack of understanding of how to work with startups.
Here is a case in point: a friend of mine has a startup that recently began discussions with larger company considering a sizable investment that would in effect cover a large chuck of the seed funding round. This company was already a paying customer, so an investment made sense from a synergy perspective. As he was discussing the deal, I thought everything sounded kosher until I asked about the terms. Long story short, it involved contingent earn-outs, paying out a percentage of capital based on performance metrics.
This is a disaster in the making and demonstrates quite clearly the lack of understanding of how startups operate and succeed. Contingent performance targets make complete sense for partnerships and joint ventures in measuring and compensating for results. However, startups, particularly in the early stage, do not have a clear view into what the product-market fit is, who their customers are and what their business model even is. Pivots are a fact of life; products get dropped, new business models get revved up, and goals change. If your startup is stuck in a contingent earn-out situation, however, your startup is effectively wearing handcuffs.
This is just one example of onerous terms by non-investors, but there are many other situations that can be just as detrimental. Whether it is quibbling over valuation, shareholder terms or voting rights, non-investors will generally enter deal negotiations with a winner takes all mentality*. This is not unexpected, as they want all the upside without any of the risk. Unfortunately, they do not understand that startup investing is all about shared risk and engaged support. The successful early stage startup investors, the ones that win in this game, understand that the traditional tools for measuring business success do not apply. The market is simply too unpredictable to be guided by spreadsheets, projections and metrics alone.
If you are a late-stage startup or an ongoing business, then speaking with non-investor investors makes sense. You are probably on more solid footing, with money in the bank, a stable balance sheet, resources to succeed and a sizable share of the market. If that is the case, look at that those opportunities, as you are negotiating with a stronger hand.
If you are an early-stage startup, walk away if the terms are anything other than standard template agreements. You and your lawyer will spend more time in negotiations than it’s worth, without anything to show for the effort. If the terms are particularly one sided, you will not be in a position to challenge them anyhow. Even if the terms are plain vanilla, be very cautious as they may attempt to inject their power as investors to bully your startup into bad decisions. One other important point is that bringing on non-investor investors will scare off most professional investors, making your fund raising all that more difficult.
If you do decide to take the plunge and bring them on as investors, learn as much as you can about the person or organization you are doing business with. See if they have made other investments in other startups to see what their track record has been. Understand the organization and its power structure to gain insight into who exactly could potentially cause issues downstream. Your initial supporters could very well be gone the day after you have signed documents. Lastly, be sticklers when it comes to the terms and any that potentially handcuff your startup should be vigorously argued and mitigated. While these are practices that you should use for any investor, you need to double your efforts when it comes to working with non-investors.
Read part II of this post called More About Non-Investor Investors.
* There are some VC’s and experienced angel investors that do that as well, so you are well within your right to tell them to go to hell.
This article was originally published on Strong Opinions, a blog by Birch Ventures for the NYC tech startup community.
Image credit: CC by Northern Ireland Executive
