Two weeks ago my blog post was directed to investors (and by implication, to entrepreneurs) and encouraged them to ask three essential questions before making an investment in a healthcare company, particularly a digital health company. Note that I don’t think my post was entirely applicable to biotech investments since most of them are intended to be one product companies given the way M&A and R&D work in the pharma world.
But with the previous post in mind, one of my very thoughtful regular readers, Dr. Sherif Khattab, made this comment: I hope your next post is about the three questions that founders should be asking every investor – in other words, what key things should entrepreneurs be doing their own due diligence about when considering taking money from investors. It was an excellent comment and one definitely worthy of a detailed response, so here it is.
Granted, it’s been a reasonably long time, over 20 years, since I myself was on the management team of a fundraising young company. I have revisited this role a few times since then, as I have had to temporarily step in as CEO of portfolio companies in which I have invested while working to recruit a new leader. In each such case, that happened when things have gone horribly awry at companies, or there wouldn’t be a breach into which the investor would step. But it happens. For companies in highly compromised situations who need money and fast, sometimes the only question to ask of potential investors is “how fast can you hand over that money?” But that is a terrible position to be in and hopefully not the place from which most entrepreneurs approach the investing community.
So, on the theory that the spirit of the question applies primarily to those with excellent prospects and the time to patiently raise money from the RIGHT investors, what three questions should entrepreneurs ask? Here is my opinion below. Yes, there are others beyond these three, but these rose to the top of my mind’s hierarchy regarding what I think you should know and do have the right to know BEFORE you take money from a venture fund.
Question 1: Where is your fund in terms of its life cycle and level of capital deployment?
Most funds have a fixed amount of capital available to them over a fixed period of time. For instance, a typical fund has a “life” of 10-12 years and an investment period of 3-5 years. The fund life is the amount of time the fund has to return capital to its investors, distribute stock to its investors or otherwise operate. At the end of the fund’s life, it may get a few years’ of life extension (requires a vote of its own investors/limited partners), but the time is, ultimately, finite. After the fund life ends, the ability to further invest ends. The investment period is the period of time during which the fund can make new investments into companies it hasn’t invested before. It can make follow-on (aka, the second or third) investment anytime during its life. I give you this detail because knowing that, it’s important to realize that the answer to the capital deployment question is important and has two parts to the answer; the first is about remaining fund life and the second is about follow-on strategy.
Fund life remaining is the number of years left before the fund is, effectively, done. It matters because even if the entity raises a new fund (aka, FleeceVest II or III), it is often the case that those separate, later funds cannot and will not invest in the deals of an earlier fund from the same general organization. The reason for this is that the different funds have different investor/limited partners in them and you never want to raise the prospect of a conflict of interest among your investors because you appear to be bailing out a company from FleeceVest I with the money of investors in FleeceVest II. Now, there are definitely exceptions to this and there are times when funds specifically tell their investors they are going to do this and all is hunky dory. But that is the exception, not the rule.
And I tell you that tidbit of trivia because if you are an early stage company and you are taking capital for the first time from a fund that is late in its fund life (aka, year 5), that fund’s runway is relatively short. Here’s the math: in healthcare, it often takes 8-10 years for your company to go from startup to exit. Like it or not, VCs are there to make money and exit (mostly). Thus, if the venture fund only has 5 years left in its fund life, its interests may not align with yours. You may want to grow the company for a full 8-10 years before selling, and the fund may want to exit long before that. The fund may also have less money available for reserves then you should want them to have in its later years. As a result, it is important for entrepreneurs to explore this issue with venture funds from whom they are considering taking capital. There is no black and white here, only shades of gray. Some funds are evergreen and really don’t have a fund life. Some corporate venture funds and have a much longer runway and don’t even think in these terms. It is, however, worth noting that corporate venture funds are often more short-lived than one would like to believe. The average existence of these funds runs around 4-6 years, though there are also some have been around for 20 years or more (aka Kaiser Ventures, Ascension Ventures, Intel Capital). My point is this: know where they sit so you know where you stand.
With respect to follow-on strategy, every fund is different, but no fund is immune from having one. Unfortunately, some funds don’t realize they are without immunity and some funds aren’t good at living up to their strategy. What you really want to know is if the fund will keep capital in reserve specifically for YOUR company for that time in the future when and if your company needs money again. In other words, if a fund invests $5mm in your A round of funding, you want to be sure that they can and will be there with a check for the B round and, if there is one, the C round, and so on.
