David Frankel
As soon as you capture the attention of a VC, they’re going to start performing the “due diligence” required to justify the investment. This is when the investor checks into the bold claims you have made about the size of your market opportunity and your work experience. The process effectively begins as soon as the VC has a real interest in pursuing your deal, and steps up when you’re offered a term sheet.
The conventional “gentleman’s agreement” in this period of formal diligence is that, barring some revelation about the founder’s character or a previously overlooked problem with the market, a deal will consummate. The diligence process is designed to act as a safety valve for VCs. Unfortunately, it’s also when thoughts of the “winner’s curse” may take hold in an investor’s mind.
It’s a fragile period. Even worse for founders, it’s a largely asymmetrical process. VCs can acquire a bad reputation if they repeatedly lead on entrepreneurs, only to drop them during diligence. But that’s cold comfort for a startup, where a deal falling apart in diligence can be a deathblow.
Your team knows you’re in a process (even when you think they don’t), so when things start to fall apart, morale does too. Many firms will avoid digging in when another firm they know just neg’d a deal. And the more prestigious the firm, the more damaging it is to have a deal scuttled during the fact-finding process.
Founders can be so focused on perfecting their pitch that they neglect to think about the second step of the process. This post explains what to expect when VCs start digging into your business, as well as the diligence you should do on your investor before accepting their money.
Personal Diligence
Criminal/Financial Background Checks
This is the simplest, lowest-cost way for a VC to eliminate risk. We’ve seen situations where senior hires defrauded their companies. Often these harmful situations could be avoided by running simple criminal background/credit checks.
Think about it. You wouldn’t want a convicted embezzler running finance for your startup. Someone with a history of defaulting on loans isn’t the kind of character you want shaping your team’s culture. And it’s definitely not the type of person we want to back.
That said, don’t freak out if you’ve got a misdemeanor on your record, or there is some financial infraction on your credit report. We’ve funded people with blemishes that are immaterial to their business, or well in the past. If your investor asks you for background checks on the founding team and key execs, don’t feel like they’re prying — it’s part of their responsibility as a fiduciary.
On-List Reference Checks
Investors will ask you for a list of contacts that can vouch for your credibility and technical expertise. These are helpful, but just like when you’re interviewing for a job, we know that you’ll only give us the names of people who like you most. While obviously biased, it’s helpful to hear what your hand-picked promoters have to say. Here is how I evaluate these on-list reference checks:
Are these references impressive? The ideal reference check would involve calling Tim Cook and hearing that he made his best offer to keep you. Failing that, a supervisor, or impressive peer at a name-brand organization lamenting your loss, is impressive. An articulate subordinate can work in a pinch. When I had the opportunity to fund SeatGeek, founders Jack Groetzinger and Russ D’Souza were both young enough that their college transcripts were actually relevant.
We have seen deals die when entrepreneurs couldn’t provide impressive references. Remember, we’re betting that you will be able to assemble a constellation of world-class employees, partners and advisors. If you can’t find a few people to tout you, it’s a problem.
Is the entrepreneur being damned with faint praise? Assuming your references are impressive, the first thing that will pop out is if you’re being praised, but only lightly. We want to hear tales of world-beating performance and exemplary character. Little else will allow you to displace market leaders. Again, if you can’t give your investor a list of 3-5 people who will vociferously sing your praises, that’s a concern.
Am I hearing a pattern of negative comments? Even positive references, when pressed, will likely find some area that you could improve. It’s natural that to be credible you also need to be critical. This usually takes the form of a third-person dig. We hear things like, “Some people thought he was difficult,” or “She’s a bit of a lone wolf.” Comments like this are rarely disqualifying, but do help illuminate the founder’s personality.
Off-List Reference Checks
Off-list references are the best kind. We’re in a world where all our professional histories are easily accessible on-line. Your potential investors will be privy to a list of names with whom you’ve made contact. Assume that they’ll reach out to them before entrusting you with large sums of money.
Don’t worry if you’ve been fired. Or if someone has horrible things to say about you. We know that not everyone is a good fit for every job. VCs are in the business of pattern recognition. Every investor has a different laundry list of traits that they find admirable or unsavory. Here are few examples:
Are you intolerable? Jobs and Gates (in his youth) have helped create an expectation that great entrepreneurs are often painful personally. I’d prefer contentious, opinionated chutzpah without unnecessary friction, but they often go hand in hand.
Are you paranoid? I completely share Andy Grove’s perspective that paranoia is a requisite for startup founders. I always like to back teams who exude a sense that, “If we don’t move our asses now, we’ll be irrelevant.” We want to fund people who are manically focused on getting huge leverage on every unit of time.
Are you “all-over” it? We’re not exclusively looking for people with insane academic credentials or a resume dotted with blue-chip companies. We do want to back teams that are preternaturally focused on their market and have the ability to visualize their market five years hence.
We’ve funded entrepreneurs in their forties who previously sold companies for nearly a billion dollars, as well as founders who are barely old enough to drink. The common thread is that they were obsessed with their markets.
