Entrepreneur, startup advisor, and VC John Greathouse shares eight red flags inexperienced entrepreneurs routinely raise when pursuing venture capital investment.
Because of the rapid pace with which venture capitalists review investment opportunities, they must employ pattern matching techniques which include identifying common fundraising deal breakers.
Fortunately, most deal breakers can be avoided, with a bit of pro-active thought and deft execution.
Breaking the Venture Capital Deal Breakers
Surprisingly, most venture investments do not break down over valuation. Although the issue is inherently contentious, it can usually be resolved if both parties negotiate in good faith. However, it is often more difficult to salvage a deal once one of the following deal breakers comes to light. In many instances, investors simply do not have the patience to wait for an entrepreneur to sufficiently clean up their deal once a significant issue is identified during the due diligence process.
Such deal breakers come in a variety of colors and styles. Some of the most common include:
1) A Junked-up Capital Table
A hodgepodge of small investors who may cause potential headaches for management and/or institutional investors.
Solution: Repurchase as much stock from these unsophisticated investors as is practical and then convert any remaining preferred stockholders to common stock status.
2) Untenable Bridge Terms
Convertible debt terms that are prohibitive to an institutional investment, such as large discounts and/or warrant coverage that significantly dilutes institutional investors.
Solution: Marginalize the relative dilutive impact of these terms. For instance, converting warrant coverage to non-participating status will enhance your venture’s fundability.
3) Band of Brothers
Friends, family, former roommates and other unqualified people occupy senior management positions.
Solution: Replace such mis-hires with experienced executives who have relevant, successful track records.
4) IP Confusion
Questionable ownership of key intellectual property, including non-exclusive licenses, potential infringement of a third party’s technology and/or inappropriate use of open-source tools.
Solution: In most failed ventures, the only asset of value upon dissolution is the company’s underlying intellectual property (IP), as further discussed in Worthlesss IP. As such, make it easy for investors to unequivocally evaluate the veracity of your venture’s IP.
5) Legal Landmines
Real or imagined legal exposure.
Solution: No matter how frivolous, lawsuits seriously chill investors’ interest. It is generally advantageous to fight nuisance lawsuits to avoid becoming known as an easy mark for unscrupulous lawyers. However, when fundraising, it is more appropriate to expeditiously resolve pending litigation, rather than expend energy trying to convince a skeptical investor that your legal challenges are without merit.
6) Geographic Dispersion
Significant physical separation of the startup’s Tribe.
Solution: During a venture’s early days, virtual teams are often viable. However, as a company’s growth accelerates, the core team members are often handicapped by disparate locales. As such, remote members in key roles should be prepared to either routinely commute or relocate, once institutional capital is secured.
7) Way-Out Sourcing
Core competencies are executed by independent third parties.
Solution: Identify the competencies that are critical to your startup’s success and develop them internally. For instance, technology startups should maintain key development resources in-house, rather than relying exclusively on third-party, contract labor. If your business model is predicated on online customer acquisition, do not exclusively rely on consultants to craft and execute your online marketing initiatives.
8) Double Agent
Problematic agency issues, such as high salaries, non-entrepreneurial perks (car allowances, exorbitant travel expenditures, etc.), side businesses and/or cross-ownership of related businesses.
Solution: The inclusion of disciplined, experienced investors will require you to focus on deriving a measurable return on every dollar you spend. As such, eliminate any unconventional forms of compensation or other potential areas of agency conflict before you engage with prospective investors.
No Deal Breakers = Frictionless Fundraising
Savvy entrepreneurs resolve potentially problematic issues on their own terms, before they begin raising capital. By ensuring that investors perceive your venture as deal-breaker-free, you will significantly reduce the friction of your fundraising efforts, allowing you to spend your valuable time running your business.
Special thanks to Jim Andelman, Co-Founder and General Partner of Rincon Venture Partners for his insightful suggestions.
Do you agree the items above are “deal breakers”? What other red flags would you add to the list?