3 ways to select smart investors and avoid toxic partnerships

I recently came to the rescue of a startup in crisis. The idea was solid: The company wanted to develop heavy-duty drones that could assist firefighters in battling wildfires. What its founders lacked, as many first-time entrepreneurs do, was real-world business experience. By the time I got involved as an angel investor, the company was entwined with two other investors who had no idea what they were doing. It truly seemed like everyone involved was in over their heads.

As a serial entrepreneur and angel investor, I’ve seen a lot of bad ideas work, and a lot of good ideas fail — and a lot of that has to do with how knowledgeable, experienced, and helpful the investors are. Just because investors have the money to fund your venture doesn’t mean they have the subject matter expertise, wisdom, and shared expectations to help you manage your company and guide it toward a successful exit.   

Bringing in the wrong investors can be a grave mistake. To identify those who would be the best fit for you and your company, founders need to ask potential investors the right questions to determine if their interests are fully aligned: if they truly fit with the product, market and company vision.

It’s equally important to connect with investors who know your specific industry and understand the value of your product or service; “smart money” can be a huge benefit throughout the lifecycle of your startup. And, before signing any definitive agreements, founders need to make sure the investment will be structured in a way that supports their vision for building — and exiting — the company.

Alignment is key

Beyond money and mentoring, it’s important to find investors who share the same values regarding communication, accountability and company culture. Investors and founders also need to agree on the expectations and timing of the company’s exit. Misalignment in any of these areas can — and likely will — cause friction down the line.

To ensure that all parties are on the same page, founders and investors need to have a reciprocal interview up front. Both founders and investors should ask questions about previous deals and experiences to determine the other’s level of expertise, as well as their temperaments and expectations, and determine whether the relationship will become a valuable partnership or a toxic one.

It is particularly important for both parties to establish their expectations from the beginning. I’ve seen many founders fall in love with their companies and delay an exit — meanwhile, the investors expected to get money back on their investment within a certain period of time. Having an in-depth conversation up front about the projected path of the company will help both parties understand what to expect as the partnership moves forward.

Smart money

The partnership between the drone company founders and investors was, in my opinion, doomed from the start. The investors had little experience with early-stage companies, and they had never worked in the technology sector. They didn’t fully understand the product or the ecosystem, and the founders had to devote time to educating them along the way, which put everyone at a disadvantage.

Meanwhile, the founders came with a great idea, but they had no market validation, no customer profile, and no discernible value proposition until I got involved at a later stage. As first-time entrepreneurs, the founders could have avoided many startup pitfalls by selecting an investor or investors with more expertise relevant to the company’s stage and market.

As with any relationship, it helps to find investors who fill gaps not already covered by your executive team. Whether it’s financial expertise, marketing know-how, or connections to prospective customers and acquirers, there is an array of valuable capabilities that the right investor can potentially offer.

Think before you sign

From the beginning, investors have the choice of buying equity in the company at an existing valuation, or having the option to convert their investment into equity in the future at a discounted valuation, known as a convertible note. Some entrepreneurs and early investors prefer convertible notes, while others will not touch deals that don’t involve equity.

As an angel investor, I don’t like convertible debt transactions, because you lack control. You tend to have little to no involvement; if an inexperienced entrepreneur makes a bad decision, you have no say in the matter. And, if other investors come in later on, you have no choice but to work with them.

The drone company’s original investor used a convertible note. When the company started hitting roadblocks and the relationship wasn’t working, the investors pushed to get their money back and wash their hands of the deal. Misalignment around investment structure and expectations related to long-term liquidity is common among inexperienced parties in early-stage transactions, and in this case was particularly toxic. It’s critical for both entrepreneurs and investors to discuss upfront how involved investors will be and what they can expect to exit as the company grows.

Investors can offer much more than funding, but the wrong investor can easily run a company off the rails. The drone company founders spent at least two years getting their product off the ground, in part because they wasted so much time answering to an investor who requested irrelevant information and couldn’t contribute any meaningful guidance in return.

An investor with the right kind of business acumen and experience with a company’s market sector can be enormously helpful in validating a company’s idea, articulating its value proposition, and serving as a trusted advisor during a startup’s inevitable ups and downs.

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