If I ask you a domain-related question a few minutes into your pitch and you don’t have an answer, that’s a problem.
Are you savvy about competition? A marker of maturity is when founders recognize that their greatest competition is not a VC-funded upstart or the behemoth legacy player, but apathy. Startups, especially those in SaaS markets, often face competition from a carefully constructed Excel model.
Customer Reference Checks
Like physicians, VCs should work from a position of “do no harm” when calling on customers for reference checks. This is a critically important step for B2B fundraising, but it’s also tremendously risky from the founder’s perspective.
Only connect investors to customers who will be enthusiastic champions for the product. There is a risk of being damned by faint praise.
Don’t be shy about reminding your potential investors about the importance of the calls with regard to your ongoing relationships. You’re happy to connect, but the tone of the call should be positive, not disapproving. My colleague Gaurav Jain has written a great post on how to hack this process.
How To Handle Negative Feedback
A good VC that’s still interested in pursuing the deal will present you with the feedback they received. How you respond can mean the difference between a finalized deal and dashed dreams.
You should have enough emotional intelligence to know what people might say about you. Along with this, you should be able to handle criticism without being defensive. The ideal response to a VC surfacing a potential character flaw is to walk through the history of the relationship in question, explaining the differing perspectives.
If you’ve been reasonably successful in your career to date, there is probably someone along the way who doesn’t think too highly of you. Maybe it’s someone you beat out for a promotion, or someone who feels you took an undue share of credit on a project.
Or it might be someone with a legitimate beef. Maybe you interacted with them early in your career when you were cockier, or while you were going through a stressful divorce.
In either case, think about the bad things someone might say about you and be prepared to address them. Not defensively, but demonstrating that you accept reality.
This is a critically important test. If I get the sense that you’re obfuscating now, when your company is at a positive inflection point, what kind of truthfulness will I be able to expect when the company faces challenges?
Market Diligence
Personal diligence is only half the battle. Often the more challenging part is getting comfortable with a market. Part of a VC’s job is learning how to get comfortable with markets as diverse as urban transport, event ticketing and 3-D printing — all in a matter of days or weeks.
We do primary research, study analyst reports and look through financial statements. We try to corroborate whether there genuinely are weaknesses that may be ripe for exploitation. Later-stage investors have a team of analysts that can chase down a deal from any conceivable angle. TAM, SAM and SOM analyses will be generated. Comps will be calculated. If there are irregularities or you overstated your case, expect the facts to be uncovered here.
Get The Bad News Out Of The Way Immediately
As my fellow debate club veterans know, a key skill in winning an argument is to be able to anticipate the concerns of the opposing side and pre-empt them. If there is bad news, like shrinking margins in your business or negative secular trends, don’t try to hide them. Embrace them. Explain why the conventional wisdom is wrong. Display an unparalleled mastery of your market.
Often a VC will turn to a trusted expert in the industry to get feedback on your business. These people are typically senior in their careers and out of touch with the modern dynamics that are reshaping the market. But their opinions carry significant weight.
Assume a former CEO in your space will throw cold water on your concept. What are the 5-10 reasons they would say your company is doomed to fail? Have compelling arguments to all of them in your pitch deck. Arm your potential investor with questions that will leave their expert without clear answers and cement your status as a person “in the know.”
Beyond these techniques, like so much else in investing, it comes down to the story that you can tell. Here are some of the questions that will most commonly be asked:
How did you arrive at this idea? The ideal answer is, “I worked at a company that needs this project and is willing to pay us a large sum for what we’re building.” In the consumer market, the best thing we can hear is that it scratches an itch you have had for years and is rapidly gaining market traction.
The best investors aren’t looking for a specific answer here, but rather, a real sense that you have an edge: relationships that give you unique insight or a deep, unfair knowledge base that will give you an advantage in the market.
How do you stack up to the competition? An extraordinary investor once told me that he learns the most during the last few minutes of any conversation when he asks about competition. I try to emulate him. I’m looking for nuanced analysis and a clear understanding of the market forces or technology evolutions that make your success possible.
Overconfidence is an immediate turn-off. Challenging a massive market-leading company with a tiny, under-funded startup is an act that involves a certain amount of hubris. But that audacity can also be a short path to your company’s eventual bankruptcy. I want unrestrained optimism and audacity coupled with insight and paranoia.
Are you thinking about distribution? The cult of product has infiltrated startups. Marketing should start on Day One. Marketing strategy will be discussed during your first meeting, but during diligence you can expect a deep-dive. Your Customer Acquisition Cost (CAC) to Lifetime Value (LTV) calculations will be probed, along with your approach to cohort analysis — a nitty-gritty accounting of how and where your marketing dollars are being spent.
If you only acquire customers via a single channel, that’s an Achilles heel. Be prepared to explain why it won’t end and what you’re doing to diversify acquisition channels.
