How does an investor protect himself when investing in a startup?

Q: How does an investor protect himself 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.

Founders can:

  • 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 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.

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.

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.
  • Founders should send over the bank statement each month. This protects them as well. I don’t see enough founders do this. I included my bank statement with every investor package.
  • 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.
  • Audit. This barely helps, but you can see why it gets important for bigger funds.
  • 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.
  • 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.

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Published on February 21, 2020

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