Does a customer make a good investor?

March 1, 2001
Is it OK to have a potential customer as a seed investor?
1304qa Chang New

Q: Is it OK to have a potential customer as a seed investor?

A: There are pros and cons. On the plus side, this provides a solid validation of your technology to convince other investors to fund you. The downside you want to avoid is that the investing company (Company) may have some "strategic" objectives. Some of the stated reasons can be that they want a window into your technology and business, they want to be a preferred customer of yours, and they may also want to be in a position to buy your company when there is a good reason for them to do so. Unstated reasons can be to make you a less attractive supplier or even to preclude you from selling to the Company's competitors. So the Company will put hooks into the investment agreements to get what they want and to limit your freedom. That diminishes your value. For example, the first right of refusal, which seems harmless enough, would make your company less attractive as an acquisition target. The possibility exists for another buyer to do a lot of work in analyzing and negotiating an acquisition, and then have it be all for naught if the transaction is scooped by the Company. For the unstated reasons, they will put a person on your board to look after you rather than what a director is supposed to do, which is to look after your interests. It is also bad for your business because the Company's competitors will hesitate to buy from you for fear that important sales data might go to the Company. My recommendation is to have them give you a purchase order contingent upon successful development of the product. That may be an even better endorsement, and you can avoid all the pitfalls. If you feel the pros outweigh the cons and want to go forward with an investor relationship, make sure you have a capable lawyer on your side to structure an agreement.

Q: With all the startup activities in our industry, people have less time to write papers and attend conferences. Doesn't this impede the exchange of information?

A: In checking with John Horner and Paul Shumate, executive directors of OSA and LEOS respectively, there is an overall increase in both published and presented papers; but a lot of the growth is coming from overseas. Given major shifts in the way we transmit and gather information, I am not sure there is a lack of cross-pollination. People are definitely less open because there is a greater sensitivity to the economic values of intellectual properties (IP). But information exchange can occur in unsuspecting ways, and I've found people are still quite open one-on-one. Individuals changing jobs is one mode. An employee, even without disclosing any proprietary information, can bring a wealth of know-how that would have required a lot of internal effort to develop. Students new to the job market disperse information about their professors' projects. Venture capitalists also promote cross-pollination by having their companies share information. Another positive trend in this regard is the role of the federal government in forming research consortiums and DARPA University Centers, where several groups brought together on a project will exchange ideas. Given that people are more open in smaller groups, a logical conclusion is that the technical societies should organize more workshops and topical meetings.

Q: How do I deal with a director who does not come to most of the board meetings?

A: Directors who do not contribute substantively should get off the board. You wanted that person for a reason; his absence has an effect that is worse than not serving. Absenteeism results in knowledge gaps and a lack of historical perspective that make it difficult to make sound decisions. What I have also seen is that nonparticipating members wind up overcompensating for their guilty feelings by taking strong positions on issues they don't fully understand to show they care. That of course makes matters worse. It is important for you to have a heart-to-heart talk and make your feelings known. If the absenteeism persists, ask that individual to resign.

Q: Should I insist venture capital investors (VCs) sign nondisclosure agreements?

A: Almost all VCs do not sign nondisclosure agreements. It is not uncommon for a VC to receive several business plans with similar technology/business ideas. So potentially the VC can have several lawsuits on his hands if he invests in any one of them. While this kind of "gentlemen's" agreement is hard to enforce, there are cases of large pay-out. Another reason VCs may not cooperate with this is the belief that people who insist on nondisclosure agreements have low confidence in their competitive advantages. My advice is to work only with reputable VCs, do not disclose proprietary information until you have patent filings in place, and disclose only when a VC shows serious interest.

About the Author

Milton Chang

MILTON CHANG of Incubic Management was president of Newport and New Focus. He is currently director of mBio Diagnostics and Aurrion; a trustee of Caltech; a member of the SEC Advisory Committee on Small and Emerging Companies; and serves on advisory boards and mentors entrepreneurs. Chang is a Fellow of IEEE, OSA, and LIA. Direct your business, management, and career questions to him at [email protected], and check out his book Toward Entrepreneurship at www.miltonchang.com.

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