At its most basic level, the business of investing is about managing risk. In order to reflect the risk in the terms of a deal, most investors know the basics risks to look at (e.g. market, management, operational risks, etc.) and engage in intensive due diligence processes to discover what the extent of those risks are.
One source of risk that is rarely considered in the investment process, however, is sometimes readily discoverable if investors simply look in the mirror.
Fred Destin at Atlas Ventures has put together an interesting post on the topic of investors behaving badly after the money goes in, but an investor can also unintentionally notch up the risk BEFORE investing a single cent.
I once had the opportunity to see this happen first hand. Briefly, the company had an exceptional management team, proven technology, good track record, full order book and a slew of potential customers in their pipeline. A large round of financing was needed to scale the company rapidly to seize a market opportunity that would have given any first mover a significant sustainable competitive advantage. In other words, the company had to move quickly and needed the financing to do it. After much negotiation and due diligence, we were ready to close with the material issues having been reasonably addressed in the terms of the deal…
…then some of us decided that even bigger belts might look good with our already hefty suspenders.
Initially, this was not necessarily a bad thing. But as weeks turned into months, the value-add of the negotiation process began to decline exponentially. As some insisted on debating what colour costumes the angels dancing on the pin should be wearing, the company’s window of opportunity was shrinking. The absurdity of the situation was brought home when a particularly combative member of the investor syndicate suggested now not doing the deal because company management had failed to achieve their projections for that year – projections that had been based on the assumption that the financing would have been in place several months earlier on the initial expected closing date (in fact the performance numbers showed the management were still making remarkable progress despite funding capital expenditures from a relative dribble of internally generated cash).
Although the deal eventually closed, and on terms that made some sense, the business plan ended up being riskier than it had been at the start of the process. It had nothing to do with the entrepreneurs involved, however, and everything to do with some investors trying just a little too hard to justify their existence.