A commercial banker friend of mine likes to say, “All money is green.” That may be true of commercial banks, but it is not the case with private capital investors.
Taking on an outside investor, whether a venture capital fund, growth equity investor, private equity sponsor, strategic investor, or family office, is far more than a capital infusion. It is a relationship, for better or worse.
There are many exceptional private investors who provide capital, experience, discipline, and relationships that can help a founder grow a business or stage a multi-phase exit. But private investors differ considerably in their access to capital, financial sophistication, temperament, and ethics.
Choose your investors as carefully as they choose you.
Private Capital Is Human Capital
Investment agreements establish important legal and financial terms. But legal documents can only do so much to protect a company from an investor who is predatory, perpetually adversarial, dishonest, or endlessly looking for an angle.
Once an investor owns a meaningful stake, holds veto rights, or occupies a board seat, removing that investor may be difficult or impossible without a sale, recapitalization, or contentious negotiation. Depending on the documents, the investor may also be able to block a financing, acquisition, executive hire, or eventual sale of the company.
That makes reverse due diligence important. Just as an investor investigates a company’s finances, management, operations, and risks, the company should investigate the investor’s resources, reputation, decision-making process, prior conduct, and, perhaps most importantly, character.
Certain behaviors deserve particular attention.
- Seeking Control Disproportionate to the Investment
Minority investors reasonably seek protections against actions that could fundamentally impair their investment. Approval rights over a sale of the company, senior securities, extraordinary debt, amendments to governing documents, or related-party transactions may be entirely appropriate.
The warning sign is something different: an investor making a relatively modest investment but demanding influence over ordinary business decisions.
Approval rights over routine hiring, vendor contracts, pricing, ordinary capital expenditures, or even board agendas can indicate more than aggressive lawyering. They may reveal an investor who views a minority investment as an opportunity to exercise de facto control without paying for it.
The risk is control creep. A founder may discover after closing that decisions previously made in a day now require negotiation with an investor whose economic stake is small but whose ambition is expansive.
Watch how the investor responds when reasonable boundaries are proposed. An investor who insists upon extraordinary control but cannot articulate a legitimate investment concern may be telling you something about how it intends to use that control later.
- An Inflated Valuation
A high headline valuation can be seductive. It flatters the founder and board of directors. It can also obscure what the investor is attempting to do.
Liquidation preferences, participation rights, cumulative dividends, redemption rights, anti-dilution provisions, and other preferred terms can dramatically alter economic outcomes. A nominally higher valuation may produce a worse result for existing owners than a lower valuation with cleaner terms.
More importantly, consider whether the structure appears designed to create an attractive headline while quietly shifting the economics elsewhere. The risk is not merely unfavorable economics. It is cynical dealing: an investor willing to exploit complexity because it believes the other side does not fully understand what it is agreeing to.
An inflated valuation may also be a prelude to the next concern.
- Re-Trading the Deal
Late changes can be legitimate. Diligence may uncover an undisclosed liability, deteriorating performance, or another fact that genuinely changes the investment. But sometimes an investor re-trades the deal as a calculated strategy.
After months of negotiation, the investor knows the company has spent money, lost time, perhaps stopped talking to other investors, and may be running short of cash. The closer the company gets to the edge, the greater the investor’s leverage becomes.
The is risk is manufactured leverage. Conduct during negotiations can also predict conduct after closing. An investor willing to exploit temporary vulnerability before it owns part of the company may employ the same tactic during a future financing, covenant waiver, management dispute, or sale process.
Maintain alternatives as long as reasonably possible. Keep exclusivity periods narrow. Most importantly, distinguish a legitimate response to new information from opportunistic re-trading.
- Resisting Questions About Its Own History
Investors expect extraordinary transparency from founders. Founders should expect reasonable transparency in return. A reputable investor should ordinarily be willing to facilitate conversations with executives from current and former portfolio companies, including companies that encountered difficulties. Carefully curated references are useful, but incomplete.
Pay attention when an investor discourages independent inquiries, restricts references to a single hand-picked success story, becomes defensive about prior disputes, or portrays every failed relationship as the product of an incompetent, dishonest, or unreasonable founder.
The risk is a pattern of externalizing blame. If every former founder was the problem, there is a very real possibility that the common denominator was the investor.
