One of the often neglected parts of fundraising is the process of doing due diligence on potential investors. Raising money is super hard. But assuming success, a moment will come when a founder will have multiple funding options.  Partnering with an investor and/or board member is very long term commitment, and I’m always surprised by how little diligence founders do prior to signing up for what could be a 10+ year collaboration.

When you do your VC diligence, here are some of the things to consider focusing on.  This is based on our own experience with founders and downstream investors as well as some feedback from my followers on Twitter.

 

When to do what?

There are some norms around VC due diligence from a timing standpoint, just like there are norms around the sequence of diligence that VC’s do.  Prior to an investor giving you a verbal or written offer to invest, most of your diligence should be self-directed based on your own network and research.

The first steps are obvious – look at a VC’s online profiles and try to get a sense of which companies they have been involved with. Then, try to dig a bit deeper to see if there are companies that the VC has invested in that has since disappeared from their online profiles. Generally, companies fall off a VC’s profile when they fail or when something has gone wrong, and these are precisely the founders you may want to speak to at some point later in the process.

Crunchbase can be a good source for this, as are any press mentions and former funding announcements mentioning the investors.

The goal of your initial work is to get a feel for who may be a solid mutual fit for your business. You are looking for some combination of domain knowledge, shared ethos, and fit in terms of stage and strategic approach.

For example, if are focused on a bottoms-up end user focused GTM strategy, you may not jive well with an investor that is very focused on top-down enterprise sales.  You also want to be aware of potential conflicts that an investor may have and other biases in their view of the world.

All this work should be helpful, but don’t try to be too clever. It’s very hard to really tell who might be the perfect fit for your startup.  People’s interests and preferences change, and whatever information you can discover is probably 6+ months old.

However, it is usually pretty easy to tell who would be a bad fit.  I would try to build my fundraising pipeline such that it is broader than you think while excluding those that are almost certainly a bad fit.

Speaking to founders that an investor has worked with before tends to work best at the very beginning of the process or right at the end. If you have a strong relationship with a founder that a VC has backed, that is usually the best intro you can get to kick off conversations with the investor. But if you only have a weak relationship with a founder, I would probably wait until late in the process to start getting their feedback.

Once a VC has given you a term sheet or told you that they want to invest, it’s fair game to ask VC’s to introduce you to founders they have worked that you can reference. Asking a VC for references is a good confirmation that they are indeed serious, but asking for them too early can make you come off as looking too presumptuous or over-confident. Good VC’s will also give you a reasonable amount of time to process these calls.

I find that ~2 days is usually more than enough to schedule and get references done.  This allows you to buy a little bit of time to get other investors over the finish line, but beyond a couple days, VC’s will know that you are stalling.

 

What to ask?

When you are talking to entrepreneur references, keep in mind that almost no one has an incentive to offer a negative reference. Founders would worry that a lukewarm reference would get back to the investor and they’d have to live with that awkwardness for a long time.

Founders also like to be associated with great investors, so they are likely to have confirmation bias when talking to folks they don’t know.  Also, investors that are wonderful cheerleaders may come off very positively, but investors that do tons of work but also end up dealing with tricky situations may come off in a more mixed light.  So overall, I’d focus less on the founder’s overall sentiment and more on her specific answers and examples.

I actually think a founder’s overall sentiment is only directionally helpful unless it clearly lukewarm or worse, in which case, you should really dig in.

Here are some important general questions to ask:

  • Tell me about the dynamic of the board. How does this investor contribute relative to others around the table? How much air time do they consume?
  • Tell me about a stressful moment when things were not going well.  How did this investor respond?
  • How did the investor respond when you messed something up?
  • Did you ever face serious financing risk? How did the investor help or contribute to your stress in this situation?
  • How does follow-on decision-making work at their firm? What hoops did you have to jump through to figure out their follow-on investment?  How did this differ in a weak vs. strong financing round?  Are you aware of any internal rules that govern how the firm approaches follow-on financing?
  • Where is this investor not as strong as others?  Does he/she know this?
  • Can you think of something specific that the investor did to help you in the last 3 months?
  • Has the investor ever gone out on a limb for you, and done something helpful that has real cost to them?
  • Has this investor ever introduced you to a customer you closed or to a candidate that you gave an offer to?  If not, did any of your other investors do this?
  • If you raised capital for your next company at this stage, who would be your first three calls and in what order?

 

I’m sure there are other good question to ask, so please share them in the comments.  I’d also recommend that your diligence be tuned to the tenure and profile of the particular partner.

For very senior partners that are later in their career, my questions would center around their level of focus and engagement. Do they show up to all board meetings? Are they prepared?  Are their comments relevant? Do they follow-through on things they say they will do? Do you get the benefit of their seniority before you have “made it”, or do you sense them hanging back until it looks like you might be a winner?  Also, I’d focus on how flexible and current their thinking is, or if they tend to see all problems through the lens of the past.

For newer partners or non-partners, you’ll hopefully get a much higher level of focus, hustle, and drive.  These partners may not have had their big win yet, and they want to do all they can to make your company a success. The downside is that new partners might have a harder time leading inside rounds and their level of strategic insight might be limited.

They may also be so nervous about things going wrong that they react badly in stressful situations. I’d recommend focusing your diligence on these issues. Ask about what the firm’s process is for committing to follow-on rounds or bridge rounds.

Try to get a sense of the partner’s political capital and momentum within the firm.  And try to understand how the partner reacts in tough situations and whether they offer a steady hand and sound advice even if they are relatively inexperienced.

Some other partners may be in their prime investing years. They have had some big wins, so they have significant seniority at their firm, but they are still early enough in their career that there is less risk that they are just about to ride off into the sunset. For these folks, the question will be around whether you will get prioritized.

These partners are probably inundated with new deal flow, are managing some high-fliers in the firms portfolio, and are probably just starting to take on a leadership role in fundraising and firm management.

How will you stack up in their hierarchy of priorities?  There is also the question of whether a partner’s success results in an inflated ego that can create blind spots or sub-optimal board dynamics.

 

Anticipating Partner Turnover

The worst spot to be in is working with a partner that leaves shortly after leading your investment. This can happen in both a positive or negative scenario – rising stars can get poached by other firms or weaker partners may get fired or get demoted or go part-time while they figure out their next steps.  My partner David wrote about this here.

In either case, you end up either being inherited by another partner in the firm or you get the same partner but with significantly less influence in their organization. It’s hard to predict that this will happen from the outside, but there are some signals you can look for.

First, a lot of transition happens right as a new fund is being raised because this is when comp, title, and ownership levels are being negotiated.

Second, be mindful if a partner seems to be doing deals that are smaller or out of the typically bounds of the firm. That may mean that the partner is on their way out, and only has been given rope to do small investments.

Third, look for internal firm trajectory.  Folks tend not to be mid-level team members or junior partners for more than 3-5 years.  If it looks like someone is perpetually a rung or two down from general partner, there is probably some risk to their longevity at the firm.

Finally, in all cases, I think it’s helpful to make sure you get some meaningful time engaging with other members of the firm and having at least one other strong advocate among the decision-making body. This is a good thing in general, but is specifically a good way to insulate yourself from being totally abandoned if your lead partner moves on.

Hopefully, this has served as a pretty comprehensive overview of how to think about doing investor due diligence.  Whether you are in a super strong position during your next fundraise, or barely getting someone over the finish line, it’s worth it to take these steps to really know what to expect from your new potential investor. An investor doesn’t make or break a company, but they can make your life a lot easier or a lot more painful. It’s a lasting decision, so take your time and be thorough so you know what you are getting into.