Ten Early Stage Mistakes Founders Won’t Make Twice

One advantage enjoyed by serial entrepreneurs is that having been there and done that, they have made (or seen) mistakes that they won’t make again. As an outside advisor and mentor, I see some of those. Three years ago I wrote a blog on four early-stage mistakes you wouldn’t make twice. With the benefit of further experience, my list has more than doubled.

1. Failure to Secure Founders’ Agreements

You and four colleagues get together and form a company. You split the equity equally. At some point one of your colleagues determines that his or her family can’t live on beans and toast, and drops out for good and valid reasons. However, the departing founder still holds 20% of the company.

That doesn’t work. First, it is unfair to the remaining founders who continue to build the company. Second, you need the replace the departing member, and you will need to give equity to the replacement. Third, no early stage venture capital firm is going to accept that 20% of the equity is held by someone who is no longer making a contribution to the company.

The hard answer to this question is that you need to negotiate with the departing founder to reduce his or her share. This is difficult in the best of circumstances — and it may be impossible if there has been a falling out. The easy answer, though, is that you should have signed up to founders’ agreements in the first place, providing for “reverse vesting” of equity. Typically, this is structured as a one year “cliff” and monthly vesting over the remaining three years. This means that the founder who leaves in the first year will retain no equity, and one who leaves thereafter will retain an interest proportionate to time served. In some countries, like the UK, you may need to put special provisions in your articles of association to make this work.

2. Agreeing Unreasonable Exclusivity with Potential Investors

You find an investor who expresses interest in investing in your company. The investor presents a non-binding term sheet that contemplates that it will perform due diligence and you will not enter into negotiations with any other investor for some period of time while it carries out due diligence.

You can understand why the potential investor will want protection — it doesn’t want to invest time and money in performing diligence and drafting agreements with the risk that you will then do a deal with another investor. However, you need to understand that, during this period of time, you will not be able to approach other potential investors, and you have gotten no commitment that this potential investor will actually invest. Additionally, even if the investor does invest, you may still need to fill out a round with other investors.

With early stage companies, I think a prospective investor should be prepared to perform business due diligence without asking for exclusivity. Your business should be reasonably simple to diligence, and it should not take long. The investor has a stronger argument for some protection if you get to a point where it needs to involve outside professionals, such as lawyers and accountants, to perform legal, tax or accounting diligence or draft agreements. However, even then you should resist exclusivity provisions, and perhaps consider whether some other approach (e.g., reimbursement of professional expenses up to a low cap) would suffice. If you agree to exclusivity, it should be for a very short period — no more than several weeks — and you should agree it only after you get very comfortable that the deal is highly likely to go forward.

3. Accepting Investment from the Wrong Investors

This is actually three points, not one.

Friends and Family. If you take money from friends and family, they need to be friends and family members who really and truly assume that their money is lost at the time that they write the cheque (and even then there is risk to your relationships with them). Unfortunately, most early stage companies fail. Investing in a single early stage company (rather than a broad portfolio) is like buying a lottery ticket. The pain of loss is ameliorated in some countries, like the UK, that provide very substantial tax benefits to investors for early stage investment. However, your friends, in particular, are likely to become former friends if they invest with an expectation of a return (or at least that they will get their money back) and your company ultimately fails. Also, understand that you probably will feel awkward if your business fails and this may affect your friendship, even if your friends are not bothered.

Inexperienced Angels. Inexperienced angel investors can cause you much pain. They may have expectations that are disproportionate to the level of their investment (e.g., board seats), and may make unreasonable demands on you and on your time. If you take angel money there should be an experienced lead angel who has responsibility for dealing with you. The other members of the syndicate should understand that you will report to them periodically, and may seek their assistance where appropriate, but otherwise they are along for the ride.

The wrong early stage VC. The wrong venture capital investor can kill your business. You will have a relationship with your early stage VC that is likely to be critical for at least eighteen months. It is easy to be a supportive VC when things are going swimmingly. You need someone who will be there when you need help, and whose first reaction won’t be to throw you over the side and focus on its other investments.

