This article is the second in an ongoing series on Deal Leadership. To learn more about leading a deal efficiently, download this free eBook today: Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.
The first time I served as a deal lead was unintentional. I happened upon a team I really liked, going after a market I thought was really attractive, with a solution I thought was really smart. So I started telling other investors about it. Many perked up and took an interest, but nothing was really happening because there was no bandwagon to jump onto.
The entrepreneurs had no idea how to raise money or structure a round, so they were hesitant to jump in and set terms, and the other investors, while interested, had plenty of other priorities to attend to. So if this was going to go anywhere, someone was going to need to define the round and establish an acceptable set of terms for people to invest.
In thinking about terms, I had a sense of where the market was at, but just the same I spoke to the interested investors to calibrate against what they thought might be acceptable. And I spoke to the company as my thoughts came together. From there it was very natural for me to recommend a way to go about communicating those terms. They agreed. We set out a simple termsheet. We showed it to some other investors. They agreed to come on board. And looking back, I realize that in that moment, I became a deal lead for the first time.
A lot has changed over many years and many investments, but that essential core interaction has not. Every deal needs a lead, a focal point, a way to prime the pump. When I told Ham the story of that first deal leadership experience, he asked me to expand on the role a bit more. Here are his questions and my answers.
Christopher, you and I have led many, many deals over the years. At a high level, what does it mean to be a deal lead?
The deal lead is the investor who steps up to take responsibility for driving the process and sets the terms on which the investment will happen. The deal lead is like the catalyst in a chemical reaction. It is the ingredient that makes the chain reaction start to happen.
Sometimes being a deal lead is about being a cheerleader and manufacturing enthusiasm, but more often than not it is about managing that enthusiasm and defining a process. From a leadership perspective, deals really have three main phases:
Discovery is really the “pitching” phase. It is about testing the waters and finding interest and support for the concept. The deal lead can be a very valuable shepherd during the discovery process, introducing the company around to investors who might be interested.
The diligence phase is the phase where investors try to test assumptions and gauge risks and build a pressure-tested investment hypothesis. The deal lead plays an essential role of traffic cop and coordinator in group diligence efforts.
The syndication phase comes after the initial investors have committed to the termsheet and are looking for others to fill out the round. Human nature is to procrastinate, so syndication is really about staying on people and getting them to commit. The CEO should play an important role here, too, but the deal lead is invaluable as a lead investor who can talk investor-to-investor to the people contemplating the deal.
What makes a good deal lead?
I guess at a very high level it is people skills and experience with the process. To break that down into specifics, it is:
Knowing how to run a really good diligence process that finds the efficient balance between speed and thoroughness,
Having an eye on the market and knowing what deal terms will be attractive to other investors,
Having connections to investors behind you who can invest along side you,
Knowing the right things to say so you are effective at cheerleading and coaching folks along,
Educating and mentoring the CEO through the process,
Staying on top of things and moving the process quickly,
Having connections to find a value-added director who can take a board seat and oversee the investment, and
Having a group of smart investors who can help with the due diligence.
Does a deal really need a lead? What about company-led rounds where the CEO puts together a termsheet?
A round absolutely can be led by the company, and it happens quite regularly, particularly in cases of necessity. But the company-led round really presents two main sets of issues:
The first set of issues occurs at the stage of building and filling the round. Every decently-sized round needs a market-attractive termsheet and a good diligence report. If a company does not have an investor to negotiate with them and hash out a set of terms that are “at market,” they will end up with something based on the termsheet of their friend’s company or their lawyer’s suggestions for terms. These termsheets can be spotted a mile away and often have inappropriate or off-market terms buried in them. Once a few inexperienced people have committed to those terms, they become a hassle to change and act like a big roadblock in bringing other investors in.
