The lead investor does the hard work to make it easy for others to invest

In the earliest rounds of fundraising, the process is ad-hoc.

Founders take money from whoever and whenever they can get it — founders, friends, family, accelerators, and other assorted supporters.

It’s called a friends and family round, but in the strictest sense, it isn’t even a “round” — there’s no beginning or end to the process, no fixed amount of the raise. The terms are simple — usually a SAFE, often without a valuation. If there is a valuation, the founders might increase it as they hit milestones, or they might leave it the same.

The diligence process at this stage is minimal — a pitch, a few questions, write a check. The board is usually the founders alone without investor representation. I’ve heard these investments called “angel donations” or “angel grants” since they shouldn’t be considered money-making investments.

All that changes when the startup is ready for significant investment from investors expecting a financial return. This includes VC firms of all sizes, angel groups, and serious angel investors.

The terms of the investment need to be set through negotiations between the startup and investors. But it’s impossible to negotiate a single set of terms with such a wide group. To facilitate the process, one investor takes on the role of “lead investor.”

The lead investor is typically the largest or at least one of the largest investors in the round. The lead investor will:

  • Negotiate the term sheet
  • Perform diligence on the company, usually creating a diligence report
  • Negotiate the actual investment documents
  • Take a seat on the board to represent all investors in the round
  • Help prepare the startup for the next round of financing

Terms that need to be negotiated include:

  • Financial instrument (SAFE, convertible note, preferred equity)
  • Valuation or valuation cap
  • For a convertible note: maturity date, interest rate, conversion criteria
  • Board structure
  • Round minimum and maximum amounts and closing date
  • Information rights, pro-rata rights, drag-along requirements, and other details

There’s a lot of work required to be the lead investor, from negotiating the terms to doing a thorough review of the company to serving on the board. The effort is not worthwhile unless a substantial investment is planned. Smaller investors don’t have the time or resources to become the deal lead, and large investors may, ironically, find it not worth their time for a small investment (for them) in an early round.

But it’s the work of the lead investor that makes it easy for everyone else to invest with confidence.

  1. Is the valuation fair — it was negotiated with the largest investor rather than made up by the founders.
  2. Is the company legit — they’ve done a thorough (hopefully) analysis, checked the founders’ backgrounds, interviewed customers and industry experts, analyzed the patents, and reviewed the legal documents.
  3. Is it a good investment — they know more about the company than anyone and made a substantial investment.

In other words, they’ve done everything I need to do to vet the investment but don’t have time to do it myself.

Once the lead investor has done the hard work, I can look over their efforts, perhaps ask a question or two, decide if I agree the terms are attractive, sign the documents and write a check. Easy!

Navigating Through Lead and Follower Investors

It would be great if the first investor wanted to act as the deal lead and agreed to terms the founders found reasonable. But, of course, that rarely happens.

As the founders talk to dozens of potential investors, some will express interest in investing but not taking the lead.

Many investors will only act as followers, a handful always requires a lead role, and many can be lead or follower depending on the situation.

Many early investors will not become deal leads. Accelerators can’t. Individuals don’t have the resources. Strategic investors are conflicted. Big funds won’t lead early rounds. Private equity, family offices, hedge funds, and others dipping their toes into venture investing don’t know how. In seed and pre-seed rounds, the lead is usually a small fund that focuses on investing in the sector or an angel group with wide expertise and plenty of experience with early-stage startups.

When you find investors who are interested in investing but not in leading the deal, the process is simple. You ask how much they’ll invest if they find the terms agreeable. (You should be able to provide at least a targeted valuation at this point, even if the details remain TBD.) Make a list of these “soft-circle” commitments.

Once the lead investor has signed the term sheet, completed the diligence, and prepared the investment documents, go back to those deal followers and let them know the round is now formally open for their investment.

For the larger followers, it can be helpful to introduce them to the lead investor early in the process. They may have their own requirements on hot-button issues like information rights that they want included in the terms, or may bring particular expertise to help in the diligence process. Angel groups especially find it helpful to share their expertise in diligence.

No Lead, Big Problem

Recently, I’ve been pitched by a number of startups raising a seed round without a lead.

It’s tempting to go it alone. Set a valuation and ask investors to sign a SAFE and wire their money. Or put the investment on a crowd-funding site and wait for the cash to roll in. No wasting time on a diligence process, no arguing over intrusive terms like re-vesting of founders’ shares, no pesky investors on the board. People are already offering to write you checks, so why not take the money?

It’s tempting. It seems easy. It seems better. But long-term it boxes the startup into a corner that can be difficult to escape.

Without the efforts of a lead investor to negotiate a fair valuation with suitable terms and perform a thorough diligence process, it’s impossible for a small individual investor like me to join in and have any expectation of it being a good investment. I’ll still make occasional small investments, but I have to look at as an angel donation because the odds that the company not only succeeds but my early investment doesn’t get wiped out by sophisticated later investors is low.

Further, without an investor on the board at this stage, the company is likely to make serious mistakes, possibly even fatal ones. I’d argue that raising a round without a lead investor is exactly the sort of mistake the founders are likely to make without an experienced investor’s input.

The board’s primary responsibility (other than the legal obligation to prevent financial wrongdoing) is to help the startup get to the next stage. Having an investor on the board who understands the process and milestones, provides introductions to other investors, and gives next-stage investors the confidence the company knows how to build a startup is invaluable.

It’s possible to pull off a smallish raise without a lead investor, even if that’s not advisable. For a larger raise, the startup needs someone to write a large check. If the terms are unpalatable to experienced investors, accepting money before securing a lead investor makes it difficult to change terms mid-raise.

As you begin your fundraising journey, ask potential investors if they’re interested in leading the round. Keep collecting those soft-circle commitments until you find the investor that will be your deal lead, board member, and all-around partner going forward.

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