Your prospective VC is going to perform a lot of due diligence on you and your management team. You should do as much due diligence on the VC. Speak to portfolio companies and former portfolio companies, preferably including companies that ultimately failed. Find out what advice and support they got from the VC, whether the VC was helpful in getting them the next round of funding, and how the relationship worked when things were not going well. Get to know the specific individuals at the VC firm who will work with you.

Special issues may arise in connection with first time VC’s, or investors (such as private equity investors) who are not accustomed to working in a venture capital context. Make sure that you understand what experience they have had. A savvy entrepreneur who has previously taken VC investment in his or her businesses, for example, may be a very good VC. On the other hand, a private equity investor who is accustomed to how things work in private equity portfolio companies may have difficulty adjusting to the different environment of early stage investing.

4. Failure to Understand Your Investment Terms

When one is desperate for funding, it is easy to see any potential investor as a rescuer and not pay sufficient attention to the terms of the investment. However, taking funding on non-market terms can doom the business, and you be better off shutting down the business and doing something else than wasting several years of your life on a business that is going nowhere. This can play out in a number of contexts, including the following:

· Investors who ask for too much equity for the amount of their investment and the stage of the business, so that subsequent potential investors are unwilling to invest because founders have been left with too little. Similarly, spin-off counterparties (corporates, universities etc.) may seek to retain too large an ownership position for the contribution that they have made to the ultimate business, similarly making the business un-financeable.

· Other non-market economic terms, such as unusual share preferences, anti-dilution provisions, put rights, interest rates, etc, which make it difficult to secure further funding.

· Legal terms that go beyond normal market standard governance protections, such as unreasonable veto rights over receipt of future investment.

The bottom line — get expert advice, and make sure that it comes from someone who is familiar with market standards. Your family lawyer, accountant or financial advisor, or friend at a global firm, may be a terrific professional, but if they don’t do startup work on a regular basis they are unlikely to recognize which terms are generally accepted and which are not.

5. Hiring (the Wrong) Friends

There is no doubt that you can reduce risk by hiring people with whom you have experience, and consequently whose strengths, weaknesses and skills you are in a better position to evaluate.

However, keep in mind if you hire personal friends that you may be complicating the management of your business. Friends have expectations about your relationship with them that may be inconsistent with your directing them, or asking them to change the way in which they are working or improve their performance. Still worse, if at some point you need to manage out a friend because he or she is not up to the task, that will be very difficult and your friendship is unlikely to recover from the experience.

6. Relying on (the Wrong) Incumbent Potential Corporate Partners or Customers

It’s odd. I’ve worked mainly with large corporates and financial institutions for my working career, but until I mentored startups I never fully understood how difficult it is for most corporates to innovate, or collaborate with startups on innovation. I’ve written other, more detailed, blogs on this topic, and I won’t reprise them here. However, the key point is that startups need to do due diligence on prospective corporate counterparties. Specifically:

· If a corporate has not successfully partnered with startups before, don’t think you are going to be the exception that proves the rule.

· Corporates that successfully work with startups usually have special procedures in place that treat those collaborations differently from their work with large counterparties. Find out how they manage their work with startups.

· Make sure that you are addressing a real pain point for the business, and that there is appropriately senior management and business support for working with you. Working with startups is not the easy path for most corporates — there has to be a very good reason why they would choose to do so. Corporate innovation groups can be very useful in terms of helping you manage your relationships with the corporate (ie, initial first point of contact) — however, their enthusiasm may not be matched by action if they are not integrated with the business in a way that they can get things done.

· Finally, if a corporate has not figured out how to build an internal innovation culture in at least part of their business (not process improvement — true innovation), they are unlikely to be able successfully to collaborate on innovation with a startup.

7. Going to Market Too Soon

I sometimes hear that a startup should get a product on the market first, scale quickly, and fix the things that don’t work as it goes along. This is sometimes justified based on first mover advantage, although we all know first-movers that aren’t around anymore. Anyway, maybe this works in some businesses and with some customer types. Or maybe it used to work, when we were all more patient with novel tech. What I see now, though, is rather different.

As I’ve already mentioned, startups face difficult challenges in terms of persuading established business counterparties to do business with them. And, in a b2c context, consumers now have high expectations that tech will work and will be easy to use. If you blow whatever chance you have by marketing a product that is buggy, insecure, has a poor user interface or doesn’t deliver, it may be a long time before that customer gives you a second look.

