How To Spot a Bad Fundraising Deal — Part 1
This post is going to be the first of many parts of a series. I have spent the last couple of days connecting with friends in the African startup ecosystem, mostly asking for permission to share the experiences alongside mine. We all must share, so others don’t repeat mistakes. Ecosystems thrive on many things; information and lessons are a crucial part of that thriving. Startups are hard (This applies to both VCs and Startup founders, I am sure we’ve all read about founders from hell and the unpleasant things some founders in the startup ecosystem do). My series of posts will focus on bad deals from a founders’ perspective. i.e., Term sheets from hell and how to spot them from the get-go. Most of these red flags will focus on pre-seed and seed-stage rounds. By the time you get to series-A onward, it’s pure science, and everyone knows what they are buying. By the time you are raising your series-A, your startup has traction, which would inform your fundraising. I have only been on one side of the table; The building side. I hope to transition to the investing side someday. The red flags mentioned in this series are some of the things you should look out for. If you spot any of them, run!!! These flags are in no particular order, and no VC firm or angel is mentioned.
This clause is from hell crafted by Hades himself!!!. The conversation begins with: “We are investing $50,000 in your company at XYZ valuation. You will receive this funding in three tranches, $10,000, $15,000, and $15,000. Each tranche will be tied to a milestone.”. Whenever you see a deal that has this thing, run. The first problem with this clause is that the investor is investing $10,000 in your company at your current valuation (Forget the other tranches first, they are likely audio money). The rest will come in when you hit certain milestones. By the time you hit those milestones, the company is at a higher valuation, but that investor will be able to put that next tranche of $15,000 in at the initial valuation. This applies to the next/last tranche of $15,000. Let’s say you took the initial $10,000 at $500,000 post-money valuation; you may end up taking the next $15,000 at a time when you’ve done 5x in revenue, and your startup is now worth $2.5m but would invest at the initial $500k. The second problem with this is that most investors who play this card do it because the complete fund is not available, and they need to tie down your valuation while looking for the money. If they never get that money (Which is usually the case even if you meet the milestone), you probably would have signed away more of your company for less. This would affect your next raise. It’s a very long and cumbersome process, and you will spend the energy you are supposed to invest in scaling, trying to restructure your cap table.
The third problem is that if you are raising this round from multiple investors, it’s certainly unfair to the other investors. It puts you in a bad place as a founder, and everyone in that deal, including you and your co-founder, will suffer the consequences. I know some people will argue that we are in a low-trust environment. My take is that there are many ways to hedge for trust and if you don’t trust a company enough to execute, don’t write them a cheque.
- AVC wrote about this here — -> https://avc.com/2009/08/milestone-based-investing/
- Seedcamp wrote about it here — -> https://seedcamp.com/resources/investment-are-you-in-danger-of-raising-a-toxic-investment-round/
A simple Google search can also lead you to other resources online.
2. TOO MUCH CONTROL.
A seed or pre-seed investment should not have some excess control clauses. It puts the startup in a terrible position and places founders in a cage. This goes ahead to affect everyone with a stake in the company including other investors. Imagine a pre-seed round of $40,000 at XYZ valuation with a request for two board seats; that right there is a red flag. There’s more; the right to vet and approve your subsequent investors, the power to determine the founder’s salary and that of people you hire, the right to bring in another investor without your approval, etc. Sometimes, the deals come with a request to hire/install key hires like CFO, COO, etc. This has never ended well for any startup I know. Have you ever wondered why YC and 500Startups invest >$100,000 in startups with publicly available term sheets and don’t request board seats? The answer you are looking for is in YC’s success rate and the failure rates of startups funded by god-forsaken control freaks. A friend took a deal that installed three people on his board; The investor, the investor’s friend, and the investor’s brother. The problem started when they achieved product-market fit, and the investors pushed to take over the company. The company is dead today. Board sit arguments are not what your headaches should be when you have not even achieved PMF.
3. TOO MUCH SECRECY
Another seed-stage red flag is secrecy. Usually, these deals come with some heavy NDA that restricts you from sharing the term sheet details with ANYONE. You are prohibited from communicating with other investors. These are terms you’d probably find in later stage rounds. If this seed round term sheet is suitable for the company, why can’t you share it with people you trust and get some advice and insights from other experienced founders outside my lawyers? Why can’t other existing investors see it? Again, there’s a reason YC’s SAFE and 500Startups’ KISS documents are public. These documents have simplified fundraising beyond Silicon Valley, where they originated, and have been applied worldwide. They work for both sides of the table. Any pre-seed deal that comes with an NDA is likely a setup in the making.
That’s it for this part. I will be dropping more in the next part. I am still sourcing from other founders who have been down this road and comparing notes. The whole point of this is that some founders walked so others can fly. The future of Africa’s startup ecosystem depends on successful outcomes, and repeated mistakes take away the chances of creating such success stories.