Are you overestimating human behavior? A healthy respect for the co-efficient of friction that comes with any business is a must. Noah Glass is the founder of OLO, a food-ordering technology used exclusively by Chipotle, Five Guys and sweetgreen amongst hundreds of other quick-serve restaurant and fast-casual chains. It’s a great product, but when he pitched it to me in pre-iPhone 2007, it was so far ahead of its time that I nearly passed.
It took an unprecedented level of single-mindedness by its founder to navigate years of glacial human behaviour change. While the speed has definitely increased, every-day consumers across the full age spectrum don’t change their habits overnight. Is your business situated in the right part of the adoption curve? If not, can you explain how you’ll persevere?
Keep The Pressure On
You’re being scrutinized, but you’re also selling a one-of-a-kind asset. If you’re lucky enough to have multiple interested parties, don’t let up on any of them until a term sheet is signed, a check has cleared and you’ve spent a little of the money. Without competitive pressure, an investor can become distracted and let the diligence process drag on. The longer it goes, the less likely the deal is to consummate.
Rule of thumb: The larger the check you’re requesting, the more time a VC will spend checking into your claims. At over $50 million, expect multiple parties (including paid external consultants) carefully checking you out.
The Founder’s Perspective
Diligence should be a two-way street. Try to learn as much as possible about the individual and team that’s buying a chunk of your company. They will exert massive influence on every aspect of your life for years to come. Especially if the original story is not working out.
Ask Hard, Oblique Questions
Ask potential investors for a list of CEOs they’ve backed (ideally ones that didn’t succeed) and ask tough, oblique questions, like:
What happened when you delivered bad news? Did the investor go radio silent when trouble came around to focus their energy on perceived “winners?” Did they give founders a friendly pat on the back, but offer little in the way of help? Ideally, founders should have stories about how the investor offered introductions, assistance and did their duty to help right the ship, or wind things down cleanly. Good early stage investors treat their CEOs as peers, and in the best cases learn as much from the relationship as their founders.
Does this person have their ego in check? Venture capital can attract people with healthy egos. When you’re talking, does your potential investor listen? Do they roll their eyes or check their email? These are important tells. If you email someone asking for feedback and they respond by suggesting a phone call, that’s almost always a red flag.
Think critically. Weigh the references in proportion to the success of the company’s fate. For example, 9 out of 10 times when a founder has negative things to say about an investor, that founder’s company didn’t go well. Be aware of the context in which you’re asking your questions.
Try to understand the investor’s motivations. Some people get into this business because they love the sheer potential of technology and are inspired by working with aspiring, world-changing founders. Others see it as a fun asset class in a broader wealth-creation landscape.
I cannot emphasize this enough: Understand your financial partner well. Eyes wide open. Please.
In defense of my fellow VCs, I would note that having now been involved in more than 200 ventures over the length of my career, I can’t think of more than 5 investors with whom I won’t do business again.
How To Run An Effective Diligence Process
Investors have the benefit of running hundreds of diligence processes per year. We’ve already made mistakes and augmented our processes to guard against them. You’re likely not as fortunate, so here are some guidelines to consider:
Avoid self-confirmation. As an investor, I always have to remind myself to be skeptical. Confirmation bias is a massive problem when you’re making high-stakes bets in short timeframes. You should likewise be mindful of this.
As an entrepreneur who’s hustling to get their business off the ground, a VC offering a check provides both validation and resources. It’s almost insane to turn either down, but that option shouldn’t be off the table.
In a highly contested round, the challenges can include trying to balance prestige and valuation. In a less competitive deal, the decision can become more binary. In either case you need to understand that a short-term cash infusion may create years of pain.
Don’t make 3 calls. Make 10. Take this seriously. Your career depends on it. Listen for patterns. Subtle feedback. It can be intimidating, but don’t be afraid to ask tough questions.
Know what you’re looking for. Do you need money? Connections? Domain expertise? A big VC brand to help recruit? Clarify and try to rank what’s most important to you. Some VCs are “sharp-elbowed” and are unwilling to syndicate deals beyond a trusted coterie of friends. This doesn’t help if you want to allocate room in the round to strategically important angel investors. Are you looking to optimize on valuation at all costs? Or would you rather take less favorable terms from a fund that has a history of rolling up their sleeves to help their CEOs?
There is no right answer to these questions, but not addressing them is a highly probable way of getting it wrong.
Closing Thoughts
“We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we have remembered it, the larger they have been.” George Merck
We believe the same goes for venture capital. Our remit is to make money for our investors, but our charter is to do so by funding people who want to change the world — people who want to make products that will improve the lives of millions, perhaps billions.
Often the hardest part of diligence is knowing when to quit. You can diligence your way out of anything. It’s analysis paralysis, with a seven-figure check in the balance. At the seed stage, investors need to believe in you, your team, your vision and your product. In the absence of months of product data, we need to base our decision off something.
Though it can be stressful, laziness and financial markets don’t mix. You only have to look back to 2008 when mortgage underwriters would clear no-doc loans and homeowners would sign up for mortgages far beyond their means. Be clear-eyed about any transaction before signing a contract and, to that end, make sure you do your homework.
Comment