It’s a common mistake to think that getting money from investors is the same as taking dumb money. But it’s actually not, and here are some tips on how to avoid taking dumb money in your startup.
Dumb money is a term that describes the investments that are made by investors who don’t understand how startups work. As an entrepreneur, you want to avoid taking dumb money from investors who don’t know what they’re doing.
You may believe that if someone gives you money to help finance your company, you should accept it. Knowing when to say yes to investors and when to say “Thanks, but no thanks” is even more essential than receiving an investment offer.
Just because someone has money doesn’t guarantee they’ll be able to assist you in growing your company. And that’s what I mean when I say “stupid money”: I think that anybody who invests money in your company should also contribute something else to the table.
See also: The 10 Investor Questions I Didn’t Expect To Be Asked
You should choose an investor in the same manner you would a business partner, because once you accept their money, they become a partner in your company. And you’ll end up in difficulty if you select a spouse only on the basis of their financial worth.
(It is permissible to accept money from investors who want to be “silent partners,” but you should make sure that this is explicitly agreed upon, as well as stated and recorded in your operating agreement to prevent any future conflicts as your company grows.) This isn’t the norm.)
So, how can you know when it’s a bad idea to accept money?
A Checklist with Ten Points
You may be accepting “dumb money” if you can answer “yes” to any of the following questions regarding the person or persons offering you money as an investment in your startup company:
- Is this the investor’s first venture into the startup world?
- Is this the first time the investor has invested in your industry?
- Is this the investor’s first time investing in a business that has to raise several rounds of funding (assuming you are).
- Is the investor unfamiliar with your target market?
- Is the investor requesting a non-dilution provision in your operating agreement (a clause stating that their equity shares would never dilute)? (No smart investor will ever ask for this, and no savvy investor will want to invest in your company if this condition is included.) Everyone dilutes when an investment is made!)
- Is the investor requesting an ownership share that isn’t proportional to the amount of money they’re investing in you? (For instance, let’s say you’re raising $1.5 million.) You haven’t yet released your product. An investor is willing to put up $100,000 in return for a 50% stake in your business. Regardless of what you may hear and see on the TV program Shark Tank, this is most certainly not a fair and equal transaction.)
- Is it the investor’s intention to keep attorneys and accountants out of the investing process? (Warning: major red flag!)
- Is the investor’s lawyer a first-time investor in a startup?
- Is the investor reluctant to provide references from previous investments or references in general?
- Is the investor putting pressure on you to accept the money by a particular date and not explaining why?
This is not a comprehensive list of questions to ask a new investor during your due diligence process, but these are all things you should be able to firmly say “no” to before proceeding with the investment.
I hate to say it, but I’ve been the recipient of “stupid money” myself—in my first business, I accepted a substantial amount of funding from an angel investor to whom I would have replied “yes” to questions 1, 2, 3, 4, 5, and 8.
Needless to say, the business flopped miserably. It didn’t collapse because of one investor; rather, it failed as a result of a sequence of errors that, when added together, produced a perfect storm.
It’s critical to find investors that will bring instant value to your business, not simply your bank account. This helps your business develop a healthy investment culture and sets the tone for how you’ll continue to grow.
How to Recognize “Smart Money”
Here are some instances of what “smart money” can do for you and what you should look for in prospective investors:
- Contacts to assist you in expanding your company.
- Specific skill sets that your business is lacking (e.g., human resource management, computer programming skills, operations, financial management, leadership in high-growth environments, sales, new media skills, patent filing processes, etc.).
- In a constructive way, challenging your ideas and preconceptions.
- When required, mentorship and coaching are provided.
- Other accredited investors may be contacted.
- Their credibility is founded on their history.
I’d love to hear about any “dumb money” horror tales you have.
Dumb money is a term that refers to the amount of money that someone spends on something without doing any research. This can be in the form of an investment, purchase, or even when investing in a startup. To avoid taking dumb money, you should conduct your own research before making any investments. Reference: dumb money live.
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