Many funds have adopted a specific rule for reserve capital. Two common approaches are to reserve at least as much or twice as much as was invested into your company by the fund the first time. These are generally good answers to the question, but as always, it depends. If the fund you are targeting to work with can’t give you a good answer to the question about reserve strategy, or gives you a weaselly answer to this question (aka, “well, uh, we will figure it out when the time comes” and/or “it depends but don’t worry because we have oodles of capital”), beware. Here’s why: Reason number 1: if your company truly has great prospects but has not quite hit its essential milestones and yet has come to close to the end of its capital, it will struggle to raise money from new funds at a reasonable valuation. New investors will want to see that you have hit critical milestones. They are also not stupid and know how to translate desperation into valuation. Therefore, you are going to need to rely on your current investors to get you through those bumps in the road, assuming your company is deserving of it. If the fund hasn’t kept capital for that purpose, yikes.
Here’s reason number 2: Investors in subsequent rounds generally want to see a show of support in their new round from prior investors. That show of support has to come in the form of more cold, hard cash, not just saying nice things about you while crossing their fingers the new fund to the party will shoulder the entire capital burden going forward. The new fund is coming from this perspective: “If this is such a great company, why aren’t their existing investors doubling down?” It’s a great question to be asking and is wholly appropriate. Sometimes there is understanding that small funds don’t have a lot of capacity for further investment, but sometimes there isn’t. But new investors may take it as a negative sign that old investors aren’t stepping up to the table with their checkbook. This is especially true if there is no pre-existing relationship between old and new investors. As an entrepreneur, it’s important to always keep the investor dynamics in mind.
This last issue has become more prevalent over the last several years as there have been a plethora of new seed and very early stage “micro” funds established with $50 million or less capital; some have $10 million or $15 million. This is a somewhat new phenomenon, so it has changed some of the historical investor dynamics – a bit. Being a small capital early stage fund generally results in adopting a strategy of making many investments and expecting many to fail while a few really fly and more than make up for the rest. I say this because it’s unavoidable for a good proportion of early stage companies to fail because the known and unknown risks are so high. Thus, the risk of investing in just a few companies and holding lots of reserve capital for them doesn’t work as a strategy (Note: I am definitely in over-generalization mode here so beware of being too stuck on my precise words). When the investments go well, these small, early stage funds are generally taking the bet that someone else’s fund is going to do the lion’s share of investment in a company and their early stage fund is going to reap the benefit of the uptick in valuation as it succeeds, but not provide much if any, more capital to that company in the future. Sometimes it works, sometimes it doesn’t.
It is becoming more and more common for companies to get their first institutional round of capital from these micro funds, so it is really important to understand what their level of support can be in the aforementioned situation where you need a little more to get to certain milestones and you have to go back to the well. It’s also really important to understand who typically invests AFTER these funds. Which larger funds are willing to accept this first investor’s lack of future participation with some level of mercy because they are familiar with and like the deals that come out of this fund and are comfortable with the partners reasons for not participating in the follow on round(s). It’s important to ask: what funds tend to invest in the next round of your portfolio companies? And then give a call to a few of those people – hopefully there are a few and not just 1 or 2—to double check the facts. Doing reference checks on your investors is perfectly legitimate and actually essential. If the fund can’t point to funds that tend to follow their deals, it can be worrisome. FYI, the more funds they work with, the better it is for you because you have more shots on goal when you go for money later. I’m not trying to say you can only raise money from those friendly follow-on funds, but it certainly improves your odds.
OK, that was a long one, but there are others of equal importance.
Question 2: Are you an effective and collaborative Board member?
Man, this is an important one. If you are considering taking money from a fund, realize that you will be sitting next to their chosen board member, assuming they have one to appoint, for a long freaking time. You may have a longer relationship with this person than with your spouse or some friends. And thus, you have to believe you can have a sustained good relationship with this person through good and bad, richer and poorer, sickness and health, and recession and boom time. Trust me, this is essential.
You may think that all VC money is green, and all VCs are yucky anyway. But be warned, some are definitely more yucky than others, and some are great and helpful mentors and some deserve a 0 review on Yelp. VCs are, contrary to popular belief, people and as we all know, some people are just better or worse than others. Few things are more important than knowing what kind of relationship you are getting your company and yourself into. I have written a whole blog post on this topic in the past entitled “VC or Valentine.” You can find it HERE.
Once again, do your due diligence on your potential investors just as they are doing about you. Call their existing portfolio CEOs and not just the ones they suggest you call. Call former portfolio CEO or two and listen carefully to what happened in the times when things went not so great. Ask them both all this question, “If you had a new company, would you want that fund’s money and that investor on the Board again? “You have to be very discriminating when you listen, because sometimes entrepreneurs really do screw up and deserve being removed or demoted, so listen thoughtfully. Ask if the investor works to collaborate with other Board members or always wants to fight only for their own funds’ interests. Ask if they are good listeners and helpful and constructive in difficult times. There are always difficult times in every company’s life, so it’s that sickness/health question that really matters. But you also want the Board member to expect a lot of you and your team – to be holding you accountable, because that’s how your stock increases in value. If you and your team fail to perform, everyone’s ownership position is imperiled. You do want serious, engaged Board members who are thinking about and contributing to the business’ success at all times, and who aren’t pushovers or letting the company get away with bad business practices.
