Why You Don’t Want to Give Financial Information to All of Your Investors

By Mark Suster, We all know that funding markets have changed for startups. The trends are well understood: more angels, more seed funds, more crowdsourcing and so forth. We all can intuit the benefits to founders of these trends so there’s little reason to elaborate. What is less understood are the consequences of these changes.

I have blogged about some of the downside consequences of the changes and the private information I have says the consequences are much worse than is reported in the press since few people publicly talk about

1. How founders get screwed on convertible notes
2. How party rounds can burn you if it takes time to find your groove

There’s another issue I can add to your list of things to be aware of – information rights. Generally speaking in venture capital financings the legal documents will specify that only “major investors” (a threshold set in the agreement – which can be $500,000 investor or more). There is a reason for this. In a funding round with 1 or 2 VCs and 15-20 angels or 4-6 seed funds if you gave every investor you financial information and performance metrics your proprietary information would increase in its probability of leaking out.

But shouldn’t an investor who has given you $50,000 of his or her hard earned money be entitled to know how you’re doing? Yes. And no.

I am generally a fan for providing management updates periodically for all investors but in doing so you must assume that what you send out will get read by others and thus hold back on your most sensitive information. I’m not saying that VC behavior is always impeccably honorable but the truth is that there are so few VCs and the reputational costs of bad behavior are now so high that becoming known as somebody who leaks confidential information can have immediate negative consequences. So I recommend a high-level “state of the company” email a couple of times a year but a message that you assume might get shown to others. I’d keep your financial performance to your board members who are anyways directed by law to represent the interests of all shareholders. This is no different than a public company where of course most investors are not given detailed financial and performance information and when they are it is quarterly and after the fact.

There are now so many new early stage investors and many of these are new it’s not so obvious whom you can trust.

Let me give you a real world example from this week.

We led an investment round in a company a while ago in which we wrote a seven-figure check and have taken a board seat. We are doing what we do – writing larger checks and playing an active role at the company. Another investor – not one we’ve worked with before and not likely one we’ll work with again – wrote a $25,000. Simple enough – we like allowing small investors into rounds because they often bring additional relationships to a company that can be helpful.

By Mark Suster,  This investor decided to use the fact that they got into a company that appears to be doing well to their benefit to almost fraudulently persuade limited partner investors to give them money. Here’s what they did: They blasted the market with emails describing how they “co-lead” this deal with us (they did not) and how they are planning to lead the next round with a $10 million+ check (which apparently they don’t have). They asked LPs to rush to get into their next side-car fund to have access to this great deal plus the LPs also get the “benefit” of investing in their next fund.

If you don’t mind investing in dishonest people perhaps there is still room for you in their round?

I couldn’t believe my eyes since the entire thing was such a fabrication and felt like it was bordering on securities fraud. In the email (I have seen a copy) was all of the companies performance data, revenue data, financing plans and company PPT decks, which is surely a violation of the confidentiality clauses of our legal agreements. They have listed forward revenue figures that are highly questionable and bring the issue of SEC oversight to my mind.

Let me be clear about this. I have publicly said many times that there is a positive to crowd funding. But I have always warned of the consequences of not very well regulated situations in wish investors (and even entrepreneurs) produce information bordering on financial malfeasance.

Is this investor on AngelList? You betcha. Does he blog about venture capital and try to advise entrepreneurs? Yes. Speaks on CNBC. Attends 500startup events. Has written a book on venture capital. I’ve never heard of him until now. But it would be super easy for him to represent himself to LPs and to entrepreneurs as an upstanding individual.

I was just super fortunate that since it listed our name in the email solicitation that an investor reached out to me to ask us about it. I was furious and although I have no intent of talking about this investor publicly you can be sure we won’t be working with them, recommending them or endorsing them with LPs. You can be sure that if the SEC decided to investigate we would obliged to point out the fraudulent misrepresentations that were made and I would consider it a public service to do so.

But here’s the thing. We could have easily never found out about this. We called the CEO immediately to find out whether he had any knowledge – he did not. He informed the investor that this was a violation of confidentiality clauses and we now have our company counsel reviewing the situation.

My point is this: As the number of funds that enter the market has dramatically increased the norms and behaviors of our industries will be put to tests. I know the temptation is to trust every investor – large & small – who gave you money when you were an early-stage startup. The reality is that you cannot. Major investor clauses exist for a reason. Protect your financial information wisely.

The wolves operate. And not only on Wall Street.

Source

http://www.bothsidesofthetable.com/2014/11/09/why-you-dont-want-to-give-financial-information-to-all-of-your-investors/

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