Due Diligence As a One-way Street

How much do you know about what goes on within your VCs’ own firms?

During my time in VC, we did a lot of due diligence on the founders in whom we might invest, learning about their personalities, work histories, management styles, strengths, and weaknesses. We assessed their management teams, how well the members of those teams worked together on tough issues, and current and future holes in the team. Such due diligence efforts are standard within the industry.

However, not a single founder turned the tables and asked me questions about the personality and style of the GP who might be joining their boards, how well the GP got along with the firm’s other GPs, how much gunpowder was left in the firm’s current fund, or when the next round of fund-raising would commence. (Several did ask about the firm’s overall history of investing in their segments and similar general issues.) Due diligence was largely a one-way process.

Some founders succeed despite this ignorance about their investors. However, they are the lucky ones, for I have seen many other founders get burned by their ignorance of the inner workings of their VCs’ firms and about the specific GP joining their board. Some examples:

  1. A GP on a company’s board pushes for a dramatic strategic change (changing a consumer-focused company into an enterprise-software company) and has the company hire two high-priced consultants to plan the change. The founder doesn’t believe in making such a change, but feels the need to listen to his board member and investor, and goes along with the plan. Then, the founder finds out that the GP’s firm is starting to raise its next fund, is feeling pressure to show that they invest in the enterprise-software segment, and wants the founder’s company to fill that hole. (In another case, fund-raising pressures led to the VC’s focusing inordinate attention on getting the venture a higher valuation in its next round, to the detriment of other key terms that round.)
  2. A company takes money from a VC Principal making his first investment. Before the next round of financing, the Principal is let go by his firm. Knowing that it is a bad sign if a company’s existing investors don’t re-up in the next round, the founder has to pitch the VC firm on re-upping – with the VC firm not being familiar any more with the company (now being more “new investor” than “existing investor”) and with the VC firm already inclined not to invest because of the company’s association with the fired Principal. (Making it even tougher, the Principal had failed to inform the GPs in his firm that the company’s board had decided to halt a CEO search that had been under way for several months. When the founder met with a GP from the firm, the GP opened the conversation with, “So you’re the founder we’re replacing!”)
  3. A founder really “clicks” with the specific GP leading the investment, believes that the GP will add tremendous value to the company, and decides to accept capital from the GP’s firm. Six months later, the GP leaves the firm and the company’s board, after a long feud with the other GPs in his firm. The GP is replaced on the board by a junior Associate from the firm. (More dramatically, in another case, the GP left the board because his firm was in receivership for not repaying a loan, and a representative of that debt-holder replaced the GP on the board.)

A similar, but much more public, story was highlighted in August and September by Daniel Primack in two Private Equity Week postings.

From August: “For the uninitiated, VSP Capital (f.k.a. Venture Strategy Partners) is the San Francisco-based venture capital firm that raised $185 million for its third fund early this year, and then was forced to disband it several months later after a ‘key man’ provision was triggered by the resignation of general partner Matt Crisp. … [There are lingering questions about] the future of the three startup portfolio companies within the still-born Fund III.” In the end, the three portfolio companies were auctioned off after VSP’s LPs refused to have them rolled into Fund II.

From September: “Sources close to the firm blame friction between firm founder Rees-Gallanter and three of VSP’s five general partners. That friction, they say, resulted in the termination of one GP and two others tendering their resignations. … So it was that in a span of just two months that a firm went from five investment pros, a new $185 million fund and a rosy outlook to a firm with two investors managing what’s left of an old fund.”

Are there questions you should be asking now about your potential investors? That you wish you had asked before you took money from your current or past investors?

  • What are the most important pieces of information you would want to learn about them?
  • What questions would you ask (and to whom?) to find those things out?
  • Are there other ways you should be making due diligence a two-way street?
  1. Noam, this is a great point. The first time I started a company, I was so happy that someone was willing to give me $3 million, I didn’t bother asking questions.As it turned out, the lead investor had recently converted into a publicly traded venture fund, which meant that they had basically cut off their access to their old limiteds.Then, as I heard about some of their other investments, either through the grapevine or because I was asked to help with due diligence, I realized that they were headed for trouble. Their biggest investment was a sure loser, and they were increasingly funneling all of their funds into it to prevent showing a loss which would crater the stock price.In the end, our investors went bankrupt, leaving us “orphaned.”

  2. Excellent post, Noam! Bringing an investor into your company and adding them to your board is as important (if not more important) than deciding upon co-founders and other employees. Many founders (my self included in the past) don’t enter the discussions with this view. It’s really like an HR decision. Would you hire a VP without doing references? Would you co-found a business with someone you didn’t know? I think not and the same goes for investors!Probably the best references are portfolio company CEOs who have worked with “your” partner. If you ask for CEO references, they will give them to you (provided the fund is serious about investing). Ideally you want to talk with ex-portfolio CEOs or foundering CEOs who are no longer with the fund. You also want to look for repeat CEOs (i.e. they ran more than one of the fund’s portfolio companies). Like any reference, you’ll come across negative comments–you have to look at the balance.A side benefit of reference checking is that not only will you grow your network, but also you will find out things like how to (or not to) communicate with your new board member.

  3. This is very good information, I was actually looking for this for a paper that I have to do.

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