I would be equally uninterested in a Board member who is nice and disengaged all the time and doesn’t really pay attention when things are bad as I would be in an investor board member who is just a bully or unreasonable all the time, even when things are going well. And things do go well, and then they don’t, and then they do, and so on. So, it is really important to have even-keeled, rational, collaborative Board members that want to actively stand next to you and help you succeed and hold you and themselves accountable for that success. The best investors understand that companies don’t always follow a J-curve, but a roller-coaster-shaped curve, at least in their earliest days. Drive-by board members are a bummer. Egotistical jerks are a bummer. Surround yourself with smart, good, thoughtful, rational, proactive people whenever you can – just like when hiring your team. In fact, think of it as an extension of that process, the establishment of your overall pit crew. The Board has to work well together with its members and with you and your team to ensure you are ready for the next lap of the race. You don’t have to become best friends, but you do have to become great collaborators. See this prior post on the importance of having a functional Board.
There are also times when a particular investor’s interests become misaligned with companies’ interests. This tends to happen in two specific circumstances: 1) an investor board member, and thus a fiduciary to the shareholders and employees, forgets to keep their fiduciary interests first and their fund’s interest second during a company’s difficult times; and, 2) when a fund needs to put success points on its own track record board to raise a new fund, and thus doing what it can to force an early exit is more in its own best interests than in the company’s or other investors’ best interests. It’s human nature to think of one’s own circumstances first. But quality investors will be good at balancing all of the interests in front of them and being an effective part of team decision-making. I would recommend that when talking with potential investors, ask them to give examples of situations when their fund’s interests may have become misaligned with company interests or other investors’ interests and how they handled it.
Questions 3: Why do you want to invest in this company, specifically? What is it about this investment that gets you excited?
I think it’s important to understand the investors’ motivations. It’s really easy, as an entrepreneur, to get all warm and fuzzy when someone hands you a term sheet, but make sure you truly believe the investor understands your business, is investing in it for good reasons (not just because everyone else has an investment like this and they are acting out of FOMO) and if you are both aligned about the direction in which the company is heading. The investor may have ideas about how to optimize your strategy and how to help you with partnerships or activities to get there, but you want them to be on your train, not running on parallel tracks.
I know of several companies that have taken money from investors where the CEO felt they should have a primarily enterprise strategy, but the investor was hell-bent on driving a direct-to-consumer strategy, or vice versa and don’t worry, they’ll prove to you later why they are right. This is never good. You may both come to learn together that whatever the company’s original strategy was, it was ineffective and needs to change, but if you start off in disagreement, it’s like marrying that person who you are convinced you “can fix.” I have never heard a story where that works out in a love relationship and I have never heard a story where that works out in an entrepreneur-investor relationship either.
This misalignment can be especially poignant with new venture fund partners who have just come from leading other companies and are new to the investing experience. It is a very weird and sometimes lengthy mental transition from operator to investor. And the best operations-experienced investors have learned to fight the urge to act like they get to run the portfolio companies. These investors know how to compartmentalize their brain in order to translate their experience as operations leaders into thoughtful advice for portfolio company CEOs. But they also know they are not the portfolio company CEO and that their influence and advice have their limits. Any investor who invests in a company thinking they can impose his/her own will, as they could when they were CEO of their own company, rapidly learns that they don’t get to run things day-to-day anymore. It takes time to move from operator brain to advisor brain and sometimes people don’t quite make the transition well. So just be cognizant of where the investor is coming from.
By the way, I’m not saying that you and the investor should agree on everything out of the gate, or that you shouldn’t trust investors who were previously CEOs of companies. Quite the contrary. But you should have a mutual sense of shared excitement about the plan you have sold to her/him and they should be excited about what they have backed, not feel like it’s a fixer upper (Note: sometimes investors choose fixer-uppers on purpose, but that’s a different kind of investing generally). If you sense the VC just wants to invest now and immediately start driving east while you are hell-bent on driving west, you are entering into a power struggle where no one wins, especially not you. Be open-minded about investor input, but be aligned generally on the direction that your company and their money is heading when you start the race together. If you learn things that make you change direction, do it together, not in spite of each other. Don’t ignore the warning signs that they intend to change everything at the first Board meeting, unless you agree it warrants changing.
There are lots of other good questions to ask investors. You should know about how they work with companies and how they can help you and where they are less likely to add value (and the investor should be open about that); you should know if they can introduce you to people in their network who can help accelerate the business; you should know if they really like to get into the detail weeds or if they want to engage at a higher, more cursory level; you should know what mistakes they have made that they learned from, just as they should ask you to answer that question. There isn’t a right and wrong answer to these questions, it’s all about cultural fit and how to assure a good relationship that will weather the tough times.
Good luck to all of you entrepreneurs. This building-a-company thing is never easy. Bring smart, engaged and empathetic partners to the party.