There has been an explosion of seed/series A funds and micro VC in the tech ecosystem both in Silicon Valley and Europe. We wanted to highlight 5 (legal and barely legal) mistakes of early seed investors.
Over eager for 1 investment
You just closed your new fund and your pounding the pavement for deal flow. You have been in the cold for months searching for the right opportunity since the close and finally you find a” hot” startup. You want to invest, because it is hot. That makes sense, but don’t do it. You cannot objectively invest only because this is hot. If this is your first investment do extra homework and figure out how this investment is going to be 10 X investment. May we suggest that you want to be in between cold and hot aka medium in terms of excitement over the deal. You need to see enough risks in the deal to appreciate the massive reward. If you only see the reward in your first deal without the risks you are most likely to eager to invest.
Accepting high valuation
There is no reason to accept a high valuation. A lot of times founders are not able to justify the valuation they are requesting. A good way to probe the valuation issue is to look at the legal due diligence. For example, look at the legal due diligence from the product market fit, perspective monthly GMU, unit economics and defensibility of the product. A lot of times high churn and low net revenue starts with bad contracts. Sophisticated investors can sit down with their legal teams to translate the due diligence report into a valuation model of the company that works. In our opinion a good legal due diligence should translate into a good valuation model.
Lack of due diligence
Again, you have pressure to invest from your partners and the market. You want to close fast with a SAFE or convertible note and decide to skip any type of due diligence. Not sure how you got this through the investment committee but you pull the trigger. At minimum you should have a legal review to assess if the founders are on vesting, company has its IP and the company has been properly formed. Another crazy situation due diligence situation is signing a SAFE without realizing the company has a class A and class B structure that gives founder super control over the company. Did you think how to price this into your risk model? Ok you are a serial entrepreneur and have experience with early stage financing but are you a lawyer that understands the language in the documents that can make or break a deal. Having some experience from previous deals does not mean you are the lawyer.
Investing through SAFE, Convertible Notes and KISS
Although SAFEs, KISSs and convertible notes were intended to simply the life of the investors there are plenty of traps for novice and experienced investors. Imagine you have been provided with a SAFE, Convertible Note and KISS by the startup. You take it a face value and you sign without reviewing. You keep hearing that that similar SAFE was previously signed by Ashton Kutcher. You still need to review. There are many traps in convertible notes and it is not enough to skim the document for the valuation cap and discount. We have seen investors get super excited and sign uncapped notes without recognizing the danger. There are other things that smart investors check. For example, how the note converts and your position with respect to other investors. Another problematic issue with SAFEs is whether your pro rata is a super pro rata. Most first time investors over look this item. In the context of the SAFE did you ask for a side letter or maybe a board seat? High pressure tactics by founders and SAFE translates into dangerous territory for seed funds.
Another problematic area is leading rounds by inexperienced or cocky VCs. A lot of VCs believe that leading a round is only about money. You have a big check so what, but do you have the experience to sit on boards. Do you have the patience to deal with previous investors? To create a unicorn you need all hands-on board, which means that you need to understand how the board of directors works, in particular you need to fully understand the fiduciary duties. In other words pumping the valuation upward is not enough. There are smart legal ways to lead a round without having to deal with the corporate governance head aches and syndicate feuds.