The Founder Investment Decision

So you have decided that the best way to finance your idea is through venture capital and you are willing to release some of the equity of your startup in exchange for some money. You have done your research, you know your chances, you know the VC lifecycle, and maybe you have thought of a strategy of how to get the most out of it. Now what is left is how to get there, how to execute your plan and where to focus. This article is intended for early-stage startups just before taking the first outside money. The entrepreneur might be very early, with just an idea, or might have some working prototype and even some sales.

Focus on finding quality VC’s

VC Quality matters and the entrepreneur should spend time finding the right VC for his company. Higher-quality VCs have associated with

• a better likelihood of a successful exit (Sørensen, 2007[1]; Beckman, Burton, and O’Reilly, 2007[2]) and
• more significant valuations between rounds (Fitza, Matusik, and Mosakowski, 2009[3]).
• higher likelihood to gain access other great investors (Hallen 2008[4])

Quality means a lot of things to different people, but my personal opinion is VC that quality is a combination of solid results and the overall experience being with them on this journey. You most probably want to have both as not having one or the other for a long time defeats the purpose of why you are doing this venture. A very informative article for the quality of VC and how to access it is found here.

Do your due-diligence

Usually, the lead investor of a round is responsible for the proper due-diligence of the startup with the Series A being the hardest one(see the VC funnel). The entrepreneurs have to do the same; they have to scan the investor and see if he is the right fit, he can bring added value and help deliver the expected results.

How to do that? Hallen (2008) suggests that entrepreneurs may garner high-status venture capital investors by looking at two factors:

• by looking at the VC networks and prior successes of their founders and
• by looking at the early successes of their investments.

Entrepreneurs should contact other founders of a VC, successful and failed (mostly) and ask them about their experience and the results with this particular investor. Questions about pivots and conflicts should be asked too.

Moreover, the startup should research the portfolio companies and find if there could be any conflict in the future or a potentially supplementary relationship with multiple synergies. On the other hand, doing proper due diligence is hard. Doing it might involve effort and resources while at the same time you are trying to raise funds and also building a product with limited resources. The quote from Reid come in mind “You jump off a cliff, and you assemble an airplane on the way down.”

One thing that aspiring entrepreneurs should note is that in the due-diligence process they have the advantage of the information. In particular, they have “insider” information about their vision, their product, and their company. Furthermore, they have knowledge about their potential investors, especially if they are “Quality VC’s” and have a public track record. The same cannot be said about the VC’s who invest without having this amount of information.

Find Your Team

The startup at the pre-investment stage does not have many assets. Having a co-founder or an entrepreneurial team is one of the most critical assets. Shane and Stuart (2002)[5] suggest that entrepreneurs with more human capital (and social capital) are likely to raise venture capital sooner while Hsu (2007)[6] finds that these same factors are also linked with entrepreneurs receiving higher valuations.

While it is essential to have a team, it is equally important to find the right balance. The entrepreneur should try to find complementary skills to his own. A team consisting of only MBAs or only Engineers will not last long, and VC’s will advise against that. Some schools such as MIT are actively trying to match founders from different backgrounds, and especially to match those of the engineering with those of the business degrees.

Think long-term, plan in segments

Another factor that the entrepreneur should consider is the stake he is going to give to the investors and the milestones that should be achieved before the next investment round. At this point, a founder might be tempted to promise something unrealistic just to get founded. However, most of the experienced VC’s expect big words and will correct the excessive optimism. The founder has to understand that the startup will be judged on its promises. Even if the startup gets funded, another funding round is coming after a few months, and the results might not be as good as in the first round. Failing to deliver on promises has two side effects on the VC. First, it will make the VC think that the entrepreneur deceived them and second, that the entrepreneur cannot implement his vision. Both scenarios will make it unlikely that this investor will keep investing in this startup. On the other hand, promising too little might not have satisfying outcome either. The VC’s won’t be inspired by the “pitch” and most probably will find some other startup that promises more.

Knowing how to set the milestones so that you can have the results that keep your investors happy and your company funded is fundamental to the success of the startup. VC’s follow the staging model; every few months or years the startup will require more cash. This might blur/distort the vision of a startup and adds an extra headache, but when you need the outside money, these are the “rules of the game”. The founder should always keep in mind the long-term plan, but the implementation should be in smaller chunks with visible results.

Leave some controls for others

Sometimes founders want to be on top of everything; they don’t want to give too much equity, board seats or creative control. Wasserman (2017)[7] argues that as the startup grows, founders who keep too much power over the startup and its most important decisions can harm the value of the startup. Wasserman concludes that startups attract more financing and have higher valuation when their founders relinquish some power.

The founders should understand that the entrepreneurial team and the VC’s are all fighting for the same goal. Getting obsessed with a “virtual pie” or not being able to delegate some decisions most likely will harm the business.

Note: This article has been appeared first in www.whydotheyfail.com and is based on the research for the project and dissertation named “Venture Capital failures. Why VC backed start-ups fail and how can we improve the failure rate” that was submitted to Warwick Business School on 05/03/2018 by Kostakis Bouzoukas.

[1] Sørensen, Morten. 2007. “How smart is smart money? A two-sided matching model of venture capital.” The Journal of Finance 62(6): 2725–2762. doi:10.1111/j.1540–6261.2007.01291.x

[2] Beckman, C.M., Burton, M.D. and O’Reilly, C., 2007. Early teams: The impact of team demography on VC financing and going public. Journal of Business Venturing, 22(2), pp.147–173.

[3] Fitza, Markus, Sharon F. Matusik, and Elaine Mosakowski. 2009. “Do VCs matter? the importance of owners on performance variance in start-up firms.” Strategic Management Journal 30(4): 387–404. doi:10.1002/smj.748

[4] Hallen, B.L., 2008. The causes and consequences of the initial network positions of new organizations: From whom do entrepreneurs receive investments?. Administrative Science Quarterly, 53(4), pp.685–718.

[5] Shane, S. and Stuart, T., 2002. Organizational endowments and the performance of university start-ups. Management science, 48(1), pp.154–170.

[6] Hsu, D.H., 2007. Experienced entrepreneurial founders, organizational capital, and venture capital funding. Research Policy, 36(5), pp.722–741.

[7] Wasserman, N., 2017. The throne vs. the kingdom: Founder control and value creation in startups. Strategic Management Journal, 38(2), pp.255–277.

Originally published at www.whydotheyfail.com on March 31, 2018.

This story is published in The Startup, Medium’s largest entrepreneurship publication followed by 312,043+ people.

Subscribe to receive our top stories here.