Doing your due diligence on investors

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:

  1. If they make the investment, will they take a Board seat? (Almost always). Who will sit on your Board?
  2. 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.
  3. 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?
  4. 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.
  5. 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.
  6. 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.
  7. Are there other companies in their portfolio that are competitive with yours or could become so?
  8. Can you talk with some of their LPs (limited partners)? Why did they become LPs?
  9. 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.
  10. 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.
  11. Do they hold money in reserve so that they can do multiple rounds if necessary?
  12. 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.

Why you should keep your financials on a need to know basis

If you are raising capital for your firm, prospective investors are going to want to know the answers to a number of questions, including:

  1. How much money are you raising?
  2. How much have you raised from whom already?
  3. How much have you personally invested in the company? (cash not sweat equity)
  4. How long will this round last (12 – 18 months is a reasonable answer)
  5. What are the use of proceeds? In other words how will you spend, or better put, invest the money in your enterprise?
  6. What measurable product, financial, customer, staffing, and other milestones will you achieve with this capital and when?
  7. What terms and conditions are you willing to accept as part of the raise?
  8. What is your pre-money valuation?
  9. What does your cap table – the listing of who owns how many shares – look like?
  10. What do your financial statements – income, balance sheet, and cash flow – look like?

I advise entrepreneurs to keep the majority of these answers out of PowerPoint presentations and executive summaries – documents that by their nature tend to get circulated around the investor world – for three major reasons.

Just as you would’t put your salary on your resume when applying for a job, there’s a time and a place for discussing capital requirements. Startups are dynamic, constantly changing organisms. How much money you need depends on your burn rate (how much money you spend monthly in op ex (operating expenses) and cap ex (capital expenses) and what if any revenue you are generating. Both numbers are fluid and subject to change without notice in a startup. Raising capital is a negotiation. How much you plan to raise and at what valuation also depend to a certain extent on market forces at play – is there a lot of cash out there, due to IPO and M & A exits, or are things tight? What’s the balance of power between investors and entrepreneurs?

So for the sake of good negotiating hygiene you want to keep the answers to these and related questions close to the vest until you have confidence that the investor is truly interested in and capable of making an investment in your company. And the fresher the numbers, the more accurate they will be.

Secondly, every company is competing for a limited supply of investor capital. Why give your competitors inside information on your company by revealing it in a document like an exec sum that is likely to get passed around amongst investors and could easily land in the hands of a competitor?

Finally if you do change major parameters of your investor pitch, the last thing you want is old versions of your financials floating around, possibly to be used against you in a negotiation with a potential investor.

You may need to publicize the fact you plan to raise capital, however you should reserve the particulars for investors whom you qualify and plan to enter negotiations with. Again there are similarities to finding a job, you should only give out your references when that’s the penultimate step in the hiring process.

In summary:

  1. Don’t reveal the answers to questions about raising capital until you have solid answers, backed up by data, not wishes and hopes.
  2. Qualify to whom you provide these answers to keep your confidential information from ending up in the hands of people you would rather not have access to it – like your competitors.
  3. View a capital raise as a process of negotiation, not as a PR campaign. Only enter discussions with investors you have fully vetted (and investor due diligence is subject for another post) and whom you’ve spent enough time with to know they have a real interest in your company.
  4. As in a previous post, the best time to raise capital is when you don’t actually need it.




When to raise money

As a prominent VC once told me, the best time for entrepreneurs to raise money is when they don’t need it. VCs can smell desperation a mile away. If you really need money, then you are by definition desperate and easily subject to a down round where your investors, and you, get crammed down.

So when there’s money out there and you have a strong business case to raise it, do it. Because you never know when the financial markets will turn and if you need money, you either won’t get it, or the terms will be onerous.

Of course, the flip side of this is the danger of having too much money too soon in a startup, a problem and post for another day.