Company-led rounds also don’t have diligence materials to offer prospective investors. Without a diligence report, the company will burn themselves out trying to “re-pitch” the company and re-answer the same sets of questions over and over with time-consuming and not entirely convincing results. A third party diligence report is not gospel, but, like a third party termsheet negotiated at arm’s-length, it does add a big measure of credibility to the round. Without this credibility, it can feel like the entrepreneur must have some kind of a flaw if they have not been able to find any investors.
The second set of issues presents itself after the round is complete. It can be summarized as a “diffusion of responsibility” issue. Company-led rounds are sometimes referred to as “party rounds,” meaning all that name implies.
Nobody is in charge,
There is no investor representation on the board,
No meaningful governance or oversight,
No plan for staging capital into the company and defining milestones for the next round,
No single investor with real skin in the game,
No one to organize and rally investors in the face of management team issues,
Creeping valuation issues from things like stacking convertible notes, and
A general lack of accountability and rudderlessness.
Of course some of these party round companies get lucky, gain some traction and attract the attention and oversight of key investors later. But many do not. You can imagine what happens to those which do not.
Why put in the work to be a deal lead? Why not just join rounds led by other people?
Since a round only needs one lead for its many investors, that can be a perfectly viable way to go for many investors. In fact, some investors, particularly those in well-organized networks, go their entire career without stepping up as a lead. Even if you do occasionally lead, you cannot lead everything, so it is fine to invest where a trusted co-investor leads.
The advantages to doing it yourself, however, are that you can:
Make sure it gets done right,
Make sure the deal terms work and the round fills quickly so the CEO can get back to developing the company,
Make sure there is a good overall capital strategy for the company, and
Put someone you trust and whom you know is good on the board.
With company “projects” you really care about, sometimes the desire to lead becomes overwhelming.
Does everyone rely on the deal lead’s due diligence? Is that a safe practice?
As noted above, a third party diligence report can lend tremendous credibility to a round. It is typically shared subject to a diligence sharing “treaty” or one-off disclaimer. Sharing a report can save a ton of work for both the investors and the company, but it is not a cure-all. Unless it comes from a source you know and trust, with a process you know is consistently thorough and professional, the cautious investor is going to want to double-check some things firsthand. It is very common for investors to rely on third party diligence lock, stock and barrel, but experience has taught us that it is very smart to double check key issues like the team (with a few blind reference checks of your own) and the market (with a few calls to customers or experts more knowledgeable than yourself).
So if the lead sets the terms, does that mean no one else has any input or ability to renegotiate the terms?
It is possible to tweak the terms or even change them wholesale, especially if you are bringing a lot of money to the round. This is a major hassle for all involved, and a significant risk to the company due to the possibility of lost investors or lost momentum or both. So most experienced investors try as hard as they can to look at the the terms on kind of a take-it-or-leave-it basis. Either the deal is attractive on the terms being offered, or it is not. This is an example of why the deal lead role is so important. For things to work smoothly, it is essential to get in place at the beginning an acceptable set of terms around which investors can rally. That is what a great deal lead does.
If you have to change the terms mid-process, tremendous friction, wasted time and uncertainty ensues. In some cases it is a “tempest in a teapot” because the new terms being introduced later in the process are investor-friendly and end up being viewed as a bonus to previously committed investors. But, sometimes the existing investors think the change is a bad long-term idea, even if it is technically in their short-term interest, and so they push back on the change. When that happens, you end up with a bunch of investors negotiating and fighting amongst themselves. It quickly turns into chaos. Most investors have little patience for that and will wander off and let the loudest voice win; the theory being that there are plenty of fish in the sea and it is better to look elsewhere than to try and clean up a deal that has gotten wrapped around the axle on terms.
Best case scenario, these rounds are bumpy, unprofessional, time-wasters that highlight a lack of leadership and a lack of professionalism. Worst case, they careen toward entropy and simply fall apart with everyone concluding they don’t need the brain-damage.
Want to learn more about leading a deal efficiently? Download this free eBook today Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.