Thursday September 4, 2014 0 comments
By Peter Adams
Rockies Venture Club
Sometimes going for the "smart money" is just plain dumb.
A company recently came to me looking for investors and they told me point blank that they would only accept "smart money" and if someone didn't totally understand their industry, they weren't interested.
The problem is that this was a highly complicated biotech company staffed with nothing but PhDs. They were all smart, but not so smart about money since there might have been three of four investors in the entire state who fit their description of smart money investors, and there was no way they would raise their round with their self-imposed limitation.
"Smart money" typically refers to investors who bring more than a check to the deal. These investors may have industry expertise, connections, advice and more. These investors may advise the company casually, or serve on the board of directors, or even as CEO or chairman of the company in a full-time or part-time active role. In many cases, the non-financial value that these investors bring is more important than their equity investment. Smart money is great to have -- when you can find it.
"Dumb money" is apparently the opposite of smart money. This is typically found in friends and family or other people who have money to invest, but no business or industry experience per se. Your doctor or dentist might fall into this group, for example. I recently heard a horror story of an investor who felt that -- because they had invested -- they had the right to physically come into the place of business and direct employees and make business decisions.
The result in this case was a toxic work environment, confused strategic direction, and a distraught entrepreneur who didn't know what to do. The investor was firing employees and making the lives of everyone else miserable. To make matters worse, this investor had pledged to make a bigger investment, but only wrote checks in dribbles when the company was at the breaking point - all the while holding on to the threat of withholding future investing if she didn't get her way.
Entrepreneurs should run from investors who ask probing questions during due diligence about their role in controlling the day-to-day decisions of the company.
Active vs. inactive money
The problem with the smart money/dumb money dichotomy is that there's more to it than smartness or dumbness. Rather than a pair of polar opposites, it's better to think of them in terms of quadrants.
The best is smart money that is active in helping the company. The worst is dumb money that is active in the company, thinking that it is helping but really is dragging it down. The other two quadrants are smart inactive money and dumb inactive money. These make up where most angel investors fall and are roughly equivalent in value to the company since -- in each case -- you get the check and nothing else (for better or worse).
Entrepreneurs who loudly proclaim that they will "only" take smart money are shooting themselves in the foot. Get all the smart money you can, but then be sure to make it clear that passive investors are welcome, too.
Some angel investors are intimidated about investing in a company if they feel there is an implicit pressure to contribute significant amounts of time to the company as well as their investment. Investors are often CEOs of their own companies and run busy schedules and want to be able to provide advice and mentoring on their own terms.
Smart entrepreneurs will work with a good securities attorney when raising funds. A full-funding documentation package will include an investors rights document that clearly outlines what investors are and are not entitled to. Information rights, for example, might include the rights to monthly, quarterly or annual financials (specifying whether they will be audited or unaudited), but probably not the right to call the CEO randomly to demand information, or to attend board meetings, unless otherwise specified.
This document helps the company control who is active and who is not - allowing them to work with the active smart money investors and excluding the active dumb money.
Choose your investors wisely
Due diligence should be a two-way street and entrepreneurs need to be looking for red flags, just as angel investors and VCs are. Raising funds typically involves selling a portion of your company to investors - an irrevocable transaction - so be careful and get the right documentation in place to protect everyone's interests.