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Why investors need to practice lean startup principles too

By John Richards  •  May 19, 2014

There has been an increase in startup quality due to the now-legendary improvements in process espoused by Steve BlankAlex Osterwalder, and their lean startup principles.

Yet legions of angel and seed investors have not upgraded their knowledge and kept pace with these massive shifts. Investors need to change their investing practices and incorporate the lean startup paradigm. Here’s why:

Old ways: The termsheet

Many entrepreneurs have adopted the lean startup principles and practices when creating new ventures: They have learned that premature scaling is the number one cause of a business failure.

Despite this transcendence in entrepreneur behavior, investors have not kept up with entrepreneurs and they continue to fall back into old, bad habits, especially in negotiations for equity investment rounds.

While Silicon Valley has generally come up to speed — and this is why Y Combinator and others encourage convertible notes over equity rounds — many investors in other areas continue to lay down tired equity term sheets based on thinking from more than a decade ago.

For example, when an entrepreneur is raising, say, $250,000, it is still commonplace to see investors propose term sheets and a bundle of legal documents that were written in 1998. These documents continue to be used by venture capital firms for Series A investments of millions of dollars and the terms make their way into earlier-stage seed fundings.

I am not sure why they don’t see how crazy it is to have an entrepreneur do a great job on validating a business model and his customers and users, but then place before that entrepreneur a term sheet pulled out of the old file drawer with onerous preferred stock terms and paragraphs that have not been dusted off since the dotcom era.

In fact, there continues to be “no shop” and “anti-dilution” provisions put forth in preferred stock deals for low-amount seed fundings.

There is a healthy debate on whether preferred stock is the right vehicle for fundings of $500,000 or less, but let’s assume we can get to a preferred term sheet that makes sense. Certainly, it is not in the spirit of a lean startup to put in a “no shop” and tie up the entrepreneur for 30 to 45 days. What if the deal doesn’t happen? That entrepreneur just lost a lot of time.

Anti-dilution rights, which usually get thrown out by the newer money in the next round (he who has the “gold” makes the rules), are also an antiquated artifact of a bygone era, but they still pop up.

Today, investment term sheets for the first real rounds of money (after friends and family rounds) should follow the spirit of lean startup and be lean themselves. At its heart, the lean startup idea is entrepreneur-friendly. Terms at the early stage should reflect that.

One way to get started: Use the series seed documents devised by various groups instead of ancient term sheet templates.

Some terms are timeless

This is not to say that all terms in an old term sheet are bad. Some are timeless and should be included. For instance, the following terms (not an exhaustive list) are important to include:

  • Founder vesting: Founders return stock to company if they depart early
  • First right of refusal: Existing shareholders may buy any shares up for sale by other shareholders
  • Salary controls: Entrepreneurs cannot “exit” through large salaries

This is more about the spirit of the deal than any one paragraph or sentence. Certainly, basic protections and concepts are universal and stand the test of time.

How can investors get lean?

Investors interested in startup/early-stage should consider these preparatory activities and genuine practice changes:

  1. Become familiar with lean startup by watching Steve Blank’s Udacity course or read his book The Startup Owner’s Manual. Read Alex Osterwalder’s Business Model Generation.
  2. Assure that the following terms are in your lexicon: business model canvas, pivot, minimum viable product, premature scaling, etc.
  3. Consider participating as an investor and/or mentor in a modern-day seed accelerator like Y Combinator, TechStars, etc. It’s likely there is one close to any angel investors’ location. Or try an online startup investing platform like FundersClub or AngelList.
  4. If you meet directly with entrepreneurs, then follow this pattern: At a first meeting with an entrepreneurial team, probe them on their original hypothesis, their validation experiments, what they learned, their pivots, and ultimately their validated business model.If the model isn’t truly validated by customers, don’t fund the company. Instead, send the team back to talk with customers. Customer validation doesn’t take a lot of time or money. If the model is validated, then consider size of market, the team, and discuss funding their plan to scale.

Convertible notes offer a lot of advantages and avoid many of these pitfalls over equity vehicles. Still, plain vanilla equity terms following the series seed set of documents demonstrates that an investor who still prefers equity has upgraded his knowledge and practices.

After all, entrepreneurs have upgraded their principles and practices. It’s time for investors to do the same.

John Richards is a FundersClub panel member. He is an entrepreneur, venture investor, executive manager, and educator. Full Bio.

This article was also published on VentureBeat.