Most entrepreneurs are familiar with the entrepreneurial rite of passage of “due diligence” where they get scrutinized more heavily than an immigrant from the Middle East entering the U.S. CFO’s scramble to get the financials in order, the founders scramble to clean up the cap table, the management team scrambles to line up references – it’s a massive scramble drill.
But how many entrepreneurs perform due diligence on investors who present them with term sheets?
Getting an investment is not like auditioning for a movie role, where you get it or you don’t, based on the director’s final decision. It’s a negotiation: over amount, valuation, terms and conditions, and more.
So before you get that term sheet, but when you are getting close, I recommend you start your due diligence process. The best VCs will have no problem with this. I remember Bill Kaiser of Greylock telling me “We are 100% referenceable. You can talk to any of the CEOs of any company we have invested in.”
Here’s a few tips on due diligence on your investors:
- If they make the investment, will they take a Board seat? (Almost always). Who will sit on your Board?
- Can they give you the names of founders of their portfolio companies you can talk with? CEOs? You want to find out how the investor reacts when things go wrong. Everyone loves you when things go right. But in a startup things often go wrong. How did the investor react? How did the negotiation over the valuation go? This is the most common friction point between entrepreneurs and investors.
- Beyond being cool,calm, and collected during a crisis, how have they helped the company? Have they used their network to help recruit talent? Have they interviewed finalists for you? Found partners? Recommended top notch professional service firms or contractors? Brought in additional investors?
- How big is their current fund? I’ve wasted time with more than one VC who’s fund either didn’t have enough left to make any more investments, or who hadn’t actually closed the fund from where my investment was supposedly coming from.
- Do they often syndicate investments, e.g. invest with other VCs to spread risk and share the upside? If so, what funds? I used to call Greylock and Highland the Bobbsie Twins of East Coast investment because they did so many co-investment deals.
- How often to they lead? Leading is tough as it means setting the valuation and the amount to be raised, as well as the investment preferences. Beware of newbies or investors with reputations for onerous preferences.
- Are there other companies in their portfolio that are competitive with yours or could become so?
- Can you talk with some of their LPs (limited partners)? Why did they become LPs?
- How successful have they been recently? This can be a tough question to answer, but there are various sources on the Web that rate VCs, track M & A activity, and IPO’s.
- Can you spend some non-business time with the partner who is leading the investment? While lunch is nice, travel is best, and any non-business activity from golf to attending a Red Sox game will give you a chance to get to know your investor personally if you don’t already.
- Do they hold money in reserve so that they can do multiple rounds if necessary?
- Finally talk to the portfolio founders and CEOs whose names they didn’t give you. Especially companies that have failed or are floundering. How has the investor tried to help or has hurt these companies? Or perhaps just sat on the sidelines.
Raising money is a very draining, time-consuming process. But don’t quit at the term sheet. The game isn’t over until the check clears the bank. And most important, this isn’t a date, it’s more like a marriage – though VCs by their nature, are polygamous.
As Allan Bufferd, former treasurer of MIT who invested in my first two companies told me. “Everybody’s money is green.” I had no idea what he meant until he explained it. Hopefully you now understand it now too. You need smart, honest, fair, experienced, and helpful money. Not just green money.
Mentorphile 
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