How to Avoid a Bad VC Investor with SaaStr CEO and Founder Jason Lemkin

Nov 22, 2024

This edition is sponsored in part by Adyen: How leading SaaS platforms have adopted embedded payments

We’re obviously written up a lot about Fundraising and Investing here on SaaStr.com, but time and time again, SaaStr CEO and Founder Jason Lemkin has seen so many Founders sign a bad term sheet based on gut instinct, VC celebrity or vibes, and while that may be fine, it’s not enough.

It’s not enough because if nothing else you’re stuck with your investors for decades — for better or worse.

A bad investor doesn’t come off the cap table until you sell the company or years after an IPO. And so much happens in that time, in that decade or more. So here are 8 signs to help you avoid bad investors.

Talk to as many founders they’ve invested in as you can. Do reference checks.
Ask how many investments they write second and third checks into.
See how pushy they are around control.
Ask if they’ll still be there in 10 years, at the same fund. Just ask.
Ask what’s the toughest founder-VC experience they’ve been through, and what they learned from it.
Ask about some of their stories of bringing in outside CEOs to run their startups.
Ask what their worst investment was, and why. They know.
Ask what CEO they’ve invested in that they respect the most. This is what they’ll be looking for from you.

#1 Do reference checks

Talk to as many founders they’ve invested in as you can and do reference checks. First of all, some folks say don’t talk to their successes, talk to their ‘losers’ who fail to really get to know the VC. And by all means do that if you can find someone they invested in that absolutely failed, go talk to them. But .. you might learn more from the founders who went the distance rather than the failures.

And the founders who went the distance know the VCs that invested in them and on their board the best.

If you’re not sure, talk to as diverse a set of founders they’ve invested in as you can. And don’t expect all the founders to love them. The ones that are really engaged, the ones that are there for founders will have some friction swith some of founder they’ve invested in. Ask the founders this question when you interview them: How supportive has X person been as an investor? This will help you decide more clearly if they’re the right investor for you team up with for potentially the next decade.

#2 Ask if they write second or third checks

Ask how many investments they wrote, and how many they wrote second and third checks into. The reality is if you read the stories of a lot of SaaS successes, almost all of them had patches where, as meteoric as the growth seemed, they had patches when growth slowed, when things were harder, when they needed more money, or when they almost ran out. Some VCs will give you more money and some won’t.

And there’s some judgment on whether they ultimately do or don’t, but the other fact is that most smaller funds won’t write a subsequent check. The question to ask a potential investor to vet for this is ‘How many reserves do you keep per investment?’ You’ll find that large firms (multibillion dollar firms) often have a one-to-two ratio. In other words, for every dollar they put in initially, they earmark another 2. They might put in more, they might put in nothing, but of their pool of capital, they might earmark it.

VCs that don’t write second checks are less valuable to you because you will probably need one.

#3 See how much control they want

This has changed a lot over the years and control is not as big a deal with VCs as it used to be. This drama that you hear on X from folks about being pushed out is not as common anymore.

What’s more common today is that VCs just check out when they think you’re not doing well.

So worry less about whether your investors are going to push you out or take control of the company — nobody wants that. Nobody has time anymore, but you don’t want them to control it. And there’s a rough metric you can use to meter this: for each 10% of your company you sell roughly, you’re going to give up a board seat. So if they insist on a board seat for < 10% ownership, that’s a flag.

So if you want to go big, what you really want to find is someone on your cap table who actually cares. There’s usually only one investor on your board or cap table who actually cares. That’s actually there for you in the tough times who will write that second or third check when others won’t, someone who’s willing to do the work. Look for that more instead of worrying about control of the company.

#4 Figure out their long-term goals

Ask your investors if they’re going to be there in 10 years. There is a lot of turnover in Venture.

If investors can’t deliver the returns, ultimately they get moved out. It is a brutal industry. What it means is if they don’t run the place, they may not be there in 10 years. Just ask, if they will be there in 10 years and you will probably hear a hesitation.

Does it mean you shouldn’t take their money if you’re not sure they’re going to be in there in 10 years?

No, but you are so much better off if they’re there on the journey. Imagine you need that second check or third check. It’s hard enough in general if you’re only doing okay. But what if your partner’s gone and they bring in a new person on your board who’s never even heard of you?

Typically when someone leaves the firm and someone new comes on your board, they’re always very nice people but don’t expect them to stick their neck out for your company. So it’s a big negative when the investor that invests in your company leaves. You’re stuck with a placeholder for years and years.

And that’s why if you can, try to work with the person who’s running the place. They may not have as much time but at least they’d be there with you on the journey.

#5 Ask about the lows too

If you want to learn what it’s like to work with a VC, ask them ‘what’s the toughest founder VC experience you’ve ever been through and what you learned from it?’ Ask what it is. No one asks, so you’re going to get an honest answer. Ideally ask at a meal, before you sign a term sheet, have a sit down, in-person meeting together. VCs used to always have meals with founders when they gave them a term sheet to get to know each other, and while it’s less common less days, you absolutely should as it’s a great way to do reverse diligence. There’s always friction somewhere so see what they’ve learned from it.

