Dear SaaStr: How Does an Investor Protect Themselves When Investing in a Startup?
It’s actually pretty hard.
Investing in startups actually requires a lot of trust by VCs and investors. No matter how friction-full dealing with VCs can sometimes be, try to remember that.
- Probably steal the money. At least, until there is a real controller or CFO. Fraud is very easy in early-stage start-ups.
- Spend it terribly. There are few practical controls on making terrible hires, on dramatically increasing the burn rate, or even really spending it all in 12 months or less.
- Buy a Tesla, or lease a jet, or whatever. It is almost impossible for investors to police expense policies, etc.
- Make up fake financials. You can stress test this by examining bank accounts (i.e., the flow of cash), but many angels and seed VCs don’t. So you can basically make up make financials.
- Fake customers. Beyond pure fraud, it’s easy to exaggerate pilots and LOIs as real paying customers.
- Not actually go all-in and Also work on something else at the same time. This is more common in angel investing than you might think.
- Exaggerate the commitment of the team. In the early days, some of the founders often aren’t really 100% committed. Or sometimes, not even really employees or full-time.
- Etc. etc.
“Every VC has a fraud in their portfolio.
It won’t come out, they are just marking them to zero.
Any VCs that doesn’t admit the fraud isn’t close to it or is ignoring it.”
— Harry Stebbings (@HarryStebbings) August 6, 2023
Not saying you would. But a few do.
A few do do this, or at least pieces of it. And a lot of startups have some bad behavior here. And it got worse during the Boom Times of late 2020 through early 2022. See, e.g., FTX.
So how can an investor protect themselves?
- A board seat. This isn’t a magical panacea for bad behavior, but at least having formal accountability every 6–8 weeks can help. A bit more here.
- Real board meetings every 60 days. Not enough founders do them anymore.
- Founders should send over the bank statement each month. This protects them as well. I don’t see enough founders do this. I always included my bank statement with every investor package. It really builds trust.
- Having a trusted controller or later, CFO in place. A proven controller or CFO will be on the lookout for even a hint of impropriety. Way too many founders just hire an ops person instead these days.
- Audit. This barely helps, but you can see why it gets important for bigger funds once you are late stage.
- Knowing the founders already. Another reason investing in founders that have already made you money is attractive.
- Time. The more time you get to know founders, the more trust that is built.
- Not Having Too Many SAFEs, Notes and Debt. There is basically zero accountability when you raise with SAFEs, convertible notes, etc. A little is OK but too much and you have too much money on the cap table with zero protection — and zero advocates. As a rough rule, I don’t like to see more than 10% of the amount you’ve raised sitting in SAFEs and Notes, at least after the pre-seed stage.
- Syndicating a round. This only helps a bit, but it is one reason seed funds sometimes like to split a round among 2–3 funds.
Just remember there is a lot of trust involved in start-up investing. Once you see it through that lens, some things will make more sense.
Fintech company Frank (not ‘@fintechfrank’) founder Charlie Javice arrested for fraud in New Jersey over allegedly falsifying the number of users her app had prior to JPM buying it.
Think DOJ had a bit of fun with the ‘Forbes 30 under 30’ mention. pic.twitter.com/PWGCEIqduk
— Colin Wilhelm (@colinwilhelm) April 4, 2023
A related post here:
(note: an updated SaaStr Classic answer)