The Right Criteria for the Right Investor

For an established company, the process of raising capital is usually a straightforward exercise in corporate finance. For a startup, however, every round of venture financing is fraught with dramatic decisions and symbolism.

When a startup is struggling, or merely unproven, survival itself is at stake. In the early days at Guidewire*, my co-founders and I quickly realized that beggars can’t be choosers and that any capital meant keeping the dream alive. Trying to persuade investors was just another front of grueling effort against the tide.

Since the early 2000s era when Guidewire raised its pre-IPO rounds, an enormous influx of capital into venture has afforded founders more options. These days, any startup with strong traction will attract multiple investors clamoring for engagement. For founders exasperated by the unending cycles of selling and recruiting, being courted by VCs can be a welcome reprieve – an opportunity to be flattered and sold to, for a change!

But in that flattery lurks the possibility of a grievous mistake: choosing the wrong investor.

“Wrong” is a strong word. I choose it intentionally to describe a decision that undermines what the founder cares about most: for his or her young company to thrive, for it to compound in value and to succeed in its mission. The wrong investor can doom this quest almost as surely as a flawed strategy or team. So, to maximize what matters most, the founder must strive to see through the flattery and quiet the craving for personal validation.

The mistake can start with what seems like a rational plan: “Run a tight auction and take the highest bid from a name-brand firm.” The main point of having investors is to secure capital, so why not take the least dilutive dollars on offer?

This reasoning overlooks a criterion that matters incomparably more than investor brand, breadth of portfolio services, star power of the investing partner – or, yes, valuation.

What Matters is Deep Alignment

I call this critical factor “deep alignment”—a state of mutual confidence that, with regard to a startup’s identity, both founder and investor share (a) the same beliefs; and (b) a compatible reasoning process in the face of unknowns or adverse events.

That identity can be divided into six distinct categories:

1. Market diagnosis: a precise account of the end market — its personas, pains, requirements, behaviors, incumbents and segments — including a lucid thesis for why the opportunity exists at all.

2. Strategy: the plan of attack — rigorously informed by the market diagnosis — including a non-promotional definition of the core product and its boundaries; the business model, differentiation, distribution and the logical sequence of waypoints to be pursued.

3. Time horizon and capital plan: how long, in years, it will take to fulfill the strategy, with high resolution for the next twelve months and the hurdle for the next round of funding; and the depth and duration of the founders’ commitment to build the company.

 4. Operating principles: an expression of the “financial harness” in which the company will operate; the unit and company-level economics to be achieved over time; and the processes by which the team will define the plan and take corrective action if results fall short.

 5. Talent management: where the company will source talent; how to balance tenure and external achievement; the principles for compensation and performance management; and how the founders themselves expect to be evaluated.

6. Culture: all the important qualitative attributes that define the company. Among them: values and what the company is prepared to sacrifice to uphold them; how the team communicates and conduct meetings (including whether they start and end punctually!); how the company celebrates and spends on discretionary items; and the latitude people have to work remotely, flexibly, etc.

Here, it is important to distinguish between mere “alignment” and what I am calling “deep alignment.” You are “aligned” with investors if you use the same language and generalities when talking about your company. It’s an impressionistic — and ultimately vacuous — sense that everyone involved are “good guys.”

Deep alignment demands more. It only develops if you and your investor have discussed each of the identity topics in detail and emerged confident that you fundamentally agree and will be able to disagree constructively. Basic comprehension is the foundation of this confidence, so I urge founders to write down — in plain language — their market diagnosis, the premises of their strategy, and their company’s identity. Then the deep and vulnerable conversations can follow that engage the obstacles, downside scenarios and unknowns.

All of this can feel uncomfortable, since every founder instinctively wants to put on the bravest face rather than give voice to doubt or vulnerably share the setbacks. It can also feel taxing, as it takes precious time and effort to explore areas of possible dissent.

But this I promise: whatever energy is expended in this effort is trivial compared to the stakes.

Misalignment Kills

Let’s consider those stakes in two senses.

First, the terrible downside of misalignment. If business keeps going great, no problem! But when deep challenges inevitably arise, it can be a multi-year torment to work with investors who have divergent beliefs about the market, who target time horizons much longer or shorter than the founder or who hold sharply different expectations of the trade-offs between growth and profitability.

The friction here can go well beyond intellectual debate. Just consider the scope of a board’s power. It has approval authority over all management decisions that matter: the operating plan and budget, executive compensation, the recruitment of senior leaders, M&A, financing and just about any action that touches the cap table. An oppositional relationship with investors can render it impossible to execute these fundamental decisions.

And even if matters don’t escalate to full adversity, being in continual tension with your own “side” while trying to win in the market exacts a profound toll on the founders’ energy and motivation. Notably, big valuations awarded in advance of traction risk big disappointment, heightening the risk of this kind of dissonance.

Contemplating such downsides, some founders try to negotiate for greater corporate control: special share classes, reserved board seats and other provisions that can allow them to drive their will over potential dissent. Investors loathe these structures, but some high-flying companies can achieve them during boom times. My view is that such arrangements are about as helpful to a productive partnership as aggressive one-sided pre-nuptial agreements are for harmonious marriages.

Now, no sane investor gets involved with a company intending to go to battle with its management team, but also no one gets married intending to get divorced. And yet, it happens all too often! Why? For a thousand specific reasons but only one universal one: a failure to agree on the deep principles that define identity and partnership.

In the funding process I see founders too often fretting over funding details rather than testing these principles carefully and counterfactually. It’s a serious misallocation of effort.

The Upside for Getting It Right

Given such downsides, do I advocate that founders find the most pliable investors they can? Well, as a former founder I do believe investors should embrace the principle of “first, do no harm.” But a thoughtful founder should aspire to a much higher standard.

Deep alignment with your investors is far more than the avoidance of conflict. Indeed, along with strategic precision, it is one of the superpowers of a young, insurgent company. It enlists allies in the epic “us-against-the-world” struggle that is every startup’s habitus, empowering a young company to fight its battles with greater confidence. It unlocks the energies of veteran advisors to frame critical questions and to share broader vision. It is the critical antecedent of resilient trust when challenges inevitably arise. And it mitigates a fraction of the terrible loneliness and exhaustion of the company building journey.

To belabor the metaphor, deep alignment with investors is as consequential for the success of a young company as marital harmony is for personal happiness. It is neither necessary nor sufficient for success in itself, but it eliminates one terrible downside and boosts the upside almost as much as having the right founding team. As with any critical decision, making the right decision here requires starting with the right criteria.

“Battery Ventures is an American technology-focused investment firm. Founded in 1983, the firm makes venture-capital and private-equity investments in markets across the globe from offices in Boston, Silicon Valley, San Francisco, Israel and London.”

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