Angel/VC Deal Killers That Shouldn't be Deal Killers
Far too often, angel investors and venture capitalists pass on some of the best deals available. Sometimes, the decision is reasonable at the time. Maybe the valuation is too high, the founding team does not appear coachable, or the investor has seen similar startups fail. However, certain things that instantly turn off investors can actually be advantages for the company. I would like to discuss nine of these such items — aspects of startups that cause investors to decline an investment when, in many cases, they shouldn’t.
The company does not fit neatly into its market. Disruptive companies do not fit neatly into their markets precisely because they are disruptive! You can’t expect to find a blockbuster disruptor that doesn’t do things fundamentally differently than incumbent competitors. Many investors look for companies that provide a “better” version of the same product, but the resulting investments tend to be in companies providing iterative improvements, rather than the 10x or 100x improvements that drive rapid adoption, delight customers, and make the risk of investing in startups worth it. For example, Airbnb took a completely different approach to hospitality than incumbent competitors. Investors looking for the next huge hospitality opportunity may have been looking for a better version of a hotel that fits nicely into the current hospitality market. Instead, they should have been looking for a creative solution like Airbnb that had the potential to expand the market, provide 10x or 100x improvements to customers and other stakeholders, and/or solve critical unsolved problems for customers and other stakeholders (Airbnb did all three). The bottom line is that disruptors that create 10x or 100x improvements over incumbent competitors tend to yield 10x to 100x returns, ceteris paribus. So, as an angel or venture capitalist you want to look for disruptors and be mindful that these companies will not fit neatly into their market.
The company does not have intellectual property (IP). I will not dispute that in many verticals, such as biotechnology, companies are bought almost entirely for their IP. Having protection of intellectual property locked down is critical to the success of startups in verticals such as these. However, holding comprehensive IP is expensive and in many verticals, such as software, it does little to prevent the replication of the technology by competitors. In some cases, all that filing intellectual property does is provide competitors with a cheat sheet on how to replicate the filing company’s technology or processes. Despite these conditions being in play for a company, expensive IP is often still pursued solely because investors expect startups to have IP. Investors that impose these requirements on startups only serve to hurt themselves. Who wants their investment dollars going towards a large expense that poses little (or even negative) benefit to their portfolio company? As uncomfortable as it may make some investors, first mover advantage can be the main thing putting their portfolio company ahead of others seeking to replicate its technology or process. Filing for IP can actually diminish this advantage in many cases. Startup founders that recognize this may say to investors that they do not plan on filing for expensive IP; it would be a waste of investment dollars. Some investors simply cannot get past what I call the “checklist mentality,” in which intellectual property is a box that needs to be checked for the investor to commit to an investment, regardless of how important it truly is for the company’s success. These investors miss out on companies with founders savvy enough to discern whether filing for expensive IP would be a beneficial move for the company.
Another issue pertaining to intellectual property relates to whether the technology or process the company uses is proprietary. Many valuable companies have been built using non-proprietary technology, so prospective investments that fit into this category should not be written off for this reason alone. However, it is paramount as an investor to understand the importance of the company’s intellectual property to its favorability as an acquisition target. Many licensing agreements have written into their contracts that the license will be terminated and/or renegotiated if the licensee is acquired. This could deter acquisitions or in the very least put friction on any acquisition deal. While these terms should not necessarily be deal breakers, it is something investors should look at closely before deploying any investment dollars into the company (especially if IP is critical to a startup’s acquisition potential).
The company provides a significant social/environmental benefit, comparable to a non-profit. This should not be a deal killer. In fact, social ventures and stakeholder-focused companies tend to have stickier customer bases, more support from communities and governments, reduced ESG risk, more committed founders, less regulatory risk, more competitive job applicants, and a host of other benefits. Early evidence shows that companies scoring high in ESG outperform peers, with 81% of a globally representative selection of sustainable indexes outperforming their parent benchmarks in 2020. To further this point, nearly three quarters of respondents to Private Equity International’s 2021 Global Private Equity Divestment Study said that they expected to capture an “ESG premium” in businesses they are considering exiting. Unfortunately, many investors have trouble differentiating between social ventures and non-profits, believing that if they want to create social/environmental benefits, they should stick to NGOs and other philanthropic mediums. However, not only do social ventures often have enhanced profitability and valuation (due to the many benefits listed above), but they tend to be much more scalable than NGOs. Social ventures actually provide a way to generate real economic value while also rapidly solving social/environmental/economic problems in a highly scalable manner. So, whether one is simply looking for higher returns or truly wants to put their money to work solving the world’s most pressing problems, social ventures and stakeholder-focused companies are a good early-stage investment opportunity.
