Landing investors can be a major component of a company's growth strategy. But the truth is that many entrepreneurs don't really understand what's involved in bringing on investment capital. Consequently, they make mistakes–plenty of them. We’ve compiled a list of the most common mistakes entrepreneurs make when it comes to bringing on investors. Want to make the most of the partnership with your investor? Avoid these 11 mistakes.
1. Overvaluing your company
“Entrepreneurs often don’t understand valuation,” says Carol Roth, a Chicago-based business strategist and author of The Entrepreneur Equation, who helps companies raise money. Entrepreneurs understandably want to value their business at as high a price as possible. While that might sound good in the short term, it might cause long-term problems. “Setting unrealistic valuations can increase the amount of time it takes for you to raise capital, prevent you from raising money altogether and also create credibility issues for you as an entrepreneur,” says Roth. “Even if you can find a fool to invest at your crazy valuation proposal, beware; you may have to raise capital again in the future and having a silly upfront valuation can impede your ability to raise capital in the future.”
2. Not understanding dilution
Every time a company raises money, it updates what is calls its “capitalization table,” which summarizes the shareholders in the company. The rub is that each time new investors come aboard, the existing shareholders will typically have their equity percentage reduced or diluted. That includes any equity held by the founders. “Be careful to watch the ‘Cap-Table’ and understand dilution,” says Jason L. Sullivan, who raised $1.5 million for his company, GuardianLion, a Tampa Bay, Fla.-based manufacturer of wristwatch-mounted child locator and panic buttons. “Otherwise, entrepreneurs could quickly find out too late that they have lost control of their company.”
3. Not doing your homework
Eager to jumpstart their growth, entrepreneurs often jump at the first investor to show interest in them. Choosing an investor simply for their money is a mistake, says Glenn Phillips, an angel investor and founder of Forte, a software company in Birmingham, Ala. “Do some homework and learn your options,” he says. “Good investors will open doors, mentor and help you grow your company without micromanaging or taking over the company.”
4. Underestimating the loss of control
Many entrepreneurs fail to understand that when they bring on investors, they are bringing on new partners who expect to have a voice in how the company is run. In other words, they make the mistake of thinking that they don’t have anyone beside themselves to answer to when it comes to running the company, says Jonathan Tang, who raised $30 million for his company, Salesnet, which he sold in 2006. “When you take on capital, you have investors to answer to, a board of directors to answer to and that baby that you started is really no longer yours,” he says.
5. Not raising enough capital
However much you think you need when you take on an investor, it's typically more, says Phillips. “Don't raise money and be immediately underfunded,” he says. “Startups and growth is full of costly surprises, so take what you think you need and multiply it by 2.5 and you might have enough.” (Get more tips on raising capital.)
6. Assuming investors are your friends
While it behooves you to do your due diligence in finding the best investors for your business, don’t mistake that relationship for a personal one. “Investors ultimately have a responsibility to generate a return so they will do what's in the best interest of maximizing return on investment, whether it's to replace the founding CEO or selling the company early,” says Nathan Beckford, whose San Francisco-based firm, VentureArchetypes, helps connect companies with investors. “I've known many entrepreneurs who were very chummy with their VCs, up until the day they were suddenly and unexpectedly replaced.”
7. Not bringing on multiple investors
Whenever possible, entrepreneurs should try to get multiple investors rather than just one, says Tang, who has started a new company called Vastrm Fashion, which will sell men’s apparel. “In my first startup, we only took capital from a single firm,” he says. “That meant that in subsequent rounds of financing, we needed to go out and secure additional firms to co-invest, which was a major distraction in running the business.”
8. Getting cheap advice
While many entrepreneurs are frugal, it’s a mistake to not invest in getting experienced legal counsel and advice when you bring on investors, says Phillips. “If you go cheap on the advice, you'll pay for it later,” he says.
9. Neglecting an exit strategy
Unlike taking a loan from a bank where your obligation is to pay interest, taking money from an investor brings an obligation to seek an “exit” for the company, such as through an acquisition or an initial public offering. In other words, when a company takes on investors, it changes how the company must be run, says Beckford. “The company now must take larger, swing-for-the-fences risks,” he says.
10. Bringing on amateurs
The seeds of many companies are planted by money invested by friends and family members. The mistake entrepreneurs make in taking this money, though, is not understanding some of the strings—from unasked for advice to requests to hire relatives—that come with it. “These people, based on their lack of business sophistication, can take up a lot of your time at best and at worst, will make crazy demands on you and the business,” says Roth, adding that entrepreneurs should never, ever, take money from friends or family members who can’t afford to lose their entire investment. “You don’t want to be sitting across your mother at a holiday dinner knowing that you just lost her retirement savings,” Roth says.
11. Waiting to begin the search
As with most things in life, timing is everything. The mistake entrepreneurs make is waiting until they have to have the investment to survive or land their next customer, says Bill Watson, whose company, Advanced Business Group in Nashville, Tenn., helps buy, sell and value businesses.
(Get more advice on managing money.)