Angel and Venture Capital (VC) Investors: Due Diligence Needs to Be a Two-Way Street

Angel and VC Investors: Due Diligence Needs to Be a Two-Way Street BY BOB WIGGINS F OR A STARTUP TO STAY IN BUSINESS, ONE OF TWO THINGS HAS TO HAPPEN. Either the company has to generate a profit, or the company needs to find someone willing to fund its losses. The most important job of the CEO of any startup is to make sure that at least one of these two things is always happening. Fundraising takes so much of every startup CEO’s time because it is critical. In my experience, while many CEO’s do a good job of finding potential investors and telling the company’s story, they neglect an equally important part of the job—vetting potential investors before taking their money. At first blush, vetting potential investors would seem like an odd thing for a company trying to raise money to have to do. Money is existential. If the CEO finds a warm body with money that wants to invest in the business, the natural inclination would be to take it. Fight that natural inclination. The CEO should do as much due diligence on a potential investor as the potential investor should do on the startup. The Consequences of a Bad Investor Tech startups usually are funded by angels or venture capital (VC) funds. Angels are wealthy individuals, or groups of individuals, who invest in startups. VC funds are managed by professionals who tend to have relevant industry experience with high-growth startups. Let’s start with angels. A potential angel that has never invested in a startup may not understand the risks or lack of liquidity inherent in such deals. If the angel does not have a good understanding of what they are getting into, they may quickly become a difficult shareholder when things don’t go according to plan. Even experienced angels can be a problem. An experienced angel may have a complete understanding of what they are getting into, but may also make demands on the company that ultimately harm its path to growth, such as board involvement or contractual rights that will make raising future funding more difficult. Even professional VCs are not always great investors. Many firms with VC investors find themselves saddled with nonmarket deal terms, undisclosed goals of the VC that are inconsistent with the startup’s goals, and difficult or unhelpful board members from the VC firm. So, What Is a CEO to Do? It’s impossible to eliminate all surprises in life, but shame on the CEO who gets surprised by something that a little due diligence would have easily discovered. In the case of any potential investor, the CEO should at least do an Internet search to make sure there are no red flags. The CEO would be wise to ask any potential angel for names of startups that the angel previously invested in. Contacting the CEOs of those companies to see what kind of shareholder the potential investor was could be time well spent. In the case of a VC investor, it is even more important for the CEO to do appropriate due diligence. The CEO should of course follow up on offered references, but should also contact the CEOs of the VC’s portfolio companies in the startup’s industry. The CEO should also find out who the VC intends to put on the board, and ask other portfolio companies specifically about the potential board member. It’s essential to do some work upfront in order to avoid surprises later. n Bob Wiggins is a shareholder at Lane Powell PC and manager of Mount Hood Equity Partners. He has been CEO of three startups and an investor and board member of more than a dozen startups. Bob can be reached at 503.778.2112 or [email protected] Just because a potential investor has a gold pen and an expensive watch doesn’t mean you should take his money. 38 LEGAL BRIEFS Sponsored legal report