The company aspires to become a B-Corp. Becoming a B-Corp is simply a certification that has no effect on the company’s legal structure. Therefore, contrary to some myths in early-stage investing, becoming a B-Corp does not negatively affect the attractiveness of a company as a potential acquisition or complicate the investment process. In fact, B-Corps (being certified stakeholder-focused companies) tend to command a valuation premium, given the numerous benefits to achieving B-Corp Certification and to the underlying actions taken by the company to achieve the certification. These benefits include favorable consumer preference, happier & more productive employees, higher customer & employee retention rates, improved long-term relationships with communities, support & networking within the B-Corp community, and many others. The only word of caution I would offer is that if a prospective startup investment is considering B-Corp Certification, ensure that the company is responsibly spending towards this goal. If a startup has considered this goal since its inception, the costs of doing so can be minimal, but the bigger an organization gets, the more costly it can be to make all of the necessary changes to qualify a company as a B-Corp. Ensure that your prospective portfolio company plans to start taking action towards certification early and is spending responsibly to reach this goal, rather than aiming for certification at all costs and/or planning on waiting until the firm is bigger to start making changes.
Benefit Corporations (not to be confused with B-Corps) are another topic worth discussing here. While B-Corp Certification is simply a certification with no changes to the legal structure of the company, becoming a Benefit Corporation does affect the company’s legal structure. Companies with strong stakeholder-based cultures and values might seek to become Benefit Corporations to solidify the company’s mission and values into its legal structure, preserving these aspects of the company long after the founders have left. Benefit Corporations are traditional corporations with modified obligations committing them to higher standards of purpose, accountability, and transparency. These modifications include a clause protecting the company’s executives in the event that they make a decision that benefits a stakeholder (customer, employee, environment, community, supplier, etc.), but does not (at least immediately) benefit shareholders. While hypothetically, this clause would protect the executives of the company in such a conflict, there is no legal precedent to back this up. In most regions, becoming a Benefit Corporation also means being required to produce and publish annual reports (using a third party standard) on the company’s social and environmental impact. All of this said, becoming a Benefit Corporation does not negatively affect a company’s attractiveness as a potential acquisition or complicate the investment process. Similarly to B-Corps and social ventures, Benefit Corporations tend to enjoy valuation premiums and many of the other benefits that come with embodying a stakeholder-based approach. More often than not, companies that want to become a B-Corp also want to become a Benefit Corporation and vice versa.
The company is unlikely to exit in 10 years. This applies more so for angel investors than VCs, because most VCs must exit their positions at the end of their fund life (10-12 years max). Some companies have business models that will grow more slowly, but will nonetheless yield excellent returns once an acquisition or IPO takes place. This is particularly true in the energy sector or in other industries that focus on making infrastructural changes. Open-ended fund structures, which are characterized by having an indefinite fund life, are increasingly being employed by VC and private equity firms to cater to these industries. While like many items on this list, it ultimately comes down to investor preference, tolerance for risk, and many other factors, the typical 10-year timeline should no longer be considered an absolute deadline to achieve an exit. Just make sure that the reason the company has a longer time horizon is consistent with its industry and/or that its growth strategy is sound. Slow growth due to incompetence is not a good reason to accept a longer expected timeline to exit.
