#30- Most unfortunate - How lack of communication sours relationships (Part 1)
My experience of passing an early-stage deal that would have formed on the pillars of dishonest communication
This is part one of a three-part series on the misfortunes of lack of communication that I have experienced while evaluating early-stage deals.
Behind the scenes
As part of OKRs that I have created for myself, I want to issue at least one term sheet every quarter. And because I believe in front-ending the dirty work, I spend anywhere between 4-6 weeks engaging with a founder, and their business model - conducting product demos, reference check calls, customer calls, competitor reviews, mystery shopping, financial analysis, understanding projections and the thought process behind it, and also try to understand the founders and their lives - before I issue a term sheet.
Contrary to how some founders feel, conducting diligence is a difficult task for the investment team. I want to keep an open mind, learn new things, at the same time be objective, be cognizant of the principal-agent relationship with my investor, and be confident enough to be able to issue a term sheet.
And this also means that I am continuously on the lookout for signs - both good, and bad. Green flags and red flags. At the same time, considering most of the prospective growth, and future market positions will be binary in nature, I am also willing to take a leap of faith in the founders and their ability to deliver. While evaluating a company and the founders, I am equally (if not more) invested in the process as the founders are. For my success, lies in theirs!
I am a firm believer that early-stage investing is a people’s game and not a number’s game. There are hardly any numbers to evaluate in the first place. Early-stage investing is believing in the founding team’s vision and ability to execute.
What am I looking for during the course of the engagement?
Clarity, and steadiness of thought
A specific, unchanging ask
Transparent & honest communication
How does this help me in the evaluation process?
There is no science behind this. However, in an uncertain world of venture financing, having the certainty by way of the above does make me sleep better at night.
“Doubt is not a pleasant state of mind, but certainty is absurd.”
-Voltaire
I am cognizant of the fact that certainty in the face of glaring contradictions is foolish. However, logical and beneficial certainties should not be looked at as absurd.
The past three months have been a roller coaster in this regard.
Disqualification & Running Family Businesses
How dishonesty didn’t help seal the deal!
I recently evaluated a growing company working in the field of digitizing a key sector of interest for my firm. Long runway for growth, especially with a push towards digitization. One of the features of the product was to keep the pricing as variable as possible and incentivize their partners and themselves via transaction fees and add-ons. Nimble.
Disqualification
As part of my diligence, I like to look at audited financials and glance through Zauba to verify the signatories. Instead of the founders being directors of the company, their spouses were listed as directors. At first, I did not pay much attention to that. But there was a nagging thought that warranted a clarification on this - If the spouses are not a part of the business, they are neither independent nor fit to be decision-makers in a fast-growing startup!
Upon pressing the founders for a clarification, they wrote back saying it is not odd, just that they wanted the board to be fresh and rotated it every few years. So odd. But I let it pass. However the nagging thought did not subside, and when I took it up with the founders over a phone call, they said they’d been disqualified from holding director positions due to a couple of reasons mentioned here.
Big red flag. Maybe if they had provided this reason the first time I broached the subject, I would have let it slide. And that is still a BIG(!) maybe. But when they knowingly withheld information that was twice solicited from them, it was strike one.
How do you feel about this? Please share your views in a comment below!
Running Family Businesses
I have no problem with you (or Don Corleone) running a family business. But if you do, then venture money should be off the table. Case in point, the Head of Dept of the company turned out to be the spouse of founder #1, and consequently the Director of the company as stated above. Okay so good stuff - one of the directors is actually fit to make decisions regarding the company.
Looking at the names of the founder #1 and the Head of Dept, I put 1 and 1 together to conclude that they are married! Upon asking, they said yes. How 007 of me! But when asked why not disclose it, they replied by saying everyone is a professional, and they do not identify as family members while working. Sweet! This is healthy.
But what was unhealthy was that the Head of Dept was neither paid a market salary, nor did they have any ESOPs. “As long as it stays in the family!” was the justification. So much for being professionals! Soft strike two!
Enter founder #2. A senior citizen, nearing retirement age in a handful of years. I casually happened to ask about succession planning and future plans for the company - it is only fitting for the founder to work their ass off and flip it by the time they retire - rich! But I understood that the kid of that founder (currently not a part of the company in any capacity) would be eventually groomed to take over the reins! Hmmm… one big happy family indeed!
But do we even know if the kid is capable of taking over the ship in the middle of the journey? So should I also be speaking to the kid right now to evaluate fit five years in the future? Wait, is this is startup or a family business? Super confused! Alas, strike three! And how!
Would you have still evaluated the company further? Share your views!
Needless to say, I passed the opportunity. I can not entertain dishonesty, and unaligned interests however exciting the opportunity might be.
Maybe I could have handled the director disqualification piece if conveyed honestly the first time I asked. But I had to write more than two times, and then again ask them over a call to get to the truth. As an investor, this is the worst position to be in. Imagine getting to know this after you’ve put in the money. If a prospective founder withholds sensitive information about themselves, and the company’s representation - how am I, as an investor expected to trust and believe in them? For me, there is always another deal to evaluate.
So much for being a people’s business!
In part two of this series, I will touch upon another very exciting company that I had to pass - after issuing the term sheet (there goes my OKR)!!
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