Why Picking the Right Investor Matters More Than you Think

sign "Mind the Step"
November 15, 2022
Written by
Terkel Douglas

Selecting an investor for your company is often a long-term commitment as a founder. While it is tempting to go with the first and best offer, this is an incredibly important decision to make and one that should not be rushed or taken lightly.

Good investors can be a massive boon to your growth journey, adding capital, knowledge, sparring partners and strong networks to your company, while wrong investors can suck out time and energy and be detrimental to growing your company

Here are some key points you should consider when picking your next investor because the right investor matters more than you think.

Find value-adding investors

Many venture funds speak about active ownership and “hands-on” when talking to startups. In reality, few funds can be great additions to a company’s growth journey, while many quickly end up as passive investors adding little value apart from capital.

Separating the two can be a challenge for startup founders, but it is important to do your own due diligence on potential investors in order to establish whether the investor is a good fit for you and your company.

Get references on the fund

Try to get references on the fund, particularly the partner assigned to your case, from the fund’s portfolio companies. Ask for concrete examples of how the fund helped the company and also how they handled difficult conversations, “run-dry” situations and other challenges. Has the fund team been supportive? Have they rolled up their sleeves and worked with the team?

Check if the team has the capacity to be “active owners”

A good way of assessing this is by looking at the number of startups in the fund’s portfolio and comparing that to the number of employees in the fund. Funds with very large numbers of portfolio companies typically struggle with dedicating enough resources to each, whereas smaller funds with more dedicated portfolios simply have more hours of the week to give to you and your team.

Map out how the fund adds value

Are they a generalist fund that will only attend board meetings, or do they have specialist competencies needed to take your company forward? Do they have strong networks that can open doors to customers, new investors, or new markets?

These are all important questions that should be answered before deciding on which investors to go with for your funding round. At Scale Capital, we strongly recommend founders pick active investors with complementary skill sets.

Ensure that the investor adds more than just capital.

The highest valuation = the best offer?

When negotiating with investors, most founders encounter numerous terms and clauses in addition to the valuation offered. In many instances, these matter as much, if not more, than the valuation put on the company. It is completely understandable for founders to push for the highest possible valuation of their company. High valuation both limits the dilution of large capital raises, generates a lot of press and makes your personal shares worth a lot on paper.

Check the liquidation preferences

However, there are downsides to going with the highest possible valuation, especially with certain terms and conditions. A common issue for startup founders is high liquidation (2-3x) preferences paired with high valuations; in such a scenario, investors will receive a large share of an exit before founders and warrant holders receive any proceeds. In some instances, such as the $465M PaddyPower acquisition of Fanduel, founders received no financial returns because of the liquidation preferences.

Investigate if there is room for a valuation uplift

A good question to ask yourself as a startup founder is whether there is still significant room for a valuation uplift from this round. If you are currently raising a round at a $40m valuation, is it realistic that the exit is $400M? If not, and you are offered a term sheet with a high liquidation preference, it may have large consequences for how much you as a founder get from an exit.

Watch out for future down-round

Another key risk with too high valuations, especially in these uncertain economic times, is a future down-round. Industry multiples have shifted considerably over the last year, and some companies are facing having to raise at a lower valuation than their last post-money valuation. Down-rounds represent a number of issues. Not only will you dilute more and upset existing investors, but you also risk a significant negative reaction from your employees if they have exercised options at a higher strike price, putting them in the red on their incentive scheme.

In short, the right investor is not necessarily just the one offering the highest valuation. Look for fair terms and conditions, focus on your total dilution instead of the valuation alone, and ensure that your valuation is sustainable in the future – and always remember to ensure that the investor adds more than just capital.

In a nutshell

Entering the growth phase and choosing an investor to support your business is an important step and should be carefully looked into. To make the best decision in this phase, make sure to:

  1. Do your homework on the fund because they do theirs on you.
  2. Look for fair terms that will not negatively affect you down the road.

And even if sometimes it feels like you don’t want to waste time and just would like to go with the first best offer, slowing down to check if it is indeed an offer that would benefit your company best would be a much more sustainable and future-beneficial approach.

Read also
How to Get a Seat on a Board: Advice from an Entrepreneur and Investor

Terkel Douglas
Terkel believes in start-ups' potential to make a positive impact through technology. With a finance background, he was drawn to venture capital to support passionate founders. Today, as an Investment Associate at Scale Capital, Terkel focuses on sourcing and scaling prominent early-stage B2B tech companies.
Scale Capital
Scale Capital is a Danish venture fund from 2012 investing in Nordic B2B tech startups at Seed/Series A and helping them win in the US.