How to Avoid Taking “Dumb Money” in Your Startup 1

When to say "no" to investors.

You may think that when someone offers you money to fund your startup, you should find a way to take their money. But even more important than landing an investment offer is knowing when to say yes to investors and when to say, “Thanks, but no thanks.”

Just because someone has money doesn’t mean they have the knowledge to help you grow your business. And that’s what I mean by “dumb money”—I’m a firm believer that anyone who invests money in your business should also bring something other than money to the table.

You should think of choosing an investor the same way you consider choosing a business partner, because after you take their money, they become a partner in your business. And if you choose a partner based on money alone, you’re going to find yourself in trouble.

(It is possible to take money from investors who choose to be “silent partners”—but you’d better have that clearly agreed upon, as well as clearly outlined and documented in your operating agreement to avoid any conflicts later on as you grow your business. It’s not the standard.)

So how do you know when money’s dumb to take?

A Ten-Point Checklist

If you can answer “yes” to any of the following questions about the person or people giving you money as an investment in your startup company, you may be taking “dumb money”:

  1. Is this the investor’s first time investing in a startup company?
  2. Is this the investor’s first time investing in your industry?
  3. Is this the investor’s first time investing in a company that needs to raise multiple rounds of financing (if you are in fact doing so)?
  4. Is your target market new to the investor?
  5. Is the investor asking for a non-dilution clause (a stipulation that their equity shares never dilute) in your operating agreement? (No savvy investor will ever ask for this, nor will a savvy investor want to invest in your business if you have any investors who demand this clause. Every time an investment is made, everyone dilutes!)
  6. Is the investor asking for an equity stake that does not fairly correlate with the amount of money they are giving you? (For example: You’re raising $1.5M. You haven’t launched your product yet. An investor wants to invest $100,000 in exchange for 50 percent of your company. This is most likely not a fair and equitable exchange—regardless of what you might hear and see on the TV show Shark Tank.)
  7. Does the investor want to keep lawyers and CPAs out of the investment discussion? (Major red flag!)
  8. Is the investor’s lawyer new to the startup investment scene?
  9. Is the investor hesitant to share references from other companies they’ve funded, or references in general?
  10. Is the investor pressuring you to take the money by a certain date and not transparent with you about why?

This is not an exhaustive list of questions to consider during your due diligence process with a new investor, but these are all items you should be able to confidently answer “no” to before moving forward with taking the investment.

I hate to admit it, but I’ve been on the receiving end of  “dumb money” myself—in my first startup company, I took a significant amount of investment capital from an angel investor about whom I would have answered “yes” to questions 1, 2, 3, 4, 5, and 8.

Needless to say, that company failed. It didn’t fail because of that investor, but it did fail because we made a series of mistakes that, when combined, created a perfect storm.

It’s important to seek out investors who add immediate value to your company—and not just to your bank account. This helps create a healthy investment culture in your startup and sets the tone for how you’ll continue to grow the company.

How to Identify the “Smart Money”

Below are examples of what “smart money” brings to the table, and what you should seek out from potential investors:

  • Contacts to help you grow your business.
  • Specific skill-sets that are missing in your company (e.g., human resource management, computer programming skills, operations, financial management, leadership in high-growth environments, sales, new media skills, patent filing processes, etc.).
  • Challenging your ideas and assumptions in a productive manner.
  • Mentorship and coaching when needed.
  • Connections to other accredited investors.
  • Credibility based on their background.

If you have any “dumb money” horror stories, I’d love to hear about them.

About the Author Caroline is a two-time technology entrepreneur. She's co-founded and held the CEO position for two internet companies, OsoEco (social bookmarking/shopping site) and RealLead (mobile marketing for the real estate industry). Follow Caroline on Google+. Read more »

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  • http://callboxinc.com.au/ Bianca Farrow

    If you have a business and you want to expand, choosing the right investors will be great. But we must choose investors that will complement with the kind of services we offer and not just to have more money to earn.