Not so fast! Raising money: seeking an investor? Slow down and take five steps to protect your company from making a bad choice

Entrepreneur, Sept, 2003 by David Worrell

BOB SHALLENBERGER KNOWS TIME IS money. He talks fast and makes decisions quickly. By all accounts, Shallenberger's need for speed has made him a highly successful entrepreneur. But last year, when his home-building business needed an investor, Shallenberger's rapid-fire approach to decision-making almost burned the house down.

Being in real estate, Shallenberger finds that investors are not shy about offering him their money. Says Shallenberger, "Having an investment that returns 30 percent annually and is backed by real property, it's pretty easy to get people interested."

For Sale

Shallenberger's company, Highland Homes of Saint Louis, never needed an investor until, early this year, with two $500,000 homes already under construction, his banker pulled the plug. "When the bank said we were already overextended, we decided to take on an investor," he recalls.

With hardly a second thought, Shallenberger, 33, reached out to a casual acquaintance who had previously indicated an interest in investing. Immediately, it seemed like a good fit, so Shallenberger closed the deal. "We shook hands and next met at the title company," says Shallenberger. "But did we have a written agreement? No. Did we research his background? No. We just knew he was a partner at a respected law firm."

Shallenberger soon regretted shooting from the hip. He quickly discovered that the investor expected to be consulted on everything from the exterior landscaping to the interior paint color. As a result, the home that was supposed to take five months to build instead took 10.

In hindsight, if Shallenberger had slowed down to better evaluate his investor, he might have seen the warning signs before it was too late. Before you jump the gun with an investor, work through the following five steps:

I. KNOW THE INVESTOR'S PERSONALITY. According to attorney Marc Morgenstern, who advises both investors and entrepreneurs in private equity deals at law firm Kahn Kleinman in Cleveland, there are some people an entrepreneur should simply avoid. "For example, I try to never let a client take money from lawyers; they're the worst," he says, without a hint of irony.

More generally, different kinds of investors have different reasons to invest. Shallenberger thought his investor simply wanted a good return on his money. In fact, it was probably more about the status of building expensive homes, he says.

To glean personality clues, Morgenstern advises clients to listen to the questions investors ask. An obsession with operational detail is often a sign an investor will worm his way into day-to-day company management. If you need additional management help, that may be to your advantage. But it can easily spiral into a case of too many chefs spoiling the stew.

2. DO BACKGROUND RESEARCH. No matter how badly you need investment money, there's no reason to get it from a deadbeat or felon. Internet-based reference search companies, such as ChoicePointOnline.com, LocatePLUS.com Inc. and USSEARCH.com Inc., provide quick and easy ways to know if your investor has any skeletons in the closet.

Reference search services access databases of business licenses, criminal records, bankruptcies, real property transactions, civil court judgments, even utility bills. A basic search through LocatePLUS.com costs less than $8 but could save you thousands in the end.

"Within the search results, look for inconsistencies," advises Jon Latorella, president of Beverly, Massachusetts-based LocatePLUS.com Inc. "A lot of times, the absence of data is more important than the info itself. If very little is available on a person, it could be that they simply pay cash for everything--or it could be more insidious, like their whole personality is fabricated." Likewise, multiple occurrences of different names, or different spellings of the same name, may indicate previous fraud.

Morgenstern also uses background reports to look for someone involved in multiple lawsuits. "People who have been in litigation tend to end up in litigation," he warns. "They could be someone who seeks litigation or simply someone who does not know how to resolve conflict. Either way, avoid those people."

3. GET HELP. Taking on an investor is like getting married: It's an emotion-filled decision with long-term consequences. That's why consultant Mike O'Malley, who provides due diligence services through his Chicago company, The O'Malley Group, recommends getting an outsider or a consultant to look over the deal. "A consultant has no stake in the deal and can operate at a level above any particular self-interest," he says. "We can ask the tough questions that other people are unwilling to ask because it makes them uncomfortable."

If a paid consultant isn't in the budget, look within your own network for a person whose judgment you trust. Ask them to look at both the investor and the players in your company to assess the fit. "The whole system has to work together," says O'Malley.

4. SET EXPECTATIONS. Perhaps the most overlooked aspect of taking on an investor is setting expectations. Even when a formal contract or subscription agreement exists, it rarely addresses issues like mentoring and management. Do you expect your investor to help manage the business or to keep his distance? Let him know in advance. Morgenstern puts it succinctly: "An expectation unarticulated is a disappointment guaranteed."