Should I Back Out Of A Deal?

When a founder is fundraising, sometimes they have to deal with unhappy surprises.

For example, they might spend months fundraising… only to find out that their lead investor has suddenly backed out of the deal.

When this happens, other investors who have verbally committed to the startup might be scared off.

If a lead investor backs out, it’s not uncommon for co-investors to do the same.

Here’s the question: is this the right reaction?

Well… it depends.

Is the founder dishonest or untrustworthy?

If the lead investor discovered the founder crossed moral and ethical boundaries, dig into it.

Maybe the founder had a history of scamming customers and partners. Or maybe they were a former criminal and tried to cover it up.

Do your due diligence. If you find facts to corroborate your suspicions, strongly consider backing out.

What if I’m just scared of the market?

We are in a recession right now – things look scary.

Of course, you could back out. But if you do so, you are breaking a social contract with that founder.

See, you can live life in two ways: through single-term transactions or long-term transactions.

In a single-term transaction, your incentive is to get all the benefits.

You sell your used office chair on Craigslist for the highest price and never see that random stranger again.

However, in a long-term transaction, it's not about this one exchange.

It’s about the hundreds of deals you will make over your lifetime. And the way you approach those deals will affect your reputation.

Founders talk to other founders. If you treat them through a single-term transaction lens, they’ll tell their friends.

“That investor brought us all the way to the last mile before she pulled out.”

“Don’t work with him. He’s not trustworthy.”

When you make a promise (even verbally), you shouldn’t go back on your word unless there is a serious breach in the process.

Your reputation is the most important thing you have as an investor. Make your decisions carefully and stick with them.

What if it’s too risky to stay in?

If you’re investing in early-stage startups, you have to assume your portcos are generally not going to work out.

But the beauty in working with early-stage startups is that when 1 or 2 of your portcos take off, their exponential gains will make up the ROI for your entire portfolio.

So when a company fails to put another deal together, what you should care about most isn’t your initial investment.

What you should care most about is your integrity.

Give the founder the feeling that you stayed by their side. Keep it classy and professional.

Because in a long-term game, your integrity doesn’t only benefit the founders you work with… it also gives you opportunities to invest in other startups.

A feel-good story

Eric ended our interview with a story that I can’t stop thinking about.

Eric met Brexton Pham, a freshman at Stanford University, at one of their on-campus events.

Eric saw big potential in Brexton, and eventually invested in Brexton’s first company.

Like most startups, things didn’t work out.

But a few years later Brexton started a new company that had fast and early success. Eric asked if he would like to collaborate again.

Brexton had already closed his round so it was too late for Eric to join. But because of their previous relationship, Brexton convinced the other investors to make room for Eric.

When you have an excellent reputation and a genuine desire to support founders, they want to work with you again and again.. and recommend others work with you, too.

We are playing a game with long-term transactions – keep your word and support your founders all the way.

Psst: this article appeared in Small Bets – a newsletter for early-stage investors. Sign up here.