Allocating a share of your company seems like a good way to save money. I wish it was that simple. Shares held by a third party can either be an advantage or a disadvantage.
Raising money for the first time is a hard thing even when everything goes according to plan, and that rarely happens. It’s hard to filter investors to find the right one, hard to get an intro, hard to leave a good lasting first impression. It’s hard to build a good story, and very hard to get to a place where investors compete for investing in your startup. These hardships make room for many misconceptions, many value extracting players, much frustration.
I participated earlier this week in a heated Facebook debate about the role of finders (people that “find” an investor or make an intro for money or shares). This discussion led me to think that maybe, just better understanding the way VCs work, will help founders play their cards smarter. I think that considering working with a finder, except for a few very unique situations, often steams from misunderstanding the VC’s interest. My basic argument is that allocating shares to anyone that is not actively contributing to the company’s effort, continuously, is a mistake.
For the sake of argument, let’s say a startup is a business built on rapid growth, that the startup wants to raise money to facilitate this growth, and that we’re talking about the first round of fundraising. There’s a founder (founded the company) in our story, and an investor, which hasn’t met.
The investor, referring here to a generic VC model, would want to find and invest in the companies that have the best chance of becoming big (good founders, tech advantage, working in a growing market). When that investor finds a good company to invest in, they will wish to hold a large-as-possible portion of that company, in order to benefit in case of an upside scenario. Holding a large share of a company is the result of investing a lot of money, and keeping the valuation in check. That’s simple math and I’m guessing most of us know that.
Now try to think like an investor that is yet to find that company: If a founder finds you, it’s a good sign (the founder has a strong network, resilient, resourceful….); if the founder had to pay someone to get to you, it’s a bad signal (couldn’t get a direct connection). For that reason, investors make themselves accessible. All big VCs today employ a team (associates, principles) that would meet almost any startup. They publish posts, they hold events, have fancy websites). They want you to get to them.
Making an introduction between a startup you believe in and a VC you know is a GOOD THING. people actually really want to do it. It’s a win-win situation. This means, by proxy, that if you haven’t found someone to make that introduction, you haven’t convinced the right people you are ready for an investment. Use it! take a step back and work on your proposition. Don’t pay someone to make that introduction.
II. The cut
Now let’s assume you did engage with someone to find you an investor and he wants a cut and you agreed on that cut. What will the investor make of it? For the investor, this is a disaster. Let’s consider two scenarios — finder rewarded in cash and in equity.
- The finder taking 5% equity. Now you (investor Joe) invested in a team that just got diluted by 5%. They have less control of the company; there’s someone on the cap table that you don’t know (if you had known him the introduction would have been made ;-)); there’s a 5% share of dead equity in the company (equity belonging to someone that’s not actively helping the company); and finally, there’s someone who got better terms than you. Once again, investors will do everything they can to avoid that.
- The finder taking 5% cash. In this scenario, the company sends off 5% of the received investment sum to the finder. From the investor’s perspective, the company now has 5% fewer resources to succeed. The company waived 5% of its hard-earned cash flow and the investor invested 5% less of what he/she wanted the company to have. The investor wished to invest money in order for the company to use that money to grow. If 5% of the investment sum goes to waste, the chances of success decline.
III. There’s no “Them”
Founders might think of the finder as a shortcut. As a loophole in the system. As a service provider. But this service provider burdens the company. This service reduces the potential outcome of the fundraising process, the very same process it was hired to perform.
Thinking in terms of “us” vs “them” is a very natural thing. Entrepreneurs don’t always understand the way VCs work, and it’s quite easy to slide to an adversarial mindset. The VC wants to take a cut in our business, we want to hustle them into investing. I can’t tell you how much everything made more sense to me once I learned this one simple principle: the VC’s interest is to invest in a company that will succeed. Making a decision about an investment is guided by this principle all the way through. There’s just no benefit to investing in a company that’s only 95% committed to succeeding. Holdings in the company should be in the hands of parties working for the success of the company (founders, employees, investors).
I mentioned earlier the existence of a few unique situations where there is a rationale behind working with a finder. Finders in the world of sales are a different thing, much more like a commission, viewed as a very common practice. Set that aside. Are there investment finders that add value?
Chinese investors and other players from the far east face significant barriers to entry for investing in western startups. That’s also true the other way around. This is a good example of an ecosystem that had intentionally normalized middlemen. Some Asian investors engage with agents and proxies in order to access local investment opportunities in specific markets. A good way to spot those is to ask yourself if this investor initiated the efforts of the finder. It still remains far more efficient to grant the finder cash over shares.
V. My lesson
A couple of years ago someone I trust introduced me to another person, who claimed to be part of a group of wealthy individuals looking for investments. They didn’t invest but then called and said they have foreign investors they can introduce us to. They sent a contract (5% commission) which we debated for a few days ($1,000 for legal fees down the drain). Never heard from them again. They didn’t make a dime but we lost $1,000. Today, looking back, I know that if they did have that investor at all, they would just make the intro. I’m glad that lesson only cost me $1,000.