One of my investors candidly asked me recently, “Shelly, if I have an opportunity to invest with people I’ve just met, how do I avoid getting screwed over?” This is a good question; for most investors interested in startups, co-investing is the de facto way to invest.
Just like you scrutinize the entrepreneur, the technology and the market opportunity before investing, you also need to assess the people with whom you’re investing. Why are they investing? What is their track record? What type of value do they bring to the startup? Why did they present the opportunity to you?
Invest with people who are in it for the returns
This might sound like stating the obvious, but you’d be surprised. I see investors invest in companies for various reasons. Angels sometimes invest because they have a relationship with the founder or want to help. Corporates may invest because there is strategic value of the technology to the company, not the potential for a big exit.
If you are partnering with other investors, take the time to understand their motivation behind the investment, and always strive to co-invest with people who are in it for the financial potential of the opportunity.
Track the track record
Aim to co-invest with people who have a proven track record for identifying talent (a history of successful portfolio companies) and adding value (opening doors and securing investments). These types of investors see the most deals and attract the highest-caliber entrepreneurs. More importantly, their superior access and active involvement increases the likelihood that the investment will succeed.
Fear the infrequent
When an investor brings you deal flow on a regular basis, you should feel much more comfortable co-investing — as opposed to an investor who sends you a deal once in a blue moon. In the former case, you don’t have to ask why the deal is coming your way, especially if every deal is shared. In the sporadic case, the investor may be having trouble closing the round, and you should evaluate with caution.
Do due diligence
Although you can leverage the due diligence your co-investors have performed on the company (to save time and energy), reviewing the deal terms proposed by your co-investors is just as important.
Startup investing should be fun.
Notable investors who get involved in the company’s day-to-day often will demand preferential terms in the form of kickers (options or warrants), effectively reducing their entry valuation. Your job as the co-investor is to ask yourself whether this special treatment makes sense, and if your price points reflect the risk adequately.
Be mindful of adverse selection
When you see a company for the first time, assume others have seen it, as well. Try to understand on what grounds other angels and VCs passed. Some investors may have wanted to invest, but already invested in a competitor, have a past history of conflict with the founders or lack the industry connections necessary to add value.
See if you can identify insights that others likely missed (with respect to technology, team, market, etc.) to strengthen your case for investing, and avoid the notion of doing the deal that no one else wanted.
Beware of biases
It’s always great when investors from previous rounds follow-on their investments and continue to support the company. But be aware that these investors already have a working relationship with the founders, inside information on the company’s prospects and knowledge that new investors are watching carefully for a signal.
If they don’t believe in the company, this puts them in a catch-22… invest, and they risk more money in a losing bet; don’t invest, and the company may fail to raise a subsequent round, resulting in guaranteed losses. In contrast, investors seeing the deal for the first time lack an emotional and/or financial attachment to the company, and their investment conviction will come from a less biased position.
Be wary of co-investing with the co-investor
In venture capital, everyone is co-investing… accelerators, angels, VCs, corporate VCs, PE funds. Even most of the professional VCs that “lead” rounds co-invest 90 percent of the time.
To avoid this circularity, try to identify at least one smart person with a track record. It can be an angel, an industry expert, a partner in a good VC — someone who understands the industry and has conviction in the opportunity, regardless of anyone else’s opinion. This is a true lead.
Skin in the game from a portfolio perspective
You want to invest with someone who is truly vested. In dollar value, that means different things for different investors. For an angel investor, $200,000 could mean a lot of money and a real bet on the company. For a VC, it could mean just a foot in the door. To illustrate, when a $200 million VC fund invests $200,000, they are risking only 0.1 percent of their capital on the opportunity.
In such a case, you can guess that the amount of attention this company received is limited. Furthermore, if the company doesn’t evolve into being a huge opportunity, the VC might not be keen to make substantial investments down the road, which will hurt the company’s chances to raise from other investors.
Alignment of interest
Alignment is more natural when you invest with someone who has the same disposition as you. For example, if you have a net worth of $3 million, co-investing with a professional angel investor who has $20 million creates more alignment than co-investing with a $300 million VC fund.
Like individual investors, angels are usually sensitive to valuation, while VCs are sensitive to ownership — the reason being that angels typically won’t be able to follow-on on their investments indefinitely, while VCs have deeper pockets, prefer larger opportunities and allocate smaller amounts in the beginning to double down at later stages when the company does well and they want to maintain their position.
Consider each potential co-investor’s motivation when evaluating the deal.
Strategic investors (corporations) often do a lot of ground work and due diligence around their investments to ensure they create a viable exit strategy for the company, or to understand how the technology will integrate into one of their product lines or IT infrastructure. This can benefit the co-investor if the startup quadruples revenues by selling through the corporation’s distribution channels.
But if the company signs an exclusivity arrangement that prevents the startup from doing business with other companies, or a right of first refusal that discourages other strategics from bidding in an M&A situation, it can actually hurt the company a lot. Consider each potential co-investor’s motivation when evaluating the deal.
In trust we trust
Startup investing should be fun. Invest with good people you trust and build your reputation as a good, trustworthy co-investor that others want in their cap table. Each startup investment is a partnership with the entrepreneurs and co-investors. These are long and bumpy rides with much that can go wrong if you are doing it with the wrong people.
I have witnessed tense boards, investors putting down entrepreneurs, aggressive financing rounds… and other such instances that reduce your chances of success and, frankly, take out all the fun from the ride.
If you can check off the majority of these boxes, you’ve got yourself an interesting deal.
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