We are all familiar with the historic mythology of the Trojan Horse.
Sadly, in recent years we’ve also been introduced to its contemporary version in the form of Trojans, malware programs containing malicious code that, when executed, carries out actions determined by the nature of the Trojan, typically causing loss or theft of data, and possible system harm.
But there is another type of Trojan horse, less familiar though just as malicious and harmful. This is the Trojan horse investor.
The Trojan horse investor is someone who presents himself as a credible startup investor, however has a very different agenda. His purpose is to take over the company and lead it in a direction that suits his own interests, and not necessarily those of the founders or the other (minority share) investors.
Unlike a typical financial investor or a VC, who invests in the company because they believe in the founding team, their idea, and its business potential, a Trojan horse investor has a very different motivation. He seeks to take over the company and its IP and use it to achieve his own business objectives.
His Modus operandi is quite simple. For example, let’s take an early stage startup that’s trying to raise a round A investment of $2m in order to develop their product and take it to market.
The Trojan investor offers to make a considerable investment of say $1.5m. Such an investment is typically hard for an early stage startup to ignore. It’s not entirely what they need to develop their product and go to market; however it’s a good start and may last them for a year.
However, this “Trojan horse investment” comes with some very specific terms of conditions, including a relatively low valuation that guarantees the investor a large share of the company. It also includes some veto powers that essentially limit the company’s funding options in the next round, such that they are forced to take additional funding only from the “Trojan investor”.
Thus, a year after their round A of $1.5m the company runs out of money. They don’t have a product yet, nor any customer deployments, not to mention actual revenue. Their bargaining power is weak and valuation low.
At that time, our Trojan investor comes to the rescue offering them additional funding at a low valuation, which they are forced to take in order to keep the company running. Now, his takeover is complete and he has obtained full control over the company, in terms of equity, and board representation.
The startup founders, who worked hard and risked everything to start the company and create its IP, are now left with a very small share of the company, no control over its direction, and no influence in its operations.
For the Trojan investor this approach is more advantageous as compared to other alternatives, such as acquiring the company, or paying it NRE to develop his product. In the investment approach he ends paying much less than a straight up acquisition. On the other hand, unlike an NRE payment he gets his product, as well as the entire company with its IP.
So how can entrepreneurs avoid this Trojan investment? Unfortunately, there is no “investors’ antivirus” that you can install and run. And yet, I would like to offer a few suggestions:
1. Review any offer or term sheet you receive with a trusted legal adviser to understand the potential risks, as well as the proposed terms and conditions. Also, review worst case scenarios of how your next funding round might look like, in terms of valuation, equity, and control, if you take this offer.
2. Consult with your current investors. They are your allies and have a strong vested interest in the success of the company.
3. Never give any single investor complete control of your company, in particular on critical issues such as funding, strategic directions, or key hires.
4. Trust your guts. If it smells fishy, or feels wrong, it’s probably wise to politely say no and look for a better offer.
So beware of the Trojan horse investor. He can turn your dream into a nightmare.