I got an email the other day that I've excerpted a bit of as follows---
My business partner and I are in the process of setting up a company and looking for money. We have been offered 2 million dollars from (X) but he is looking for a very, very substantial return and I think we can do better.
We have a patented process to manufacture (Y) products different than they are currently being manufactured. Our process has many advantages and we believe will take off once introduced to the market. We are in the process of having a machine manufactured so we can make samples to show potential investors. We believe that our business plan is attainable and the numbers are on the conservative side. We also have several potential customers waiting for the samples.
Here's what's interesting about this. I called the person who sent this to me. The product is pretty credible and will address the home construction market. But the deal that they were considering was not very good.
They were going to sign up to performance penalties that potentially would cost them the company if they missed their projections by six months or so.
This is a product that ought to produce nice growth, but inevitably growth takes longer to achieve than plans call for, especially out three years, and especially when beginning with only an idea (albeit a pretty good one).
So why would an investor offer a couple of million dollars? An industry insider would know the value of the product in the market and the distribution required to make it go. Perhaps the long term prospects are excellent. (Perhaps the "offer" was only meant to be so egregious as to suggest that any sane entrepreneur should walk away.) In any event, the entrepreneur was going to put herself in a corner from which there is little escape. If things don't go perfectly in this case, the investor owns everything.
The nightmare scenario is one in which the product performs, but not as well as projected, and the investor takes over and forces the entrepreneur out. A year later, the thing is a growth story.
What's a better idea? A partnership with someone on the distribution side might be a better answer, as well as a prototype developed on friends and family money - or on a good deal with that partner. Yes, a deal like that will have a buy-sell, but constructed properly, everyone can win.
This probably isn't an angel deal because the returns will be good but not in the range of returns angels look for. Also, I told him, this may be a very nice company for a long time, and forcing a sale may not be in the best interests of the company.
How do you avoid these situations?
1. Know what is being proposed. This seems obvious. It's not. Understand what the mechanics are for warrants, common vs. participating preferred stock, convertible debt, and all of the terms investors are talking about to you. Of course, consult experts - but make sure you understand what is being proposed - not what their interpretation is.
2. Have a low burn rate. Easier if you are younger, I suppose. But the ability to require very little cash as you develop your venture pays huge dividends in flexibility and opening up choices.
3. Don't think that all equity investors want the same "harvest" event. People who invest other people's money invariably want it back on a schedule, and therefore invest in deals with a sale of the company as a goal. But, there are investors who may be happy with a piece of the action for a long time (as long as there is a way to trigger a buy-sell in the future) especially if they may have another strategic interest in the deal, such as a distribution partner.
4. Beware of individual investors who do not have to worry about their public reputation as investors, as VCs or angel networks do. They can make this kind of predatory offer with little regard for who may know about it.
5. Ask yourself what value the investor can add - beyond the money.