Michael Gilman

Five Questions To Ask Your Investors Before You Take Their Money

Posted April 22nd, 2015 by Michael Gilman, in Biotech startup advice, From The Trenches


This blog was written by Mike Gilman, CEO of Padlock Therapeutics and Atlas EIR, as part of the “From the Trenches” feature of LifeSciVC.

Padlock Therapeutics is my second startup, and it’s not nearly as scary as the first one. Not because Padlock is any easier. In fact, it’s considerably more complicated – new biology, hypotheses in flux, multiple targets and therapeutic profiles to explore, a zillion potential disease indications in play and, of course, not enough time and capital to do it all. So why am I relatively unruffled about it?

One reason is exactly because it’s my second time around. I was frightened out of my wits through most of the Stromedix experience. I had no idea what I was doing most of the time. And I knew it. So much seemed to be at stake. The consequences of failure – my failure – would be millions of dollars in capital squandered, jobs of people I admired and cared for lost, a drug patients needed consigned to the scrap heap (again).

On the other hand, I would tell you now that it’s not actually that complicated. There are some details to know, of course, but like most things in life navigating the startup world relies on pretty basic principles – common sense, transparency, and an unstinting search for truth, no matter how unpleasant it might turn out to be. Moreover, despite what your investors might tell you, it’s not actually a matter of life and death. Drug discovery, as you all know, is a sea of failure – no one with an IQ above room temperature should be surprised by failure here.

But let me get to the point – finally. Another reason I’m relatively calm about the whole thing is precisely because I made a pile of mistakes the first time around and I know what they were. I’m pretty sure I won’t make them a second time (though no doubt I’ll make new ones). In the spirit of sparing any of you first-time entrepreneurs at least a tiny morsel of misery, I’d like to share one of my learnings here today:

Do as much diligence on your investors as they do on you.

If you are a first-timer, you can bet that any investors considering giving you their money will talk to everyone you’ve ever known. Not just your last boss or the names you’ve given them (totally representative, right?), but they will dig and dig and dig until they find that one person you pissed off fifteen years ago. If they can find your kindergarten teacher or your high school bridge partner, they’ll go there too. Hey, who can blame them? They’re gonna write you a check for millions of dollars.

But you should do just as much digging. Venture capital comes with costs, heavy costs. Yes, you’re giving up ownership in your company – that’s unavoidable, I’m afraid. The strategies for minimizing that cost are honestly not that interesting to me, so I’ll let one of my other In The Trenches colleagues write that post. I am here to today to talk about the psychological cost of venture capital and how to understand what other baggage you’re taking on board along with the cash.

So let’s get started. Here are five questions that you should ask potential investors before agreeing to take their money. I should say that the first two are basically venture capital 101, so you pros can step outside for a smoke. Meet me back here in a few.

  1. How old is your fund? Typical venture capital funds have a ten-year term (though they can and often do extend them a few years if needed). By the end of that period, VCs want to be out, out, out, having returned capital to their limited partners and, hopefully, themselves. Consequently, the usual duty cycle for a venture fund is three or four years of investing in new companies (called the “Investment Period”), three or four years of babysitting their investments, and three or four years of getting the hell out. Why is this important? Well, if the fund is late in its Investment Period, you are likely to be under significant pressure to produce a quick exit, even a crappy one. If there are large mismatches in where your different investors are in their fund cycles, board dynamics can degenerate quickly. You may have some investors who are happy to put in more capital, whereas others may have little or no capital to give and face ugly financial consequences if they don’t participate in the round. No surprise that these folks will suggest any other alternative, including a bake sale, to avoid having to do another financing. Bottom line, you are best off by far with a minty-fresh fund like the one announced by my friends here at Atlas just last week. As investors, they will be enthusiastic and patient – and grateful that they’re not out raising money themselves.
  1. How much capital are you reserving? Face it, you will need way more capital than you are collecting in the first round, no matter what you think today. So make sure that sufficient capital is around the table. Good funds know this and will formally set aside (reserve) capital for future rounds of financing. Make sure they’ve reserved a goodly amount for you, on the order of two to three times the initial commitment. If you’ve got three or four investors with this kind of cash stashed away with your name on it, you are going to be in pretty good shape. One caveat: You won’t have any good way to verify this number. Which brings me to the next point.
  1. Can you provide me with references? They’ve certainly asked you for references. You should do the same. And, like they will do with your references, toss them in the trash and do your own research. Actually, it’s fine to talk to the folks they suggest, but just know that these will be the ones with whom everything is hunky dory. It’s dead easy to be a reasonable, relaxed, and generous board member when everything’s going great. What you want to know is how these folks act under stress, when everything is going to hell. Because this will happen to you at some point, and you want to know if they’re going to be in the foxhole with you or miles away lobbing artillery shells in your direction while sipping Bordeaux. So don’t just talk to their “successful” CEOs; track down the people they fired, shut down, or recapitalized. These are perfectly acceptable, even responsible, actions for an investor to take, but how they behaved in these situations – toward the management team, founders, and other investors – is your best window on your own future. A couple of other questions I’d ask. How hands-on are they? I’ve had investors I rarely saw between board meetings and others who were on the phone every week. How available are they when you need them? Nothing is more frustrating than an investor going dark when you’ve got a critical and time-sensitive decision to make. In short: Dig, dig, dig.
  1. How are decisions made in your partnership? This is the polite version of the question. The more direct one is: Are you a decider? VC partnerships are like marriages. Some are strong and healthy, whereas others are fractious and unstable. Some are paragons of equality, while in others the power dynamics can be downright bizarre. You need to figure this out for each of your potential investors. A few partnerships are completely flat, with each partner having an equal say in investment decisions. The good ones operate by consensus, which works if the partners have a truly strong marriage – shared assumptions, common interests, open conversations, honesty and loyalty. Investors from high-functioning partnerships like this are as good as their word – if they agree to something in a board meeting, you know it will stick. Other partnerships are “pseudo-flat” – all partners may well be equal, but any single partner has a veto right. If the partners do not see eye to eye or are squabbling for other reasons, your investment decision can get caught up in a domestic dispute and you can get a nasty surprise. Still other partnerships are tiered, sometimes deeply so – only a subset of the partners, perhaps only one, is the real decider. That’s great if this is the guy on your board. But if your board member is not a decider, be prepared for multiple trips to the mother ship to sing for your supper. That’s a pain for all kinds of reasons, which I’m sure are obvious to the reader. But the real problem is when your non-decider board member is faced with a choice between keeping his partners happy or advocating for a bunch of slobs toiling away on a project that is doomed to fail anyhow. Which way do you think he’ll go? In general, it is good to understand where your particular investor sits in the firm’s pecking order and what their investment track record has been. If, for example, this is your investor’s first solo flight, you can assume he will be nervous, needy, and very conservative – the outcome he is desperate to avoid is the zero.
  1. Tell me about your network. OK, so strictly speaking this is not a question; please forgive me. Anyhow, most VCs are exceedingly well connected and that’s a big part of their value to you as an entrepreneur. They can often direct you to a consultant, advisor, or a fellow portfolio company when you’ve got a specific problem to solve. A good investor has seen lots of crazy stuff over the years and can be an excellent source of both business and technical advice. On the other hand, they can get lazy and rely too heavily on a small cadre of external advisors that they’ve worked with for many years. These people can become a shadow board – another group you have to explain yourself to over and over again. When it comes time to partner or engage in an M&A process, your investor’s relationships with the heads of R&D or corporate development, in some cases even the CEOs, of potential pharma partners can be priceless. They can provide high-level introductions to these companies so that you don’t have to fight your way up the corporate food chain while the best years of your life slip away. And they can often broker a solution to a contentious issue in a negotiation. A VC with a great network is an awesome asset.

