Due Diligence on Your Investors, Revisited

Note: For an overview of the issues covered in this blog’s past posts, click here.

Thank you to everyone who contributed suggestions and insights to the recent posts on founder scenes and split boards! Now that I have wrapped up my MBA teaching (thanks for an awesome semester, Sections A and D!), I am very much looking forward to diving back into our regular blog dialogue.

The first item on my agenda is to flesh out four more aspects of a pet topic that I first examined in “Due Diligence as a One-way Street“: the critical need to understand what’s going on within your investors’ own firms. The first three of these aspects are relatively quick:

1. I recently completed a case series, “The Tale of the Lynx,” that will be the capstone for the “founder frustrations” MBA elective course I’m developing. The case series focuses on a founding team that faced many of the critical choices covered in this blog — With whom should I found this new venture? How should we split equity within our team? How should we make decisions within our team? How should we hire so we can scale up effectively? Does our founder-CEO have to be replaced? From whom should we raise our next round? — but also delves into multiple ways in which founders can get blindsided by (adverse) developments within their VCs’ own firms. At the core of this problem is the question: Is it possible to avoid being blindsided, by doing due diligence on your investors before signing a term sheet?
2. Over the last month, I have been getting to know a new site, TheFunded.com, whose core mission seems to be in perfect sync with my exhortation to founders to do their own due diligence on their potential investors. Instead of having to rely on ad-hoc, word-of-mouth approaches, TheFunded makes possible a more systematic approach to being able to learn about potential investors. Most centrally, founders can read multiple “reviews” of investors from people who have dealt with them in the past or present, and can do so at both the level of the overall firm and the level of the individual partner. So far, the site seems to have been able to avoid many of the biases that could harm its usefulness (e.g., only getting reviews from people with axes to grind, or from planted “moles” for the investors) and in doing so seems to have brought an increased level of transparency to this type of due diligence.
3. Finally, I have always been intrigued by founders who move to the VC side of the table for a period and then head back into founder-dom, using the insights that they gained on each side to help when they are on the other side. (I was even tempted to try doing this myself, before deciding to head into academia. :->) One such founder is Furqan Nazeeri, a regular participant in this blog, who recently moved from the founder side to the VC side (until he finds his next venture?). Furqan has started blogging about his observations from the other side of the table. For instance, a recent post was “Top 10 Tips for Entrepreneurs Pitching VCs,” and one of his items extends our theme of doing due diligence on potential investors to doing due diligence while you’re making pitches to potential investors: “When the VCs are introducing themselves, great entrepreneurs are doing more than just listening; they are qualifying the prospect.Entrepreneurs should take the VC intro part of the meeting to ask a few questions with the goal of understanding the VC’s perspective…how much do they know about my market, my company, competitors, etc.?“

My next series of blog posts will delve into a fourth aspect of this topic. In my doctoral thesis (half a decade ago), I examined several dimensions of life within VC firms that have direct relevance to founders. For instance, how do VCs decide how to structure their firms internally? What drives their decisions to hire or not hire junior staff? Do those decisions affect their ability to add value to their portfolio companies and thus affect their investment performance? My research paper examining these inside-VC issues was recently accepted by an academic journal (Organization Science), and my upcoming posts will explore these issues and the paper’s findings about them.

Update (08/28/07): The first two posts about the internal decisions made by VCs are here (Part 1 overview) and here (Part 2, on internal hiring decisions).