What Stops Lateral Capital from Investing?

 In

With only a small staff and a significant number of investments, we have to make quick decisions on investing in new companies. Since our investment levels don’t support much in the way of paid consultants, we have to rely on experience and the hard work of other Angels across the country – and our own advisors. So we are always open to a reason to say “no”; to put our pencils down and move on. Here are some of our show stoppers, greatly informed by the work of John O. Huston of Ohio Tech Angels.

  • Overall
  • The idea is “new to the world” and not an improvement on existing products or services. We don’t have the money to invest in big, all new categories which require huge marketing investments. Rather, we want to get behind products and services which are so obviously superior to what’s out there that customers “buy” right away.
  • The entrepreneur is only partly committed. We run from CEOs who are part-time, part-enthusiastic or part-hearted. Early Stage companies are for people who are crazy about being successful; who are in it for more than the money.
  • When the idea is “borrowed” from someone else, particularly a previous employer, who is likely to be “not so happy” about someone running off with “their” idea. Defending lawsuits is not a good use of equity capital.
  • The entrepreneur tells us even one small untruth – no matter how modest or inconsequential. Rather, we look for every contact with the company to build trust; not erode it.
  • Founder / CEO / Management Team Issues
  • The company expects Lateral to sign an NDA. We don’t sign NDAs. As stated at the bottom of every Lateral Capital e-mail, we specifically do not promise to keep anything given or shown to us as confidential. Simple reason: we see material from so many new companies, many of which are very similar, that we can’t promise to keep track of who said what to whom.
  • The principals will not authorize a personal background check. This is standard these days and it rarely turns up anything significant. But it is simply good practice.
  • The company won’t grant Lateral Capital observation rights if we ask for them. We don’t serve on Boards of Directors, but we want to know that the company is having them, when, and what is discussed. Key point for us: that every Board agenda includes a discussion of the plan to sell the company.
  • The entrepreneur has no “skin in the game”,e., their investment is non-cash or conversion of a previous loan. This is particularly worrisome when the entrepreneur expects a salary from the company, but it signals that the leader really wants to be an employee, not an owner.
  • The CEO lacks the “Passion, Presence and Conviction” to present well to other funding sources. If the CEO can’t sell the idea behind the company, but still expects to be CEO, something is awry.
  • The Founder is in love with the idea of being CEO – this instead of doing what’s best for the company. What we don’t want is a CEO who would not allow their company’s fortunes to be optimized under someone else’s leadership. Often, finding a new CEO turns out to be what’s best for all shareholders – especially the founder!
  • The Founder/CEO feels that receiving $10MM net proceeds is not enough. This kind of return from the sale of the company (i.e., from their share) in five years should be seen as a lucrative exit for the entrepreneurs we get behind. We can’t wait for a greedy CEO to drag out the sale process and $10MM or more is a great payday in anyone’s book.
  • There is an un-coachable Founder/CEO; one who really isn’t open to the thoughts, guidance and challenges provided by people like us. We don’t expect the CEO to always agree with our input, but we do expect to be taken seriously. We want to see them step back, internalize our comments, do the appropriate homework and then respond. Our experience: CEOs who won’t listen to investors are unlikely to listen to their own customers.
  • Capital Issues
  • The company has an unwieldy Cap Table and/or complex shareholder issues. Key examples would include investors who are not accredited, many family members owning a significant position in the company or early investors that have too many preferences for return of capital ahead of new investors.
  • Complicated contractual features from previous or senior investors, including liquidation preferences, put or call rights. Similarly, a structure with no lock-ups for key employees or co-sale requirements on the sale of the company is usually troublesome.
  • Unacceptable legal structures. For example, Sub S corps can’t have LLCs as shareholders. We prefer C Corps and Preferred Stock.
  • The company is already surviving “on fumes”. If the current burn rate has less than three month’s runway left, the company may be a victim of poor planning or slow fiscal decision-making. John O. Huston’s Rule:
Job One of the Board is to be sure that the company never, ever runs out of cash.
  • When any shareholder has a “fixed and floating ownership percentage or other kind of “forever” arrangement. People who have the expectation that this will be honored by future investors are just not realistic. It will not.
