Step Away from that Term Sheet! (Part 1)
Congratulations! You’ve got a Term Sheet from an investor and you’re pretty stoked — after all, the vast majority of startups never make it this far. You should give it a quick read and sign it before it disappears in a puff of smoke, or the whim of the investor.
Not so fast, though. This is a very important decision and if you sign it in haste, you may regret it at your leisure — perhaps for many years to come. Think about it as deeply as starting any long term relationship. Indeed, a cynic would point out that you can always get a divorce if you make a mistake with your marriage partner, but you can’t get a separation from an investor once you consummate this deal. At least, not easily.
In our view, there are three types of investors, Smart Money, then Passive Money and actually, the worst, which is Dumb Money that Thinks It’s Smart. DUMTTIS.
Smart Money is what every smart founder should be aiming for, certainly in the first few rounds of funding. These are people who will accelerate your journey, make important introductions to clients, other investors and key future employees. They’re the ones who will pick you up when you’re down and remind you that you’re only human when you start believing your own PR. They’ll help you figure out the right path, when it’s not obvious and won’t kick you round the board room table when things go wrong.
Passive Money isn’t necessarily a bad thing, providing the investor themselves knows that and is prepared to say something like: “Look, I like you and think that you’ve got what it takes. But don’t rely on me to help if I give you a bunch of money. Just try not to screw up, please.” Passive Money can be especially useful in later funding rounds when you, your team and your earlier investors know what you’re doing and basically just want more fuel for the fire.
DUMTTIS is dangerous and in the worst cases has been known to wreck a promising startup, or certainly change its trajectory detrimentally. They give the wrong advice based on opinion, not data or experience. They won’t have any sector expertise. They’ll waste your time asking for pointless and time-consuming extra reports. They’ll delve into the minutiae of your expenditure, asking for explanations about trivial costs (“Did you really need to visit that client to make that sale?”). They’ll try to leverage your success for their personal gain. They get shouty and aggressive when things go wrong, as they inevitably do occasionally.
Your first job, when considering whether to sign a Term Sheet is to figure out what type of investor you have here, which is especially difficult when most of us claim to be Smart Money, who are going to “add a lot of value”.
This is where your Due Diligence starts — DD goes both ways and while they’ll be looking at you in the coming weeks, you must reciprocate and investigate them, before signing anything.
The most important DD is going to be about the person leading the round. If the investment is on behalf of a fund, who is the partner? Are you looking forward to meeting this person every month (at least) for the next ten years? Will they be the one you’ll call on a Sunday night before an important week? Will they even take that call?
Listen to your instincts on this one, but then listen to others’ experiences too. Seek out and ask other founders who have worked with them in the past, especially those who had companies that didn’t have great outcomes, or failed. It’s easy to be a mensch when companies start, succeed and exit, but the true test is when the opposite happened.
Don’t just take the references they give you — find some they don’t introduce you to.
Assuming the personality is a match, it’s also important to determine if this investment is going to be meaningful to them and their career. If it’s not, it’s going to be easy for them to walk away and leave you on your own, if things go poorly for a short time.
You should also try to understand where the partner fits into the politics of the fund itself. Will they be able to fight your corner when you need them to, or are they regarded as junior players?
The right investor for your startup is probably one of the most important business decisions a founder ever makes and can make a huge difference to future success or failure. It can also affect your enjoyment of the journey immeasurably.
Obviously, the key players are always going to be you and your team — that’s far more important than having even the most legendary investor on your Board. But it’s certainly worth choosing wisely.
This post has focused primarily on the people side of what to think about when you’re considering an investor and a term sheet. Part 2 will look at the terms themselves and the basics of what to look out for when you’re going through the paperwork.