A couple of months ago I was walking around entrepreneurs in one of the up and coming co working spaces in Mexico City. I saw one of their promising founder working on what appeared to be a term sheet. — ‘What are you up to Maria? I asked. ‘I’m working on a term sheet for a VC fund so he can make us a formal investment proposal’, she responded. ‘Somebody has to do it if I want his investment… I guess!’ she added as she saw a surprised expression in my face.
The great news is that the entrepreneurial ecosystems in Spanish speaking Latin America have been growing at a pace that has surprised many observers. We have more founders building better companies with increasing support from universities, seed accelerators, government programs, mentors and investors. Recently, it is striking how the quality of demo days and pitches in Latin America is catching up to that of more advanced ecosystems.
I am afraid that such a progress has not been witnessed for early stage investors: our learning curve has not been as steep. In the past five years, I have participated in around 50 early stage rounds (Seed, A and B series) in Latin America as an investor, board member or adviser. During that period, I have seen too many high potential companies being distracted, slowing down or failing because our investment community has not been up to the task. A handful of our colleagues and our group have been working hard to incorporate their experience to become better partners and co investors. Here are some of the key learnings we must carry out and the bad practices we should all avoid.
1- Communication and transparency — As other regions, entrepreneurial activity in Latam receives a disproportionate media coverage. This coupled with participation in panels, contests, university events have given investor plenty of opportunities to communicate. However, these outreach efforts are not always helpful for the founders. For example, last year a few new funds in Latam have announced in the media the launch of their super large fund (US $100M for Latam) without actual commitments to support them. Today only one is investing with a tenth of its target. Some colleagues also tend to exaggerate size, returns and traction of their portfolio. In this context, founders can get lost. Transparency is hard to find but badly needed as founders start connecting with investors.
2- Investment process — Building great products and services takes time and focus. Too many investors are seeing opportunities they won’t or can’t invest in out of curiosity, need of information, need to show potential Limited Partners some deal flow or worse, corporate espionage. Their process is often slow, opaque and disorganized. We’ve seen investors disown formal proposals, renegotiate terms up to the last minute or take up to a year to deploy commitments. Some funds should apply the added value they promise to startups: better corporate governance and internal processes… The consequence is that Latam founders as a group are spending too much time and facing unnecessary uncertainty while fund raising.
3- Valuations — Early stage valuations are half art / half science. They involve both intrinsic (traction, market share potential, business model, execution risk) and extrinsic considerations (other startups valuations, successive rounds, exit potential, regulatory and macro risk). They require a multi round dilution budget for the round investor and the founder. It’s never perfect. Investor will always value your company either too low or too high. However, because of the lack of early stage funds, too many investors in Latam are killing incentives and balance with founders with low valuations. Startups are simply not viable if founders are diluted 60%, 70%, or 90% in their first two rounds of investment.
4- Terms and conditions — Early stage investment is primarily a bet on the team and should be focused on maximizing the upside potential rather than protecting against the downside. In general, anti-dilution clauses and preferred returns iare good tools for series A and B to manage risk for the larger investors but should be treated carefully and explained repeatedly. Although I don’t think it’s a good practice, if an investor charges a monitoring fee or stock option, they should sign a service contract with deliverables and commitments with penalties. On the corporate governance side, hands-on investors and VCs often take a seat on the board. We’ve seen investors taking control of the board from founders at the seed or Series A stage. Even if young and unexperienced, founders are the heart of their startup journey, we are here to help and assist, never to take control.
5- Added value and follow on — We have partnered with more than 20 funds from US and Latam in co-investments. It will come as no surprise that investors tend to exaggerate the amount of time, resources and added value they put in a portfolio company. To be fair, as a VC firm, it is difficult to anticipate how much you will be able to help a specific startup and how much a founder will let you work to help address a particular challenge. Nonetheless, founders should understand this phenomena before partnering with an investor. If helpful, the biggest impact we’ve seen Latam investors have is helping with fundraising. Closing a successful series A or B is hard and takes very long. So much so that toxic down rounds are not uncommon in our markets. They should not be. These start-up killers are bad for anyone on the deal: founders, minority investors, bargain hunter investors and the ecosystem as a whole.
I am sure I missed additional practices angel investors and VC firms should avoid. It is critical that we learn faster from our mistakes as an industry and become better partners by changing our investment approach. We should start by focusing more on the teams and less on the deal, more on creating value and less on gaining control, more on maximizing upside and less on preparing for the downside. From Silicon Valley, we should take how investors fight for founders rather than fight each other. As a Latam investor, it is challenging to raise and manage a VC fund. It is even more challenging to create a great product, go to market and scale it. We should appreciate founders more by becoming better partners. The opportunity may be gone faster than we think.
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