CHOOSE INVESTORS WISELY
November 19, 2014
BY JAMES FORREST
Many of our clients at the Forrest Firm fall into the categories of small businesses, startups, or both. Small and early-stage businesses often have many of the same risk management concerns of larger and more mature, later-stage businesses; however, entrepreneurs and executives at small companies and startups are often their worst enemies with regard to multiplying their risk exposure due to the heavy lifting they must undertake operationally, as well as the age-old problem of lack of funding.
Many entrepreneurs choose to bring in outside capital investment, often times in exchange for equity in the business, as a solution to challenges created by funding shortages. As my Forrest Firm colleague Jeff Wolfe has outlined in his Business Capital Basics series, investors in small businesses and startups typically fall into three basic groups: friends and family, angel investors, and venture capital firms. While we all know who are friends and family are, angel investors can either be well-known to us or simply private individuals sympathetic to investing in certain types of businesses. Venture capitalists, on the other hand, are in the business of investing, and they all have their own sets of plans and rules to follow for putting their funds in the service of a business.
As with other areas of business operations, evaluating cash needs on a short-term, mid-term, and long-term basis requires a clear-headed mentality with regard to not only evaluating investors for their willingness, but also from a risk management perspective. Specifically, exchanging partial ownership for capital infusions is often just the beginning. Investors from each of these groups—friends and family, angels, and VCs—may require immediate or future power-sharing arrangements including but not limited to seats on the company’s board of directors or even senior management positions.
While the practice of exchanging equity (and the power that comes with it) in exchange for funding is a time-tested practice with great results for many companies, for others it leads to peril. Power-sharing arrangements often go awry, with founders and executives at odds with their investor-partners and their opinions on how to run the business. As with many other types of disputes that lead to costly lawsuits that saddle companies with crippling expenses, we see that these power-sharing disputes were often preventable, if only the business leadership had carefully evaluated potential investors for cultural fit with the board and/or management team.
Sometimes, there’s simply no good fit out there in the world of investors. Entrepreneurs must know themselves well enough at times to know their own single-mindedness. If they are unwilling to compromise and truly share power with those who are willing to invest in their businesses, perhaps equity financing is not the way to go. Debt financing or bootstrapping may be better options than having a professional marriage that’s doomed to fail in a messy divorce that’s good for no one.