One of the things I really like about my job studying and investing in early stage startups is that I am constantly learning something new. This is true especially when I am encountering a startup for the first time, and begin to study polished and slick pitch materials on my own, listen to the entrepreneur deliver a pitch, or independently try to educate myself about the basics of the problem that the startup is trying to solve.1
Ultimately, my goal is to make a decision; invest or don’t invest. Then I have to decide if I know enough to determine if that choice is final, or if I am open to revisiting the question when there’s more evidence to add to what I already know. Even if I do not want to invest now, I may want to have the option of investing in the subsequent capital raise.
This is an in-exhaustive list of the things I worry about during the process.2
- Do I understand the market? It can’t be the case that every startup is going to disrupt its industry. Do I understand the human side of the equation that the startup feels will work in its favor? Why will people behave in the way that the entrepreneur needs them to behave? Why might they not behave in that way? Where’s the evidence? If the startup is not selling to consumers I like to speak with a handful of customers to hear what they say about the product.
- Do I have a sense of the people behind the startup? Being an entrepreneur is extremely difficult. I have never been an entrepreneur myself, but I watched my mom try and fail to build small businesses from home when I was a child. I know how hard she worked because I helped her for 3 or 4 hours every day when I got home from school and before I did my homework. Eventually she started a school with three children from our garage. She has been running it for more than 25 years now, and it has grown to a population of hundreds of students. Building a startup requires relentlessness, resilience, optimism, determination and adaptability. I need to have a sense that the people behind the startup are committed to the vision for which they want my buy-in. I need to gain a sense of the working relationship between the members of the team, and the group dynamic at play. If there is more than one founder, I need to believe that they share an absolute trust and respect for one another. I also need to feel that they are capable of “fighting good fights” in the pursuit of building a successful startup, shepherding their investors capital, and fending off competition. I need to understand the motivation that is driving the team to do what they say they are going to do. “I would trust my co-founder with my life.” is music to my ears. When it is possible I try to spend some time with the team in a non-work social setting. I believe that a startup team that plays together and laughs together will probably stay together.
- I like to know that there is someone in charge of setting the strategic priorities for the startup, of course this person must consult with the team and then distill the teams’ ideas and input into a coherent strategy. In this instance, I see attempts to “manage by consensus” as a signal that I ought to proceed with caution.
- Do I understand the different ways in which the startup can make money? Better yet is the monetizations strategy believable? I may disagree with an entrepreneur’s reasoning behind delaying implementation of a monetization strategy. But there has to be a monetization strategy, and some evidence to support it. To this end I’d like to get a sense of what the sales pipeline looks like. I get really tentative if it appears there’s no one willing to buy what the startup is selling. Any sign of customer interest is better than none. Things may change, and quickly too, but I want to know that there is some one outside of the startup’s circle of close family, friends and early adopters, who is willing to buy and use the startup’s product or service.
- Do I have a sense of the competition? Is there a startup that “has no competitors”? I don’t think so. An entrepreneur that tries to convince me that the startup I am studying has no competition might as well be jumping up and down, waving a red flag. No one has an unlimited amount of money. How quickly might a direct or indirect competitor respond if this startup is super successful and starts to steal revenues, customers and market share? How will small, medium and large competitors respond respectively? Can I identify any substitutes? What of complements? Could bundling our product with a complement or several complements help ward off competition? How easy is it for competitors to replicate what the startup has developed? What happens if they succeed? To this end I’d like to see an inventory of the startup’s intellectual property – patents, if applicable. But definitely trademarks, servicemarks, copyrights. I’ll want to know what the secret sauce is that will keep this startup ahead of the competition.
- Do I believe that the advisors have really been adding value? Or is this all just a hoax? If at all possible, I prefer to speak with two or more advisors. It is a red-flag if a startup has several advisors who are “too busy and important” to speak with a potential investor, particularly if that investor is going to take a significant portion of the round, say 25% or more.
