Investing And The Art Of Stepping Back

While it is common for companies and their investors to talk about the value they create for each other to attract the best money and talent, often the art of investing involves the art of knowing when to step back.

Conventional wisdom in the venture capital world is to let the founders “do their thing”, from managing the company to raising funding. At the same time, investors tend to be eager about value they create along the journey. There isn’t a conflict between these ideas. The best of investors often tread on the thin line that separates involvement and interference with finesse. As an entrepreneur you will encounter an investors’ perspective very early in their investments (if you watch and listen carefully). As a lawyer, I see investors making their approach evident as early as during the time the investment is negotiated. It is still a thin line to negotiate, there are legitimate concerns that investors can and should have.

What should investors be concerned about?

When you are investing in a company, what you make out of it (and what you lose) affects you if you have not mitigated risks that are manageable. Having a clear understanding of how you liquidate your investments in the company and ensure that value is distributed back to you is an essential part of investing responsibly. Being able to participate first (or in priority) when the company raises money, is sold or liquidated helps ensure that founders or other shareholders whose financial exposure is different (or lesser) do not exclude you when the time comes to make merry. Having certain matters that require your consent at the board and shareholder meetings prevents abuse, such as dilution or alteration of rights attached to your shares, removal of board members or observers and increases the likelihood that you will take action to protect your interests. You may want to ensure that the company and founders are subject to sufficiently high levels of transparency, i.e. the obligation to periodically and on request – share information on the company’s financials and operations.

Stepping back as an investor

However, take it too far – every decision a company makes may in incremental or marginal ways impact the value of your investment. The decisions that the founders make in managing and running the business can over a period of time materially alter outcomes for an investor. This is where stepping back becomes important. The idea of investing in people who run startups, is that you do not substitute your judgement for theirs.

If you do this, you become more than an investor. You take on the responsibilities of a promoter or founder, and it takes away from your focus on investing rather than managing businesses. It makes you responsible to the founders and other shareholders for the company’s failure or success – responsibilities you are ill-equipped to handle. Your legal and moral authority to hold founders of a company accountable for respecting their commitments to the business and its shareholders arises from your capacity as an investor, a silent partner in the business. Excessive indulgence in running the company fritters away that moral  authority and makes you invested in more ways than you would like to be. More often than not, founders require extensive operational freedom to innovate and experiment in new ventures that can be constrained or regulated in ways that may be damaging to the business, which in turn would be damaging to the interests of the investor. Future investors and acquirers are meant to be on the scout for great teams and great existing investors, you cant be both at the same time.

The importance of protecting yourself

None of this takes away from the need to protect yourself where necessary. such as when the company faces situations that should require your involvement. What if one of the founders departs? What if circumstances have arisen where the founders cannot continue to operate or are unwilling to? What if the company is liable to its other investors or shareholders in ways that you are not protected? How do you ensure the value of your shareholding is protected if the company does exceptionally well? Also as your shareholding gets diluted by other shareholders, it becomes increasingly important to look out for yourself.

No one has figured it all out

The art of balancing each of these considerations is easier said than done and almost investors tend to each define their own. No matter what the differences may be, stepping back is most well understood and compromised in practice. Protecting yourself tends to take up more time than addressing genuine concerns that increase value, which in early investments often bear little connection to your investing goals.  No one has figured everything out, but we can make a start.

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.