Weekly Briefing Note for Founders 12/9/24

10th September 2024
CATEGORY:

Building investor trust means one thing - aligning expectations

Founder/investor relationships are built on trust. But this trust is often misunderstood. Founders typically believe it is forged from an alignment of interests. But investors believe it is forged from an alignment of expectations.

A subtle but important difference.

This means that when problems occur, the divergence can be rapid. At the point of investment such a breakdown seems so unlikely; there is a mutual understanding of how value will be created, what will constitute progress along the way, and how this progress will be measured.

This is especially important for VCs that place huge bets on founders that have sold a compelling vision of high growth and category leadership. When progress is made and expectations become reality, trust is then developed.

This works well - until it doesn't. When (rarely 'if') the company begins to deviate from the agreed pathway of value creation, tension rises.

Unless resolved, the selfish interests of investors will eventually take over. As VC Jerry Neumann points out, this divergence can occur in fundraising, in board meetings, in growth mode, when facing problems, and when selling the company. Those are the moments that can break everything.

Understanding investor expectations prior to taking their money would seem to be best move. If those expectations are unrealistic, better to step back early.

But we get caught in a trap.

Under time pressure to close a round, these cues are often ignored. They just don't seem that important at the time. Getting vital cash into the bank to make payroll gradually dominates all thoughts.


First institutional raise

Serial founders often say that the toughest capital-raising experience of them all was their first institutional round. Closing earlier rounds from private investors was much easier. The process was far less complex, with fewer checks and balances. As a result, it was much faster.

As a first timer they found it hard to get the attention of the bigger, well-known funds. Their network within investor circles was limited and they were still building a profile as a 'must-back' founder. Out of necessity, they gravitated to the smaller, lower-profile investors that were more willing to give them time.

This is very common in early funding rounds. Here, there is a whole raft of different types of investor from emerging fund managers, to more experienced early-stage fund managers, and many other niche players that sit outside the classic VC fund construction. And this is where things often get tricky.

The motives and operating priorities of those that don't manage institutional funds can often be much harder to determine. This creates a danger zone for inexperienced founders who may find themselves unwittingly engaging with unconventional (and sometimes unscrupulous) players.

For example, those that market themselves as VCs but in reality are some other form of private investment vehicle. They may just be managing the money of a wealthy individual or group of connected angels, more in the vein of a family office than a proper institutional fund backed by limited partners. And that drives very different expectations.

This can also happen with an emerging manager that is struggling to pull together their first VC fund. In this case they actually fit the VC model but may not (yet) have the means to invest if a deal comes together quickly. But that doesn't stop them pursuing deal flow and taking up precious founder time.

And of course there are the legitimate, well-established funds where an unscrupulous (or inexperienced) partner may be happy to take advantage of a naïve first-time founder when negotiating terms. Every founder will have heard one of these horror stories. As we highlighted in Startups must increase investor due diligence choosing the partner is just as important as choosing the fund.


Investor selection

All of this is a reminder that investor due diligence is a crucial aspect of the funding process. Just as investors dig deep on founders, so too must founders dig deep on investors.

The most reliable route is to take references. Talk to other founders that have taken money from this investor. How did it work out? How interventionist were they when expectations diverged? But this is only something you want to spend time on if you are considering a term sheet.

Prior to that, when building the investor target list, what are the most useful indicators to check? The obvious ones are fund size and age, Limited Partners, AUM, portfolio size, typical deal size, and typical % stake taken.

Fund size is always crucial. When we asked a first-time founder recently what financial outcome they were personally shooting for if their startup was a success, they said without hesitation, "£10M. That would be a life changing experience". No doubt it would be, but such a low figure would immediately turn off the majority of mainstream VCs.

From an investor's portfolio you should also be able to deduce the real investment thesis (versus the one that is marketed). Is there a clear thesis or do they operate at all points on the map? Generalist investors usually put much greater store by the founder and exec team than by the specific market opportunity at hand.

Beyond this it's often highly revealing to check out their co-investors on prior rounds. Most importantly, do high-quality mainstream funds subsequently invest in the later rounds? i.e. Are top-tier funds happy to sit on the cap table (or even on the board) alongside this earlier investor? If these initial investors don't 'collaborate' in some way with other investors this is usually a red flag.

Mainstream VCs operate in a syndicated world where their reputation is essential for survival. If you stumble across a lone wolf, make sure you don't get bitten.


Better definition of trust

If we are to form an 'alignment of expectations' as the bedrock of trust, we need a more balanced definition.

As we have said before, our own take is: 'Investors trust that founders will ultimately deliver a return and founders trust that investors will let them get on with the job (and support them when asked), even when circumstances change.'

And circumstances will always change.

If we adopt this definition, it means that founders should not succumb to the illusion that VCs care about them, their team, or their vision. They ultimately only care about one thing; returns. That's their job (and their fiduciary responsibility), so let's just say it like it is.

Of course, when returns look likely, all is well. Investors are usually happy to let founders get on with the job. Support - if requested - is usually very forthcoming.

But when returns begin to look unlikely, that's when things start to change. VCs, especially those that have board seats, begin moving in ways to exert more control.

Much of this will come from the 'soft' influence they have by virtue of being major shareholders. But they will also have a menu of 'hard' options available. The ultimate sanction is to replace the CEO. But this is often tantamount to blowing up the company if it's still in the early stages.

Experienced founders accept that big shareholders will want to exert their influence if a major divergence in expectations occurs. That is not unreasonable. But too much intervention at too early a stage can simply be counterproductive as well as deeply frustrating for the founder.

Experienced founders select investors that are not 'premature interventionists'. And they move proactively to negotiate reasonable terms at the outset to make sure that they have the freedom to operate.


Control mechanisms

Inexperienced founders are typically not as proactive in building in the same control levers and may only realise this when it's too late. These levers are embedded in the investor relationships formed during the fundraising process; in the investment terms agreed (especially in the investor consents); in the constitution of the Board; in the growth plan itself; and even in the exit strategy.

Why are these areas so crucial?

Because there is a natural mismatch in the power dynamic between investors (who focus huge amounts of their time on such matters) and founders (who often don't, given the much wider demands of their operational focus).

This is why serial founders, who have seen this all play out before, pay significant attention to these areas. They become masters of investment terms (that first appear in the Term Sheet and often seem boringly arcane and unimportant).

These terms shouldn't dictate the day-to-day investor relationship. But, when the chips are down, they will dictate how and under what circumstances investors can exert more control over the company. And they will usually not hesitate to do so if they feel their return expectations are in jeopardy.



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