Frequently, the best approach is to find innovative, early stage customers or appropriate testers that are prepared to help you build something that doesn’t yet exist, at least not in a polished form. That requires some patience on both sides, startup humility and willingness to listen, legal clarity as to who owns what, and a clear view from the startup as to how the results of that effort can be scaled for a larger market.

8. Misjudging the Competition and Potential Competition

I’ve been mentoring startups for about seven years. In that time, I’ve seen multiple iterations of most of the business ideas, including some very good ideas. A lot of those startups do not exist any more, or they exist in a quasi-zombie state, continuing to operate but with limited growth prospects. There are many reasons why these businesses haven’t thrived. However, a key reason frequently is a failure to assess not only existing competition but also prospective competition. Here are a few points to consider:

· Capitalization. An incumbent or startup that has an inferior product or is later to market may nonetheless defeat you simply because it has more money, or better access to money, with which to reach customers, iterate, recover from mistakes, and survive.

· Customer relationships or access. A competitor that already owns the customer, or has superior access to the customer, starts with a huge advantage. Don’t underestimate the ability of a sleepy incumbent that owns the customer relationship to awake from its slumber.

· Defensibility. Many ideas can be easily copied, and a lot of intellectual property can be engineered around. Being first is not enough.

· Attractiveness to large players, especially tech players. We’ve all seen good businesses that have been wiped out because one of the big players, especially one of the tech goliaths, has decided that the business area is relevant to its expansion. Particularly if you are going after a very big market, make sure you understand who may be likely to move into that market. If you are lucky, you could benefit as an acquisition target, but that’s a pretty big bet.

9. Not Managing Cash

This point should be obvious. Unfortunately covid-19 has made it more obvious for founders in adversely-affected industries, like travel and hospitality.

For a startup business, cash is king. You can’t survive if you run out of cash, and you can’t assume that you will be able to raise funds at any particular time. So what does this mean in practice?

First, properly cost your milestones (with a 25% buffer) and runway, and don’t exceed your plan.

Second, get paid for at least the cost of proof-of-concept trials, except perhaps for the first one or two. The cost of paying for a POC is immaterial to a corporate, and is material to you. More importantly, corporates don’t respect what they don’t pay for, and you are unlikely to get the internal support from the corporate needed to execute a free project in a timely way.

Third, if you are going to need to raise again, leave a conservative amount of time to do so. If you find that fund-raising is going more slowly than you had anticipated, be ruthless in cutting your use of cash. Achieving milestones on your original timing is of no use if you don’t survive.

10. Failing to Look After Your, and Your Co-Founders’, Mental and Physical Health

This may seem an odd item to include on this list. We have this macho attitude (for which I am afraid Silicon Valley bears much responsibility) that startup founders are super-heroes. Any suggestion of weakness is seen as an anathema.

However, it’s really stressful to be an entrepreneur. There is no safety net beneath you. Reid Hoffman has described an entrepreneur as someone who will jump off a cliff and assemble an airplane on the way down. Needless to say, that can be about as high pressure as it gets, short of wartime.

You and your co-founders need to have appropriate routines to look after your health, and you need to watch out for each other and for your employees. This should be part of your company culture. What works is personal. For some of you, a daily jog or workout may be critical — others may focus on meditation or yoga, or even baking! But there needs to be some part of every day when you disengage from the business. If you do this, you will find that you also are more able to address problems creatively when you refocus. If you fail to do so, you may blow up your business. I’ve seen good startup businesses fail due to serious founder mental and physical illnesses (including some that have been life-threatening) and founder disputes brought on by stress. Additionally, if you see problems emerging, seek advice, and don’t be afraid to get professional counselling.

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Needless to say, these are only a few of the mistakes that early stage entrepreneurs come to regret. Please feel free to comment on others that you have made, or seen.

This discussion is not intended to provide legal or tax advice, and no legal, tax or business decision should be based on its contents. If you have any questions or comments, feel free to contact robert.mollen@friedfrank.com or via LinkedIn here.

You will find Bob’s other blogs for emerging and growth companies and early stage investors on US issues, international expansion and early stage financing indexed here: http://bit.ly/StartupGuidesIndex