How investors can kill your startup without losing any money themselves

This is the story of a major mistake I made – not once but twice while fundraising for Posse.  Each time it almost cost us the business.  I like to think of it as a disease investors often unknowingly give entrepreneurs during this vulnerable time.  Unless the transaction is completed, an attack leaves entrepreneurs heartbroken and exhausted, while their businesses lie in agony for months, or die. I want to tell the story from our perspective, so both sides may recognise the symptoms, saving other businesses from suffering this way.

It all starts so well.  You meet a VC and deliver a knockout pitch.  They love it, you exchange business cards and they set out the next steps.  First, you have to meet a few other people from the firm: they’re busy so it could take a few weeks to secure the appointments, but they’re genuinely interested and ensure that you are seen quickly.  You meet again for lunch, then dinner, then drinks.  You become friends.  You discuss the wondrous opportunities for your business and ways in which they can help in reaching them. Watch out: you’ve started to fall in love.  You discuss generalities about the deal terms, big stuff like valuation, how much they’ll invest (a lot) and, of course, they’ll want a seat on the board.  You’re excited; this will transform your world.  In no time, you’re planning how you’ll spend the money, looking at new office space and thinking about recruiting new team members.

One of the senior partners you needed to meet with was travelling, so you wait six weeks for the meeting.  It’s promising too; he wasn’t as excited as the junior guys, but he likes them to be autonomous, and allows them to pick their own deals.   The senior partner suggests you meet a friend of his who runs a big company that, he says, would make a great partner for your business.  It sounds helpful but you know he’s checking out what his friend thinks of you.  The company is based in Melbourne; you have to travel and the meeting takes two more weeks to set up.  All goes well and after a week you hear the team at the VC wants to move forward with your deal.

Phew.

Next comes due diligence.  This starts with a long list of requests and a promise that, once all the information is together, this won’t drag out.  They assure you’ll receive the term sheet within two weeks.  You pull in your team and work late — very late — to assemble the material quickly.  It may include questions like, ‘who holds all these shares on the cap table?  Is there anyone here without an employment contract, why did you model revenue a particular way, will you really need all those engineers? (Looks expensive.)  You diligently answer all their questions, repeatedly rework your financial model, and make changes to or write new contracts.  More than a month passes; you’ve spent money you don’t have getting help with contracts, accounts and a revenue model to satisfy the VC.  You’ve answered almost every tricky question about your business plan, competition and the market that could be asked.  Everyone seems happy and the VC reassures you that due diligence is almost complete.  The term sheet is only days away.  Four months have past since you first met and then there’s one more thing – a meeting, a problem, a question – something that’s going to take more time.   Finally, you start talking about investment terms.

Then something happens.  It could be any number of things, but it’s a knockout blow that kills your deal.

The first time this happened to me, I negotiated for six months with a big name brand.  They proposed to invest $3 million dollars and the association would have catapulted Posse’s profile to the stars.  I liked the executives leading the deal and couldn’t wait to build the business with them.  They assured me they could move quickly, and would reach a decision within a month.  But the months dragged on and more people became involved, asking more questions.  I wasn’t even worried; I was so sure we’d close the deal.  After all, they wouldn’t have invested so much of their company’s time if they weren’t serious.  But the terms they came back with killed the deal; they were nothing like the proposal we discussed when we initially met. They would invest, but placed a valuation of less that half our expectation.  I might have accepted, but our board refused.   Another time (last year), I spent five months attending to the whims of a New York Women’s Angel group.  I answered their questions, recreated financial models and met every relevant person full-time for months.  They said they’d invest over a million dollars, and the process required only four to six weeks.  Then they discovered they couldn’t invest nearly as much as they claimed.  The exercise had been a gigantic waste of time, distracting me from talking to other, serious investors.

I remember venting my frustration during one of these drawn out funding situations to Matt Barrie of Freelancer, who mentors me from time to time.  He said, “Never start due diligence until you’ve agreed on a term sheet”.  With hindsight, it seems so obvious.  If I refused to do any work until a term sheet was worked out upfront, then I wouldn’t have spent months and tens of thousands of dollars pleasing investors who weren’t serious, didn’t have the money, or whose deal expectations were vastly different from ours.

The problem is, refusing to do any work until a term sheet is signed sounds great but is hard to implement.  When you first meet, you’re excited and the investor promises that the process only takes few weeks.  You can afford to invest a few weeks.  Even as time drags on, everything appears to be proceeding well; you’re certain the deal will close.  As more time drags on, costs pile up and cash reserves dwindle. You realise that, with so much time invested in this deal, you can’t afford to start the process again.

To any investors reading this: for the good of the industry, respect the time and resources of entrepreneurs.  An entrepreneur can only afford a few months to launch a business; if you string them along, you’ll distract them from building the business and talking to other investors.  Then if your deal doesn’t go through, there’s a good chance you’ll kill their company and their spirit as well.

I will never get stuck in this situation again.  I’ll never let an investor seduce me into believing that a term sheet is around the corner while I invest time and money into more meetings and answering thousands of questions.  I will ensure that a term sheet is agreed upfront and then start the due diligence process.  Of course, if the VC finds something they don’t like during due diligence they can always back out of the deal, but at least I’ll have established that there’s a deal to be done in the first place.   Even though I know your firm is big and my company is small, I’ll do this because I know that time and energy are my biggest assets.