#6 Ask about outside CEOS

Ask when they brought it outside CEOs. As a rough rule, the bigger, the fund, the more often they would have since bigger funds have ‘benches’ of XCOs, XCROs, and XCMOs waiting in the wings that they can call on in case they need one to run one of their portfolio companies.

Ask when they brought in someone from the outside and see what happens. If this is something you’re anxious about, just ask when it last happened.

#7 What was their worst investment?

What was your worst investment and why?

A lot has changed in the last four years, in particular, so every investor that has been around for a while has fraud in their portfolio. It is not just FTX. It is not just Theranos. There is micro fraud. There is fraud on a $2 million round, a $10 million. It’s all over.

And there is bad behavior all over the place on these imploding startups. If you wanna know what it’s like when the chips are down with the VC, just ask what their worst investment was and they’ll all know the answer. They’re going to instantly remember the one where the behavior was problematic and tell you, and you’ll learn a lot about them as a human, what their values are, and what they care about.

#8 Ask what CEO they’re a fan of

Ask what CEO they’ve invested in that they respect the most.

If you want to get to know this investor before you’re stuck for a decade with them on the cap table, ask what CEO they’ve invested in that they respect the most. It might not always be the biggest exit and you’ll learn why. This answer will help you better understand what they want from you. When you hear who they’ve invested that they respect the most, you’ll learn that this is what they value the most.

#9 Should you ask your potential investors to sign an NDA?

This is something that a lot of founders still worry about, but maybe a bit less than in the past. However, it’s a big issue, as no VC will sign an NDA. Maybe a handful will at the larger, late-stage private equity firms since they have the capabilities to thoughtfully sign them, but no other VCs will. Why? Because VCs not only meet hundreds of startups a year, but they also get probably thousands of random inbounds asking for investment.

For example, Jason’s gotten hundreds of emails from founders creating an AI SDR app. If he signed an NDA, he couldn’t tell you the difference between any of the two companies either way. So it’s impractical for VCS to sign an NDA, so you shouldn’t ask.

The thing is most VCs don’t care. They’re not going to steal your ideas. They’re not founders and creators. The amount of information that actually is confidential is about 5% of what we think it is. There is some secret sauce in our apps — don’t share that but if you share the stuff that people think is confidential that’s not that confidential will build trust so much quickly.

#10 Best advice if you’re going from bootstrapping to venture capital to avoid a mistake:

First, it all normalizes around 8 to 10 million in revenue. So by the time you get to 8 or 10 million in revenue, if you’re doing software your gross margins should be 80-90% by then, giving you about $8 million of cash to invest back into the company each year. So that’s a similar equivalent of raising a 16 to $20 million round.

So what you’ll find is outside of, frugality and other things, there’s not a lot of difference between a $10 million bootstrap company and a $10 million ARR company that raised 20 million. There’s just not a lot of difference. It does normalize. The more subtle point is that after 8 or 10 million, you could, (a lot of times)raise the capital, but you don’t have to anymore.

Second— 99% of companies cannot raise venture capital.

It is a niche asset class. No matter how it looks on the internet, venture capital is a tiny portion of private equity, which is a tiny, portion of investing. It is not for everybody. No matter how it may look publically with these unicorn rounds, it is a small amount of capital in absolute terms designed for a very small subset of companies. And that means that 99 percent of startups can’t even raise venture capital.

Bootstrapping takes longer on average. That’s a reality, but it forces you to focus on business models where you always win. One of the best parts about capital is if you can raise it, it lets you expand in areas where you have more competition, where you’re less competitive.

#11 If you are offered a second check, how picky should you be?

Last but not least, related to point #2 – let’s say you do have a current investor that is open to a second check — fantastic! But how detailed should you go in the terms of that second check? Do you lock the multiplier? What considerations should be made?

Remember that venture is a series of measured risks. And if you talk to super successful funds that manage more than that first check, sometimes they even see it as an option, like ‘Okay. I’m going to give you a million dollars now to see how it goes. And if it goes great, then I’ll give you five more.’

So considering that, you should not lock down the terms in any way in the beginning.

Non-Silicon Valley VCs sometimes like to invest in tranches. They’ll say something like ‘we’ll give you a million today. And then if you hit a million in revenue, we’ll give you another million.’

While that sounds great, it’s actually a rip-off because it’s a one-way option. You have to take their money. So if you hit it at the same price as before, tranches are a terrible deal. If it’s the only money you can get on planet Earth, then yes, take it, but run from tranches if you, can.

So the real question isn’t, can I get this multiplier or stipulation in my term sheet? The real question is, do you do second and third checks and what, typically speaking, would it take to earn it? That’s the right way to ask.