- Does the cap table leave any room for new investors without the need to haggle strenuously with old investors? I once saw a cap table which showed that existing investors owned nearly 90% of a startup I was studying. Given the amount of money it had already raised over previous rounds and the progress it had made to that point, I realized that we would have had to enter into difficult negotiations with the fairly large group of previous investors. The CEO would have effectively been arbitrating a negotiation between new investors and existing investors. I would rather negotiate with founders and management. I also prefer to invest in startups in which the majority of equity is owned by founders, management, and employees. It is a good sign if I find an adequate stock option pool; 10%- 15% with a healthy portion yet to be issued.
- Do the financials suggest anything I should be concerned about? Money in the bank is every early stage startup’s lifeblood. Before the startup begins earning revenues, I want to know that the team is disciplined about how it budgets, allocates and spends cash on the startup’s activities. I also want to ensure that there are no big liabilities on the books. Some level of accounts payable is not a big deal. A huge accounts payable balance serves as a red-flag that requires me to ask some questions.
- In addition to financials I want to review any operations data that the founding team relies on to monitor how things are going. How actual results compare to the startup’s historical projections will help me paint a picture for myself of how effectively the team has met its self-imposed targets in the past. I recognize that such data can be fudged, or even completely spurious. So, I’ll spend some time determining how much credence I should place on the data that I am given. I will be trying to check for internal consistency and coherence with other data that the startup has provided.
- What are the plans for the capital raised? Details, details, and even more details. I like to see a budget.
- How long before lack of money becomes a problem again? Time spent raising money is time not spent building the product and its features, or winning customers, or communicating the startup’s value proposition to the market. I need to know how long the money that has been raised will last. In the best of all worlds, the money raised should be enough to last about 18 months. That gives the team 12 months to focus on solving the startup customers’ problems, and then delivering that solution to the market before the CEO’s attention must be turned back to fund-raising. Naturally, no one will complain if the startup runs out of cash because growth in customers and revenues accelerated far beyond management’s expectations. That’s a “high class problem” – I like high-class problems, very much.
- Do I understand the legal documents? I have to know what I am getting into. I spend a lot of time reading the legal documents for myself, and I’ll have an attorney review them as part of my due diligence. This often results in a headache for me, but it is essential that I avoid any land-mines that might be neatly hidden somewhere. At a minimum I’ll want to see:
- Documentation related to any previous financing rounds.
- Contracts, letters of intent, memoranda of understanding, distribution agreements, partnership agreements – if the startup claims to be gaining traction with customers, and partners.
- Employment agreements with key team members; inventions and other IP, confidentiality, non-disparagement in the event of separation, etc. etc. Knowing the details helps, but in certain cases I’ll accept a summary if there’s a compelling reason to do so. For example, some international startups may run afoul of employment laws in their home country if they were to provide the full details to a foreign investor.
- I want to know about any legal disputes.
- What can I find out about the founders, board members, and current investors through some basic research on the internet using a search engine? This small but important step can save you from making a catastrophic mistake. At the very least, you’ll be operating from a position of knowledge rather than one of ignorance. One might even go as far as checking court and county records. Depending on the size of the investment, it might make sense to have a professional run a full background check on the key people at the startup.
- Do I feel rushed into making a decision? If yes, then I will always decide not to invest at that time. Early stage investing is already risky enough as it were. I do not need to increase the risk and uncertainty. On the contrary; I need to minimize it by taking intelligent risks. I try to avoid making bad investments by saying “no” when I feel rushed and pressured to take shortcuts.
Trust, but verify. That’s the principle I apply. Hopefully that will keep me around long enough to hit a few home-runs.3
I want to thank Jess Hsu, Shally Madan, and Seymour Duncker. They sent me copies of the original post which I lost when I deleted the first version of Innovation Footprints. I updated that post with some more details, but the final message is the same. ↩
I read Bill Clark’s 10 Things You Need To Check Before Investing in a Startup regularly and often when I got my first assignment to make an investment decision about a startup. I have adapted Bill’s checklist which was published online by Mashable on May 24, 2011. Bill’s post is here: http://mashable.com/2011/05/24/startup-investing-checklist/. ↩
Really early stage startups are unlikely to have everything I have discussed above. I have encountered startups when there was just a founder with an idea. Then the due diligence is mainly on the idea and on the founder’s ability to make it reality. ↩