  • An unrealistic pre-money valuation for the capital being raised, so a later down-round is inevitable; particularly if that next investor is a VC/PE fund who knows very well what the real market is.
  • Unrealistic valuation expectations in general. If the company expects pre-money valuations for a pre-revenue company above $2MM ($5MM if they have revenue), then the company is usually not a good candidate for investors as small as Lateral Capital. We go as high as $10MM for businesses with huge global potential and good data in hand, like our investments in human organ replacement, curing Alzheimer’s disease and “manufactured” rare earth magnets. But entrepreneurs need to remember that 90+% of Early Stage companies sell for less than $40MM. If Lateral Capital targets to deliver industry Average returns of 2.6X, investing in going in valuations above $10MM is daunting. It says that the company would have to be at the top of the curve, with a sale price of at least $26MM. Even this ignores the fact that 50-70% of Early Stage companies fail to return their capital – losses which have to be factored in to the average return.
  • The CEO/Founder is unwilling to create a significant option pool to motivate current employees and recruit future employees. Greed kills.
  • The company is using a fundraising agent which drains immediate cash from the financing. We like CEOs who raise their own capital. It’s the best way for a CEO to really learn whether the business resonates with strangers.
  • The expectation that “new money” will be used to pay off old obligations, particularly debt extended by friends, family, employees or the entrepreneur. New equity money never pays off old debt or equity investors.
  • Issues Around the Exit
  • Too much capital is needed to get “From Here to Liquidity.” Generally (and not always), if more than $10MM is required, small investors like Lateral Capital will be diluted out … by investors we have yet to meet and who probably won’t care much about us.
  • Pre-existing agreements which could complicate or depress the exit. For example, a strategic investor has a Right of First Refusal, a Founder has veto power regarding the exit, etc.
  • Family members on the payroll. This typically dampens the enthusiasm for a sale of the company as strategic buyers won’t employ relatives in close connection. Oh, and blood is thicker than money.
  • Unsettling body language from the CEO and team when “Exit” or “Liquidity Event” is mentioned. For example, unwillingness to accept redemption triggers from the investor; a feature which protects the investor if the venture starts turning into a “Build To Keep” or “Lifestyle” company.
  • Miscellaneous Issues
  • Pending litigation. Product warranty or product return problems of any kind make us nervous.
  • Markets that are too small. We have made this mistake more than once, even in markets we liked because we thought they were “protectable niches.” Generally, if 100% market share is less than $100MM of annual revenues, the market is too small for Lateral Capital to invest in.
  • When the Founder/Inventor refuses to contribute their IP to the company outright, we walk. This is another version of an entrepreneur who is not “all in.”
  • Insufficient time remaining until patents expire. Generally, this means less than 10 years.
  • Strategies that are unlikely to ever bring the company to net profitability, for whatever reason. This is usually because the business model has some significant shortcoming. Or worse, the company is a research lab (“We’re almost there – just a little more work”) for an entrepreneur who is a testaholoic.
  • The current investors/founders already have the capital needed to fund the company, but are still seeking outside capital. Often, this is a sign that they are simply “shopping” the deal so as to set a valuation for themselves; wasting our time in the process. Worse, these are often founders who are not as convinced about the company’s prospects as they would be if they were using other people’s money! Our question is usually this: “If this is such a great idea, why don’t you put in more of your own money?”
  • The entrepreneur has a reputation for being litigious, or worse, a PITA. One of the first things we do with a company is to check out the Founder/CEO; to check their reputation in the market. When the people who have worked with the CEO before have nothing enthusiastic to say, we get an instant picture of what it would be like to invest behind him or her.
  • The co-investors are inexperienced or lack significant “dry powder”,e., other investors who have not “experienced” Early Stage losses, or invested in follow-on rounds – some of which may be down rounds. These people often turn out to be prisoners of their own regret.

 

Source: This material is informed by similar lists from several Early Stage investors, but we are particularly indebted to John O. Huston, who provided the backbone of this list.

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