As the old saying goes, ‘the road to hell is paved with good intentions’. Angel investors can do far more harm than good by taking the wrong approach to post-funding relationships with the management team.
In this case, I am talking about early-stage investors and the sins that they sometimes commit when they decide to back a start-up company. I spend a lot of time engaged with such companies – and much of that time is spent working to set right things that were set in place when the first round of angel funding occurred. What follows is a partial list of ‘sins’ and a few suggestions that might both mitigate their impact and improve the investors’ prospects.
CEO Compensation: I regularly come across pre-revenue companies that are paying the CEO at levels that would only be prudent if the company was generating a run-rate in the twenty to thirty million ranges. As a result, lots of the investment capital is going out the door in the form of a fat monthly check. CEO compensation should reflect the condition of the company and the unavoidable fact that, in start-up situations, cash is a very rarest of commodities and needs to be conserved.
Top-Heavy Teams: I was recently asked to look at a company that had a senior team that was appropriate for a much larger company. There was lots of talent available but they were being underutilized. In this case, they had a fully competent director of human resources and an experienced vice president of finance. Both were high quality and very experienced people. However, what the company really needed was a first-class recruiter and a competent bookkeeper. The team has to match the needs and condition of the company.
Compensation Schemes: Quite often, I encounter companies that have base compensation schemes that are not conditional on performance. These schemes act as a disincentive and do not reflect the ‘risk profile’ of the company. A better way forward is to divide senior team base compensation into two categories – one for filling the role and a second that is calculated based on results. A good measure of the prudence of a compensation plan for a start-up is the percentage of investment capital that goes to senior team members no matter what the results are – the smaller this percentage is the better.
Technology Centric Focus: Many angel investors ‘fall in love’ with the technology and ignore the fact that the business of business is just as important as the business of the business. An unavoidable fact about any business is that implementation – not technology – is what makes the difference between success and failure. Certainly, the team needs a strong component of technologists. Implementers – those driven to turn technology into revenues and profits, dominate winning teams.
Hands-Off Oversight: Many investors seem to take the position that, once invested, the future of the company is up to the management team. Many of them actually sit on the board of the company. Two of the keys to start-up success are board oversight and ‘adult supervision’. Without it, the effort can descend into a simple roll of the dice. Investors – or better, their professional representatives on the board – should play an active and forceful role in determining the strategic direction of the company. One of the strengths of many angel investors is that they have had successful careers – experience in building and managing businesses – and that experience is invaluable to a new company and team.
Fanciful Projections: The two most insidious – nay, dangerous – pieces of software for start-ups are Power Point and Excel. Both promote shallow thinking. Start-ups are particularly vulnerable to the kind of loose thinking and untested assumptions that spreadsheets seem to cultivate. I often encounter start-up companies that are using incredibly convoluted financial models – companies that have yet to put two months of cash-flow positive results on the books. This kind of over-engineering distracts from the simple fact that the company has yet to become a going concern. Most often, these Rube Goldberg models result in a continual re-setting of expectations and little change in the culture, focus or profitability of the company.
Performance Reviews: In going concerns, the performance review is a key to evaluating management. The board uses the reviews to decide whether the company has the right CEO and senior team. It is rare that I encounter a start-up that has this process in place – and rarer still to find formal reviews as part of the corporate records. Every member of a start-up team should be performance reviewed by the board on a regular basis. Those reviews should be used to set compensation, renegotiate contracts and arrange for severance when necessary.
In the start-up world, only one in ten companies makes it to their fifth anniversary. My experience has been that most of those that fail do so because the team has performed poorly in the business of business – in other words, they do not fail because of their value proposition or the technology that is at the heart of that value proposition. They fail because they have not implemented the strategic and tactical plans in a way that generated revenue and an expanding customer base. Angel investors have it in their power to improve the odds for companies they invest in. However, to do so requires a more focused and professional approach.
© Dr. Earl R. Smith II