Four Early Stage Mistakes You Won’t Make Twice

One advantage enjoyed by serial entrepreneurs is that, having been there and done that, they have made (or seen) mistakes that they won’t make again. As an outside advisor and mentor, I see some of those. Here are a few I’ve seen that you can avoid.

1. Failure to Secure Founders’ Agreements

You and four colleagues get together and form a company. You split the equity equally. At some point one of your colleagues determines that his or her family can’t live on beans and toast, and drops out for good and valid reasons. However, the departing founder still holds 20% of the company.

That doesn’t work. First, it is unfair to the remaining founders who continue to build the company. Second, you need to replace the departing member, and you will need to give equity to the replacement. Third, no early stage venture capital firm is going to accept that 20% of the equity is held by someone who is no longer making a contribution to the company.

The hard answer to this question is that you need to negotiate with the departing founder to reduce his or her share. The easy answer, though, is that you should have signed up to founders’ agreements in the first place, providing for “reverse vesting” of equity. Typically, this is structured as a one year “cliff” and monthly vesting over the remaining three years. This means that the founder who leaves in the first year will retain no equity, and one who leaves thereafter will retain an interest proportionate to time served. In some countries, like the UK, you may need to put special provisions in your articles of association to make this work.

2. Agreeing Unreasonable Exclusivity Provisions with Potential Investors

You find an investor who expresses interest in investing in your company. The investor presents a non-binding term sheet that contemplates that it will perform due diligence and you will not enter into negotiations with any other investor for some period of time while it carries out due diligence.

You can understand why the potential investor will want protection — it doesn’t want to invest time and money in performing diligence and drafting agreements with the risk that you will then do a deal with another investor. However, you need to understand that, during this period of time, you will not be able to approach other potential investors, and you have gotten no commitment that this potential investor will actually invest. Additionally, even if the investor does invest, you may still need to fill out a round with other investors.

With early stage companies, I think a prospective investor should be prepared to perform business due diligence without asking for exclusivity. Your business should be reasonably simple to diligence, and it should not take long. The investor has a stronger argument for some protection if you get to a point where it needs to involve outside professionals, such as lawyers and accountants, to perform legal, tax or accounting diligence or draft agreements. However, even then you should resist exclusivity provisions, and perhaps consider whether some other approach (e.g., reimbursement of professional expenses up to a low cap) would suffice. If you agree to exclusivity, it should be for a very short period — no more than several weeks — and you should agree it only after you get very comfortable that the deal is highly likely to go forward.

3. Accepting Investment from the Wrong Investors

This is actually three points, not one.

Friends and Family. If you take money from friends and family, they need to be friends and family members who really and truly assume that their money is lost at the time that they write the cheque (and even then there is risk to your relationships with them). Unfortunately, most early stage companies fail. Investing in a single early stage company (rather than a broad portfolio) is like buying a lottery ticket. The pain of loss is ameliorated in some countries, like the UK, that provide very substantial tax benefits to investors for early stage investment. However, your friends, in particular, are likely to become former friends if they invest with an expectation of a return (or at least that they will get their money back) and your company ultimately fails.

Inexperienced Angels. Inexperienced angel investors can cause you much pain. They may have expectations that are disproportionate to the level of their investment (e.g., board seats), and may make unreasonable demands on you and on your time. If you take angel money there should be an experienced lead angel who has responsibility for dealing with you. The other members of the syndicate should understand that you will report to them periodically, and may seek their assistance where appropriate, but otherwise they are along for the ride.

The Wrong Early Stage VC. The wrong venture capital investor can kill your business. You will have a relationship with your early stage VC that is likely to be critical for at least eighteen months. It is easy to be a supportive VC when things are going swimmingly. You need someone who will be there when you need help, and whose first reaction won’t be to throw you over the side and focus on its other investments.

Your prospective VC is going to perform a lot of due diligence on you and your management team. You should do as much due diligence on the VC. Speak to portfolio companies and former portfolio companies, preferably including companies that ultimately failed. Find out what advice and support they got from the VC, whether the VC was helpful in getting them the next round of funding, and how the relationship worked when things were not going well. Get to know the specific individuals at the VC firm who will work with you.

Special issues may arise in connection with first time VC’s, or investors (such as private equity investors) who are not accustomed to working in a venture capital context. Make sure that you understand what experience they have had. A savvy entrepreneur who has previously taken VC investment in his or her businesses, for example, may be a very good VC. On the other hand, a private equity investor who is accustomed to how things work in private equity portfolio companies may have difficulty adjusting to the different environment of early stage investing.

4. Hiring (the Wrong) Friends

There is no doubt that you can reduce risk by hiring people with whom you have experience, and consequently whose strengths, weaknesses and skills you are in a better position to evaluate.

However, keep in mind if you hire personal friends that you may be complicating the management of your business. Friends have expectations about your relationship with them that may be inconsistent with your directing them, or asking them to change the way in which they are working or improve their performance. Still worse, if at some point you need to manage out a friend because he or she is not up to the task, that will be very difficult and your friendship is unlikely to recover from the experience.

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Needless to say, these are only a few of the mistakes that early stage entrepreneurs come to regret. Please feel free to comment on others that you have made, or seen.

This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact robert.mollen@friedfrank.com.