Bonus questions for corporate investors

Purely financial venture funds are trying to do just one thing: make money for their investors and themselves. You may not like that, but it’s not complicated to understand and the sooner you internalize that simple idea, the smoother your dealings with them will be.

Corporate venture funds, on the other hand, are odd ducks. Each one’s a bit different. Some are purely financial and structured much like standard venture funds; their metric for success is return on capital. Others are “strategic,” which can mean a thousand different things. Moreover, unlike conventional venture funds, where the partners have invested their own cash and are in it for the duration (usually), the investors in corporate venture groups are company employees who can rotate in and out of these jobs with alarming frequency. And when there’s a change in top management at these companies, corporate venture funds can change tack drastically or sometimes disappear altogether. We’ve got two corporate investors in the Padlock syndicate and I am very happy with them, but I would also say that, unlike our financial investors whose motivations are crystalline to me, I am still trying to figure out what our corporate investors really want from their investment in Padlock.

So, with that little intro out of the way, here are a couple of questions to ask a potential corporate venture investor.

  1. Where do you report in the organization? The answer to this question is, in my opinion, much more informative than asking them about their strategy. If they report to the CFO, chances are they are largely financial investors. If they report to the head of R&D, they are usually vehicles for the R&D organization to get a view into areas of science that it is too timid to spend its own budget dollars on. Some venture groups report into the corporate development group; whether it’s a formal metric or not, these groups are more likely to be looking for deals.
  1. How are you compensated? It probably takes some stones to ask this question directly, but, again, the answer is extremely informative when it comes to predicting the behavior of a corporate investor. If they are compensated like a financial VC, meaning that they get a piece of any capital returned in a transaction, you can bet that they will act pretty much exactly like a financial VC. If they are compensated like any other drone in the big pharma company – lavish salary, bonus, annual share awards – it’s a bit harder to deconvolute their incentives. You should ask them about their metrics – how is their bonus determined each year?

Well, if I’ve accomplished nothing else with this little screed, I am sure that I have effectively pissed off all of my investors, past, present and probably future too. But, honestly, I respect and admire all of them (well, most of them), even if they’ve aggravated me from time to time. They have a hard job to do – I am completely confident that I could not do it. They are much more personally accountable for their own successes and failures than most of us. And they have many, many balls in the air at any one time – you should forgive them if they occasionally drop one. Moreover, venture investors perform an invaluable function in our ecosystem. They allocate capital, ensure that it is effectively deployed, and ultimately work to get the crazy projects we undertake and the kick-ass drugs we are trying to develop to the finish line. When that happens, everyone wins – their investors, our shareholders and partners, and of course patients who need new medicines.

Meanwhile, if you’re an entrepreneur, I hope you ask some of these questions the next time you’re raising capital. And if you’ve got others to add, please avail yourself of the space below!

Michael Gilman

Michael Gilman

CEO of Obsidian Therapeutics and Atlas Advisor, Ex-CEO of both Padlock and Stromedix
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