- Being Evasive About the Source of Funds
A signed term sheet does not necessarily mean the investor has the money or authority to close.
Understand where the capital will come from, what approvals remain outstanding, and who actually controls the decision. A fund may require investment committee approval. A family office may depend upon a principal who has barely participated. An independent sponsor may need to raise the money after signing the term sheet. None of these structures is inherently problematic. But the investor should be transparent about the availability of funds and its authority to proceed.
Shifting explanations about approval authority, unidentified decision-makers appearing late in the process, reluctance to discuss funding sources, or repeated claims that previously settled matters must be reconsidered by someone else can indicate that the investor has overstated its authority or funding capacity.
The risk is an investor that cannot close. It may tie up the company without having the ability to fund the transaction, leaving the business with less cash, fewer alternatives, and a weakened negotiating position.
- Using New Governance Documents to Create Hidden Leverage
A new investor will often require amendments to the company’s organizational and governance documents. That is normal. What deserves scrutiny is a suite of interconnected documents containing unusual triggers, disproportionate remedies, or provisions that operate differently together than they appear to operate individually.
The investor and its counsel will understand how those documents interact. The company and its counsel need to understand them equally well.
The risk is hidden leverage. A seemingly innocuous provision in one document may trigger a redemption right, veto, board right, dilution adjustment, default, or other consequence elsewhere. Governance documents should be reviewed as an integrated system, not as isolated agreements.
- Conflicts That Are Dismissed Rather Than Managed
An investor’s portfolio can create real conflicts. It may own or later invest in a competitor, customer, supplier, or potential acquirer. Those relationships can implicate confidential information, pricing, customer data, strategic plans, corporate opportunities, and the investor’s incentives during an eventual sale.
Conflicts themselves are not necessarily warning signs. Sophisticated investors encounter them regularly and can often manage them through confidentiality restrictions, information barriers, board-observer arrangements, or limitations on access to competitively sensitive information.
The warning sign is an investor who dismisses the issue as unimportant or treats reasonable safeguards as an insult.
The risk is that once sensitive information has been disclosed, contractual remedies may be a poor substitute for preventing misuse in the first place. This is especially true in an era of artificial intelligence and data scraping.
- Promising Strategic Value Without a Verified Track Record
Many investors offer more than capital: customer introductions, recruiting assistance, industry expertise, future financing relationships, acquisition opportunities, or help positioning the company for sale.
Those promises should be examined just like the investor’s financial capacity. If strategic value is part of the investment thesis, ask for examples. Speak with executives of prior portfolio companies. Determine what the investor contributed when a business encountered difficulties, not merely when everything went according to plan.
An unusually high valuation can deserve additional scrutiny in this context. An investor without an established operating or investment track record may simply be paying more because capital is the only thing it has to offer.
The risk is relying on promised expertise or connections that never materialize.
- Failing Reverse Due Diligence
Ask to speak with founders and executives from prior investments. Independently investigate the investor, its principals, and, by all means the investor’s litigation and regulatory history. Allegations are not facts, But sometimes court records can reveal an investor’s playbook and their aggressive conduct toward other founders and business partners.
The Documents Still Matter
Good documents cannot make an unethical investor ethical. They can, however, limit the room for mischief.
Board rights, veto rights, information rights, financing provisions, liquidation preferences, anti-dilution protections, transfer restrictions, drag-along rights, redemption provisions, confidentiality obligations, and exit rights should be considered together rather than negotiated as isolated provisions.
But documents are the second line of defense. Judgment is the first.
To paraphrase an old expression, trust your instincts, but verify. When you see warning signs, do not dismiss them simply because the investor has capital or because everyone wants the deal to close. Conduct reverse due diligence. Ask uncomfortable questions. Understand who you are inviting into your business and life.
And communicate serious concerns to corporate counsel before the documents are signed. A lawyer who understands the concern can often structure governance provisions to mitigate a particular risk. A lawyer who does not know what is worrying the client can only negotiate the provisions on the page.
Doug McCullough is a partner at McCullough Huddleston and Woo, advising middle-market business owners, corporate executives, and private investors on domestic and cross-border mergers, tax structuring, and corporate governance.
Next in this Practical Judgment series: Warning Signs When Considering a Business Partner