The entrepreneur does not have an exit strategy. Entrepreneurs are often written off by early-stage investors (particularly angel investors) if they do have an exit strategy already in place at the pre-seed or seed stages. This is because many investors do not like to see entrepreneurs already thinking about how they are going to exit when they are still in the early stages of building the company. Most early-stage exits are either unfavorable or do not compensate early-stage investors for the risk they took in making the investment. One of the worst outcomes is investing in a company that could have had a huge exit if they had not taken the first acquisition offer they received. Many investors assume that entrepreneurs with a clear exit plan are likely to do this, because they appear eager to exit their companies. In contrast, there are also investors that want the entrepreneur to have a plan for how exactly they are going to make the investor their returns, even if it is 5-10 years down the road. This is also a reasonable concern. As an entrepreneur, the question of what the exit plan is has no good answer. So, when considering startup investments, try not to put too much weight on how the entrepreneur answers this question.
The investor does not have industry expertise in the company’s space. This of course depends on the investor’s appetite for risk and preferences, but the myth that one needs years of industry experience to identify good investments in a space simply isn’t true anymore. Now that we have access to a world of information through the internet, and loads of data through platforms like PitchBook and Crunchbase, one can learn enough to make a well-informed investment decision in a short period of time. Generalist investors often enjoy learning about various different verticals across their careers, and over time they develop informed opinions in those various verticals that can be equally as useful as those generated from working in an industry for many years. Generalist investors are also less likely to miss out on big opportunities, because they are open to any startup with disruptive potential. As a generalist investor, frequently consulting with industry experts is an excellent strategy for validating prospective investments and building your industry-specific knowledge, especially if you do not have much prior investment experience.
The company focuses on a market outside the United States or is based outside of the United States. Most investors would pay anything to have been able to invest in the past decade or two’s startup successes. Emerging markets are in many cases, a way to do just that, as these markets mature and adopt technologies common in more developed countries. Often, entrepreneurs with better insights into these emerging markets are more successful at serving consumer needs in those countries than big corporations that are already established in the United States. This is because big corporations tend to take fewer risks, move more slowly, and sometimes make the mistake of copy/pasting their business model into new countries without validating if the model needs to be modified to better cater to the new market. Emerging markets also have much more growth potential than established markets do. Companies that can creatively uplift emerging markets can harness this growth potential. Just like generalist investors, investors that do not close themselves off from non-US markets and companies based outside the US have less of a chance of missing out on big opportunities. Sweden, for example, produced several notable unicorns in the last decade or two, including Mojang (Minecraft), Spotify, Skype, and King Digital (Candy Crush). One risk that investors should care about when investing outside the United States is the integrity of the government from which the startup originates. Countries (such as China in recent years) that are known to seize control of companies as soon as they become valuable are rigged to lose investors money, with few exceptions. Countries with significant social or political instability also prove to be difficult environments for startups to thrive in. Lastly, in the case of companies where intellectual property is crucial to the company’s success, be sure to scrutinize where the IP is filed and whether that country has a robust enough IP system to truly protect the underlying technology or process.
The founder does not have technical expertise or prior experience working in their industry. There is almost always a need for technical expertise on the team, but this expertise does not necessarily have to come from the founders. Non-technical founders and founders with no prior industry experience often have the “beginner’s mindset” advantage in that they see the market or industry from a different perspective than many technical founders with industry experience might. These different perspectives have led to many successful disruptions that never could have been achieved by someone who had been conditioned to think the same way as the rest of the industry does, or by someone who could be bogged down by the current state of technology in the industry. As Albert Einstein once said, “we cannot solve our problems with the same thinking we used to create them.”
With all of this said, there are reasons why many investors have these items as deal killers in the first place. The key is not to use a checklist mentality, writing off companies that do not check certain boxes. Use critical thinking instead: “Does this founder have the ‘beginner’s mindset’ advantage? Does this company really need to spend money on intellectual property?” Typical angel and VC investors’ pipelines contain thousands of startups per year, so it is easy to fall into the trap of using heuristics to get to the no’s faster. However, because each startup’s circumstances warrant different strategies in a number of areas, these generalizations may sometimes lead the investor to make the wrong conclusion about a prospective investment. Investors that take the extra time to understand a founder’s strategy and vision have a far lower chance of missing out on the best opportunities.
Excellent considerations backed up by examples and clear rationale.