If you have a new business, or you’re trying to ramp up an existing one, the idea of securing outside capital, whether it be through a private firm, individual, or government agency can seem appealing.
Why wouldn’t it? It could help your business scale faster. It could help you finally get an office, invest in new equipment or services or even help pay for a few much-needed employees.
But capital, even the first round of venture capital, comes with some strings attached. Agreeing to take money from an investor is like entering into a marriage. There are legal ties and obligations that must be met by both sides. Sometimes, it can be a super rewarding partnership, but if you don’t do due diligence, it can turn into a messy one.
We chatted with a partner at an investment firm and a startup advisor about key things to consider when you’re considering outside investment.
1) Should you even do it?
Patrick Keefe, partner at Build Ventures, says the only types of companies that should be seeking outside venture capital are those that plan to scale fast and require large amounts of research and development (R&D).
“Typically, most types of innovation-based business that have a high R&D component have this period at the early stages where they consume a lot more capital, often before there is any type of meaningful revenue,” he says. “They have a significant financing gap that they need to fund and traditional sources of financing like banks have very little interest in investing in those sorts of companies.”
That’s where venture capital comes in, early-stage risk capital to fund those businesses, to close that funding gap so they can grow and build valuable companies.”
David Crow, a director at Toronto-based Danger Capital, there’s a perception around a lot of new companies that acquiring capital is a given when it’s not always the right move.
“My history says that people seem to think they want to raise venture capital or financing because they think it’s cool. Or they see other people doing it, or they think they can pay themselves, or it allows them to hire seven people and therefore have a successful company,” says Crow. “All of that is bullshit. The reason that you raise money is that you need to grow, and in order to grow you need money. Because without growth, there is no financing and without financing, there is no growth.”
For instance, if a founder’s goal is to just get their company to cash-flow positive, grow to a few million, be profitable and pay salaries and dividends, Keefe says that’s typically not an objective that’s aligned with that of a venture capitalist. In other words, seeking investors may not be right for you if this is your business plan.
“Not to say for a second that that’s a bad objective, in many cases, it’s the smarter path to take for founders depending on the type of business they have,” he says. “But it would be a mistake to have that objective and then raise financial capital from a fund with very different objectives about where they want the company to go.”
Which leads to the next point.
2) Make sure your goals are aligned with your investors’ goals.
Keefe says that before a company decides to take any money, they need to make sure their goals are aligned.
“I would say it’s important for everybody to understand a set of common objectives for there to be an alignment,” he says. “This goes both ways. Both investor and investee should be probing each other to make sure they are generally aligned with where they want to go.”
Crow says this means laying out clear expectations about what the investor expects in return for their money and when. Different investors will expect different things.
“A professional venture management company has a different time frame potentially than a government agency or an individual investor,” he says.
It’s also important to do research.
“Just like the investor does due diligence on the company, founders should do due diligence on the investor,” says Crow.
For instance, have they invested in other companies like yours? Will they be able to participate in those future rounds? Can you call the people they refer you to? Can you call the ones they don’t refer you to?
By getting answers to these questions, you can get a solid idea of what a partnership with the investor would look like. Keefe says it’s important to know that your investor will be able to ride the inevitable highs and lows of being a startup.
“Founders should be comfortable that when things go wrong, which they will at some point, that they’ll have a good enough working relationship with their investors to get through it and think about a path,” he says.
3) Bringing on more than one investor.
It’s not uncommon for companies to have more than one investor. But Crowe says when it comes to bringing another investor on, it’s important to remember that the investors already on board may have a say on who else joins. These terms should already be worked when they first signed on to invest.
“Most institutional professional venture management funds … will have a clause that says that, ‘You can’t venture into new corporate debt arrangement or you can’t issue new shares without my approval.’ ” says Crow.
“Then, when there are multiple investors, first, the existing investors need to be onboard with the fundraising plan. Then secondly, they may have approval on what a qualified list of investors are.”
Meanwhile, Keefe says it’s often the new investor who proposes the terms to which they will invest in the company. It will be up to the company and its current investor whether or not they will accept their terms.
“Usually, it’s the new investor that decides what they will offer,” he says. “There will be an investment term sheet or an offer to invest and the existing founder and investors decide whether to accept it.”
Keefe says the same rules of being aligned on goals still applies when multiple investors are involved in a company. The relationship just becomes more complex with more people.
4) Maintaining Control of Your Business Operations.
It’s not uncommon for investors to request part ownership or shares when they invest in a company. But Keefe says if an early-stage investor feels the need to get involved directly in the day-to-day operations of a business, that’s a big red flag.
“I don’t think there are any early-stage venture investors who are interested in operational control of a company,” he says.
“You want to be confident that when you make an investment that this is a [founder] that understands their business, understands their market and is able to execute. The last thing that we’re looking for is ways to gain operational control of the company. On the contrary, we want to give the founders the resources they need to run the business and to build a valuable company.”
If it does get to that point, there is a bigger issue at hand.
“If we find ourselves in a situation wishing we had operation control, we have a much bigger problem,” says Keefe. “You’re in a place you really did not intend or want to be in.”