One of the big concerns about investing in a startup is the lack of liquidity, which means once you put in money, you’re pretty much locked in until a “liquidity event” occurs. Most angels want an outsize return on their investments, because this is a high-risk asset class, and you invest in it because you expect to get a high return in exchange for taking on that additional risk.
This is why one of the standard questions they ask a founder is – How will I get a return on my investment?
This is a perfectly logical question to ask because an investor is putting in his hard-earned money into an unproven model. However, I think it is a flawed question. It doesn’t make sense to use standard business logic in a field which is so full of uncertainty. Trying to define the metrics for predicting success in a startup is an exercise in futility.
Unfriendly Term Sheets Lead To Confrontations
We can’t foretell what’s going to happen, simply because there are so many multiple moving parts, and so much can go wrong – not just within the company itself, but also within the external environment. However, many term sheets force very unfriendly requirements down the founder’s throat.
Thus, some will have an exit clause which forces the entrepreneur to provide them with a guaranteed internal rate of return within a defined time frame. This offers the angels downside protection, and while I can understand that they want to protect their investment, I don’t think this is fair on the founder.
Trying to bully the entrepreneur is very short-sighted. The stress to return the investor’s money creates lots of problems, and can actually set up a confrontation between the founder and the angels, which is not good for the company.
While I’m always happy to earn a return on my investment, I know that the money I invest in startups has a much higher probability of giving me a zero return, because that’s the nature of the beast. This is why I allocate my assets accordingly. I don’t have unrealistic expectations from my founders, and I don’t put undue pressure on them.
Focus On Profitability, Not On Planning An Exit
We all know that it’s impossible to predict what the outcome of any given startup is going to be, no matter how smart the founder. However, the founder is forced to include exit scenarios in his pitch, even if he doesn’t have any faith in them, because he has been told that this is what investors are looking for, and he is smart enough to game the system and give them what they are looking for, in order to raise money.
I, as an angel investor, can afford to take a far more long-term outlook, because this is my personal money, and is extremely patient capital. I know that I can’t foretell the future, and neither can the founder, and I’m happy to hold his hand and stay with him for the ride, with the expectation that there will be some happy exits, but many will crash and burn.
Does this mean that I don’t care about what’s happening to my money and that I am happy to let the founder run the company to the ground? Of course not!
I am pragmatic, and I understand that the founder will need more money to grow once he runs through his seed funding. I expect to have to give him more as a bridge and to help him raise his next round, and am happy to participate in this, as well, if he is performing as a trusted partner.
This is why we want our founders to focus on profitability, rather than on planning an exit. Once he is operationally cash-flow positive, he will be able to survive on his own steam, because he’s earning money from his customers.
Even more importantly, he will find it much easier to attract the next round of investors with deeper pockets than mine, simply because he’s proven that he can run a business which serves a need for which customers are willing to pay.
In Conclusion
The question we ask our founders as regards his financials is simple – can the company become cash-flow positive with the money we’re giving him as angels? This is something which he can focus on and is within his control. If he does manage to do so, we won’t need to worry about exits!
If he does manage to do so, we won’t need to worry about exits!
This post by Dr. Aniruddha Malpani first appeared on LinkedIn and has been reproduced with permission.
