8 Deal Breakers that Send Venture Capitalists Running

Entrepreneur, startup advisor, and VC John Greathouse shares eight red flags inexperienced entrepreneurs routinely raise when pursuing venture capital investment.

8 Venture Capital Deal Breakers to Avoid

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

Crowdfunding

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

50% OFF Pink !!!

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

band_of_brothers-e1370270711557

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

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

My Trusty Gavel

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

Geographic

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

outsourcing

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

secret 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.

Editor’s note: A version of this guest post by John Greathouse previously appeared on Forbes and his blog.

Do you agree the items above are “deal breakers”? What other red flags would you add to the list?

Share Your Thoughts

  • http://www.menco-finco.com/ edward blake mendez

    great advice john! your points appear reasonable, workable, and most certainly valid. if my own money went to a project, your points should definitely come to mind.

    providing a potential matrix decision system will help many entrepreneurs tighten up their startup before seeking full-tilt vc dollars.

    blake mendez

    • http://twitter.com/johngreathouse John Greathouse

      Blake – thanks for your kind words. No list is perfect, but hopefully this article will help entrepreneurs avoid a mistake or two.

  • PJSweeney

    1. There is no such thing as frictionless fundraising (Entrepreneurs need to know that)

    2. The biggest deal breaker should be a bad reputation of the CEO or founder

    Ethical behavior and a great history of fair and straightforward dealings are critical to fundraising success. I’ve raised fund in two of my four companies and sold two of the four and in each capital event the principles all made mention of the team’s reputation in the industry.

    On the flip side, I just passed on an investment opportunity because the CEO had a reputation of several shady deals and that was enough to send this very active angel running!

    • http://twitter.com/johngreathouse John Greathouse

      PJ – Apologies for my hyperbole. You are correct, there is always
      some friction. My intent was to indicate that you can reduce the friction, not eliminate it.

      I totally agree regarding the importance of Honesty. An entrepreneur’s reputation is their most powerful weapon.

      John

  • Amit Bhaskar

    Very Informative article John as we are preparing ourselves to raise funds for our new start up in Canada. I am kind of worried as the other person in the team happens to be family which I have read is like a Big Red Flag.

    She is the base station where I am like the fighter jet . I am logical, she is creative and this is our second business together. Thoughts going in my head is that just because she is family should it mean that she is not talented. Any Advice would be appreciated.

    • http://twitter.com/johngreathouse John Greathouse

      Amit,

      I am not sure that the biggest concern is a lack of talent. In my case, I worry more about the drama factor. It is hard enough to keep a personal relationships stable outside of the chaotic world of startups. Sometimes such relationships, even between relatives, do not survive.

      When a close relationship is broken, it can jepordize a company’s operations. For instance, if you partner were to become disastified with the venture, the investors, cor-workers, whatever, it might also influence you and your willingness to work you butt off.

      I have seen husband and wife / brother teams work at startups (not as Founders, but as early employees), but it requires a concerted effort for them to leave their personal relationships at the door each day that they come into work.

      Red flags mean caution, not “stop.” Investors will be cautious, but hopefully you can sell through their potential objections.

      Best of luck,

      John

  • Anthony J. Alfidi

    I agree with a lot of this article but point #1 gives me pause. I wonder how much longer a junked-up capital table will be considered a red flag. Crowdfunding is going to allow lots of viable startups to cast a wide net for their first or second round of investors. Portals like SecondMarket will allow those small investors an easy exit before VCs even notice they were present. VCs may see more and more promising startups with crowded cap tables full of folks who want to grab that brass ring. BTW, Google and Facebook made hundreds of people into millionaires and those companies’ VCs didn’t seem to mind.

    Full disclosure: I’m a small-time angel investor with both cash and sweat equity investments in startups. One of those is coming along quite nicely with zero VC involvement. My junk in their cap table doesn’t seem to be hurting them at all.

    • http://twitter.com/johngreathouse John Greathouse

      Hey Anthony,

      You raise a good point re crowd sourced rounds. Time will tell if these folks get crushed in future cram down rounds or if they come out (mostly) whole. I hope they make money as I am a fan of alternative capital sources.

      Re FB/Google, et al, be careful drawing conclusions from outliers.

      Re your Angel investing, I don’t consider money from sophisticated folks who can help a company to be “junk.” I was referring to friends, family, fools, doctors, dentists and lawyers’ money. Folks who are really baggage and not additive.

      Thanks for adding your thoughts to the discussion.

      John