In my last post, I covered the tough questions smart investors should ask startup founders. In this post, we turn the tables and cover the tough questions smart start founders should ask prospective investors. It’s just as important for entrepreneurs to do their due diligence on prospective investors, as it is for investors to do their due diligence on startups raising capital.
In the sea of startup investors, there are fish, sharks and whales. They represent a very diverse array of species and they feed in different waters. Before a startup goes swimming with them, it is helpful to know which is which. I’ve raised money from all of them for my various startup ventures, or for my clients. It’s also helpful to know which investors swimming around are mere guppies, pretending to be big fish.
Take it from me, I’ve wasted a lot of time swimming in the wrong waters with the wrong fish, or being seduced by guppies who talked about being big fish, but were not even big enough to be bait. These days, it seems everyone you meet is a startup investor. In fact, crowdfunding has turned all of us into startup investors. Of course, there is a big difference between investors who pledge $100 to a startup on a crowdfunding platform, and a dedicated investor (or fund) who invests $1M or more into multiple startups. This post is designed to help you discern the difference.
To do that, ask some tough questions:
1. What was your last investment and how much did you invest?
This question gets right to the heart of the matter. The answer can inform you of how active the investor is; his or her comfort zone (sector) and appetite (large or small). A good follow up question is asking when the investment was made. Serious investors love to talk about their recent investments. Pretenders will be vague and evasive about when they invested and how much they invested.
2. How many investments have you made over the last three years and what was the average amounted invested in each deal? What was the largest investment you have made?
The answer to this question will inform you of whether the investor is a dabbler or a professional. There are a lot of dabblers out there. They nibble around the edges of investments made by the pros. They throw in $10k here, $10k there, on an infrequent basis. Frequency and consistency of investment are what set serious investors apart from hobby investors. You shouldn’t discount the dabbler, but know their process and timing are going to be much different. There is a big difference between an investor whose last investment of $25,000 was two years ago – and it was his or her biggest investment – and an investor who has invested $500,000 in five deals over the last two years and the largest investment was $250,000.
3. Do you usually invest as a sole investor (or fund), or as part of a group or syndicate?
The answer to this question will inform you of whether the investor can or will take the entire round, or whether they only invest alongside other funds or angels. Some investors prefer to spread the risk. Other investors prefer to be the only investor, or at least be the lead investor (see #8). If the answer is “part of a group or syndicate,” ask them who they have co-invested with in the past.
4. What industry sector(s) do you typically invest in? What sectors are you uncomfortable investing in?
Expect to get a fuzzy, touchy-feely answer to this question. Most investors will say something like, “We are not tied to any particular sector. Every deal is different. We look at the business fundamentals and the team. We bet on the jockey, not on the horse.” So that sounds great and all, and you will have a tendency to believe they could be a good match for you, only to find out later that they won’t do your deal because it is out of their comfort zone. The life sciences sector is a perfect example. Many investors will tell you they will look at the deal, but they really have no clue what they are doing in that space and will eventually pass. Harken back to their answer to question 1. Most investors will stick to sectors they have already invested in.
5. At what stage do you typically invest? What stages will you not invest?
This is another question where you won’t likely get a straight answer until you drill down on it. Most investors will say, “We look at deals in all stages.” The truth is, they typically only invest in Series A or Series B. Almost no investor will admit that they don’t invest in seed stage (pre-product or pre-revenue companies), for fear of losing out on a truly remarkable opportunity. But if you press them, you will find most have not made any seed investments. Now, there are a few angels and funds that specialize in seed deals – they are company builders, not just investors. Just make sure the investors are comfortable investing in the stage your company is raising for, and have made similar stage investments.
6. What is your primary criteria for investment?
If you have gotten this far in the conversation with a prospective investor, the answer to this question is the tell-all. Serious and experienced investors have a formal criteria and process for investment. Pretenders and hobby investors do not – they usually invest alongside a lead or a buddy who convinces them to throw some money into a deal. Almost all smart investors consider five dimensions, each with 10-20 data points, to determine whether a startup company fits their criteria. See my previous posts on “The Five Star Startup,” or pick up my handy little pocket guide for how serious investors determine whether a startup opportunity is worth their time and money.
7. What investment structure do you typically prefer and do you have any non-negotiable terms?
Some investors like SAFE notes, or convertible notes. Some angel groups and VC’s will only invest in priced rounds. No use wasting your time on investors who only invest in priced rounds if you are raising on notes. If it’s a priced round, expect them to say they will only take preferred shares, not common shares. Their non-negotiable terms may include things like pro-rata rights and at least one board seat. If they say all terms are negotiable, then you should conclude they have no idea what they are doing, or they are baiting you. A good way to learn how they structure their deals is to speak with the founders of other startups they have invested in and ask to see a copy of one of their latest term sheets with the name of the company redacted.
For more on this subject, I recommend the book, Venture Deals, by Brad Feld and Jason Mendelson.
8. Have you been the lead investor before? What was the amount you invested and the size of the total round?
This is where the rubber meets the road with most investors. A startup will save itself a lot of time and effort by securing the right lead investor. If you get a good lead, the lead will help you round out the round and get it closed more quickly. Not to disparage most angel investors (I have been one, after all), but most are followers. They are not going to lead. They want to follow the lead and piggy back on the lead’s due diligence. This is also true of some venture capital funds. They never lead, they only want to follow and join a syndicate after the lead has done the grunt work. So, ask this question to quickly qualify the investor as a leader or a follower, and spend your time with the leaders. Refer the followers to your lead investor. The lead is going to present the term sheet and will need to convince the followers to agree to its terms, not expect different terms.
9. What is your exit horizon and your target rate of return?
This is an immensely important question to align expectations between startup founders and their investors. Some investors want in and out within three years and are happy with a 3x return on investment. Other investors expect to be along for the ride for 6-10 years and expect a 30x return on investment. The size of the startup’s opportunity and the time horizon for exit of the founders should be aligned with the investor’s expectations, otherwise the two will be at loggerheads. Some related questions to ask: Have any of your investments had an exit? What was the biggest exit? How long did it take? The answers to these questions will help startup founders to focus on the investors whose expectations for exit and return are aligned with their own.
10. Do you have dry powder and what is your decision-making process and time frame?
By “dry powder,” you are asking investors whether they have readily available funds to invest. As a newbie startup founder in one of my first deals, I once danced with an investor for three months. I thought the fund’s reputation and fund managers were the best of the best in Silicon Valley. I wanted them in my deal above all other investors who had expressed interest. It never occurred to me to ask them if they had any money.
Stupid, right? As it turns out, many funds have been fully invested and the fund managers are scrambling around behind the scenes trying to raise the next fund. They don’t actually have any money, but they will never tell you that. In fact, they are actively soliciting new deals, which they use as fodder to attract limited partners for their next fund. Don’t be bait. Ask point blank whether there are still funds left to invest. Ask if they have capital calls, or whether the funds are in the bank. Finally, ask who the decision makers are, their process and timeline for a decision. If an investor can’t put a term sheet in front of you within 30 days of meeting them (which will be contingent, of course, on another 60-90 days of due diligence), you should stop wasting your time with them.
In summary, startup founders should not be shy about asking prospective investors tough questions. It’s a two-way street. Knowing what questions to ask and how to interpret the answers will save founders a lot of wasted time and effort.
For more details on questions investors should ask startup founders and questions startup founders should ask prospective investors, pick up my handy (and cheap) pocket guide for determining whether a startup opportunity is worth your time and money, The Five Star Startup.