Monday, September 29, 2014

Reverse Due Diligence - Founders on Investors

Reverse Due Diligence - Founders on Investors

Due diligence ... from the investors view point

This time last year I wrote three posts on due diligence - what early stage investors do when they are working out whether to put money into an early stage company. All good arguments have three points so there were three posts!
I feel more strongly than ever about the opinion I expressed in the "Philosophy" post. Namely that we need to recognize who is taking the real risk when, as early stage investors, we put our money behind an entrepreneur. And hence treat them with commensurate respect.

As a practical matter, RESPECT to me in this context means undertaking your investment due diligence with the following thoughts top of mind:

1. Being super sensitive to the entrepreneur's time and not sucking them into your own time wasting analysis paralysis. This might be an interesting intellectual exercise for YOU but might kill their ability to execute their business. Early stage entrepreneurs have no staff, no admins to hunt stuff down for them; they have incomplete data; heck they probably aren’t drawing a salary.

2. Getting to YES or NO as quickly as you can.

3. Communication directly and honestly why your answer is NO, if that is where you end up.

A key issue we all face as an early stage investors doing due diligence is the question of balance.  Asking questions that matter but not being that time sink. There is no right answer here, but in my view a little (no, in this case a large amount of) respect goes a long way.

What I didn't dive into at that point was the reverse - so the due diligence entrepreneurs can and should do on investors. That said I do often mention to entrepreneurs that they have as much right, and self interest, to do due diligence on us as we do on them. So I was delighted to see Bo Peabody from Greycroft flesh that out in a recent Techcrunch post.

Due diligence ... from the founders viewpoint

Bo provided a menu of 10 questions for founders to put to VCs, many of which can be tweaked and applied to the friendly angel who comes knocking. The questions are set out below and Bo's post has some commentary around each.

Is it legit to ask questions like this? I often get asked that question especially by first time entrepreneurs. As you go through the fund raising dance there is a natural sensitivity around the people with the money - that you want pretty badly. How far can you go to ask questions about them

Absolutely you can! Is my answer. This is YOUR company and YOUR future so of course it is legit. You need to make sure that you are doing the right thing for you and the business when enter into what will likely be a long term (maybe very long term) investor relationship. Also I am am pretty sure that investors think more highly of the entrepreneurs that ask these questions than those that do not. I certainly do. It is another window on entrepreneur's thoroughness and thoughtfulness as well as a manifestation of their desire to bring together an A team that will drive success. 

And investor insights can also allow you, the entrepreneur, to focus your appeal. Knowing more about an investor also allows an entrepreneur to go beyond just assessing if there will be a good "fit" They can increase the chances of making that fit happen. As the entrepreneur building your A team if you identify that you want a specific investor on board for specific reasons - things like their focus, their expertise, the way they operate - then pitch that to them. Call it flattery if you like, but you need to do what you need to do to build that A team! (Although, as one founder pointed out to me, bottom line you should "only take investors that you actually like and respect".)

Bo's Top Ten Questions 

For the record here is Bo's list:

1. How big is the particular fund that your startup will be part of and where is that fund in its lifecycle?

2. What is the investment strategy of the firm? What are the sizes of its investments and average ownership percentages? What is the firm’s reserves strategy?

3. What is the decision-making structure of the firm and where does your deal sponsor fit into that structure?

4. Who are the LP’s in the fund?

5. What is the compensation structure of the fund and how does your sponsor fit into that?

6. What is the firm’s policy and culture around corporate governance? Do they seek board seats or not? If so, what is their in-person attendance record at board meetings.

7. What is the firm’s own view of the returns likely to be generated from your deal? How does it all break out?

8. How have previous funds performed and how will that affect future fundraising?

9. How does the firm handle re-caps and private-to-private mergers?

10. How many repeat entrepreneurs does the firm have?