4 Questions Entrepreneurs Should Ask Investors
It is common for entrepreneurs to find themselves in a reactionary role when seeking investment. It is natural to want to please an investor and cater to their every request. It is also common for businesses to fail at the 11th hour because they cannot continue without the financing that a potential investor can provide. Thus, there can be an inherent imbalance when the investor holds the keys to a critical resource.
Keep in mind that due diligence, or the process that investors and founders go through when seeking to consummate a transaction, is a two-way street. The investor is vetting you and your team as an investment, but as the entrepreneur you should also be evaluating the investor. This is a long-term relationship and although everyone’s money is green, not all investors bring the same value to the companies they invest in.
The stakes are high when looking for funding and you should always evaluate the investor you are pitching and look for alignment and compatibility. When companies need money to grow, founders don’t always want to ask the difficult questions for fear of offending an investor, causing them to walk away, etc. Founders commonly convince themselves that the investor is the right fit given the pressure they are typically under to secure financing. It happens all too frequently. Note, that an investor who easily takes offense at relevant questions should be a red flag. Any investor who brings the right mix of capital, resources, relationships and involvement should be an open book.
If you find yourself going through the due diligence process with an investor, conduct your own due diligence of the investor and seek answers to the following four questions:
Does the investor have money?
This may seem a strange question, investors are investors because they have money right? Not always. Investors come in different shapes and sizes and invest differently. Angel investors are individuals who invest their own capital. It is important to identify the amount of capital they are willing to risk early on. And perfectly reasonable to ask them if other family members or advisors have any say in the investment decision. Some investors work as “syndicates” and will need to secure the capital from their network before they can fund an investment.
Venture funds are pooled investments that are managed by the fund. The Managing Partner and Limited Partners will have their own of arrangement on how investments are approved. It is important to understand the fund’s internal process to level set your own expectations and anticipate the needs of the investment fund. For example, are you working with an investor who is just an intermediary that needs to pitch your investment to other decision makers? Also keep in mind that many funds are raising money themselves at the same time as evaluating investing in your company. You should be very clear about where they are in their process. It is perfectly reasonable to ask early on if the fund has the capital to invest in your deal today, and if not, when they would be able to make the investment.Have they made investments like this before? In particular in cannabis you will see a lot of investors looking to invest in private companies for the first time. This is not a reason to not work with them, but can be a red flag. Investing in private companies comes with significant risk. The vast majority of companies fail and the investments are illiquid meaning that the capital will be tied up in the company for a significant period of time before a return is realized. Are the investors comfortable with this? It is your responsibility to make sure this type of investment is compatible with the investors willingness to accept the associated risks. To ignore this will only lead to problems down the road.
A great question is to ask if the investor can tell you about a time when an investment they made didn’t work out. 90% of startups fail across all industries, which would indicate that any investor who has made any investments in private companies would have the majority of their investments fail. Successful entrepreneurs learn and grow through failure. The same goes for investors, investment failures offer the same opportunities to learn and improve.What are your investment parameters? “Venture Capital”, “Private Equity”, “Equipment Finance”, “Distressed Debt”, “SPACs”. “Factoring” and “REITs” are all very different investment strategies that require different skillsets, infrastructure, access to capital and teams on the investors side of the table. In mature markets, these types of investment strategies are all very different and never co-mingled within the same firm. This should be no different for the cannabis markets. Lenders and asset backed investors underwrite and evaluate risk completely differently than equity investors. Lenders don’t care about a business plan, they want to see assets and cashflow that can service debt. Equity investors are looking for a business that can grow organically such that the valuation of the company also grows and triggers a significant liquidity event.
The key characteristics you are looking for in an investor are relative to the investment strategy of your company. If you are looking for several million dollars to fuel the growth and expansion of your business, you are looking for a venture capitalist. An individual or firm that has deep experience investing in and helping shepherd investments in private companies. VC’s provide more than capital. They should have deep relationships and access to key business development opportunities that can be as valuable as the money they provide. Be wary of investors with ever changing strategies. Truly adding value to an investment takes time and consistency along with a breadth and depth of relevant experience and relationships.Can they provide references for other investments they have made? In a two-way diligence process, if you are thinking about transacting with an investor, you should be asking them for introductions to the other management teams they have invested in. An investor with experience in investing in private companies, either angel or VC fund, is always more valuable and that experience should equate to them backing one or more companies in the past. VC firms will almost always list the investments they have made on their websites as the portfolio. There is nothing wrong with actively reaching out to those companies directly and talking with the CEO’s and founders to ask about their experiences working with an investor. What was it like when things didn’t go as planned? Are they readily available and helpful in providing advice and input on the business plan? And as a reminder, if your contacting previous investments upsets your new potential investor, it’s probably a red flag.
Writing a check is a privilege, not a skill. The skill, as with anything, is building a discrete set of resources and experiences that can be effectively leveraged to increase the probability of future success. Investors have a resume just like everyone else. In the enviable situation where a company has multiple investment offers, the entrepreneurs need to compare and pick the investor best suited for helping finance the type of business they are building. Unfortunately, it happens all too often that an entrepreneur does not have any options for investment and takes an investment from an individual or a firm that is not compatible. In those situations, it is almost certainly a company that is doomed to failure. In those situations, you will always hear an entrepreneur say that they wished they never accepted the investment and continued to run their business independently as they might still be in business.
If you treat the diligence process as a two-way street and gather the relevant information you need to make an informed decision, then odds are you will be more comfortable working closely with this investor throughout the relationship. However, if you find red flags, values that don’t align with your company, etc., it may be best to walk away. Turning down an investment may not feel right, especially in the moment when an offer is on the table, but speaking from experience, saying no to an investment can end up being the best decision for you and your company.