How Do You Prepare For Investor Due Diligence?
“We won’t talk to anyone you don’t want us to,” “Raul”, a potential investor in my startup, said to me.
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I nodded my head. I had already given Raul a list of names, as he requested, as reference checks. In addition, my co-founders and I, were asked by Raul’s fund, the infamous “Donald Ventures”, to sign an agreement to allow a private investigator to do background checks on us.
Who could blame Donald Ventures for doing the digging they were doing? After all, they were about to give us $6 million.
Investors are going to do diligence on you and your team.
The diligence will include front door reference checks (references you provide) and back door reference checks (references you don’t provide).
These reference checks (especially back door reference checks) are a big part of the diligence process. Sometimes everything works out as planned, and sometimes the diligence can cost you an investment.
I wrote a story a few years ago titled, “What You Need To Know About Reference Checks”, about how things can go wrong during the diligence process, and what you should do to prevent this from happening. Fortunately, things went better with Raul and Donald Ventures.
Raul’s question to me was simple. “What am I going to learn about you that the references you provided aren’t going to tell me?”
Raul was really asking me, “Are you going to be honest with me about your shortcomings?” I didn’t mince words.
“Depending upon who you talk to, you might hear that I can be abrasive, argumentative, and difficult to deal with.” Raul started pointing to notes in his notebook to the two associates he brought to the meeting.
Raul smiled at me.
Investors networks are very deep, so expect them to know everything about you and your team.
I had passed the test. “Randy”, one of my co-founders, wasn't so fortunate.
“Okay, what about you?” Raul was now pointing to Randy.
“You’ll find I am stand up citizen,” Randy said, trying to make a joke. I wanted to scream, “Wrong answer!” But Raul took care of that for me.
“Don’t bullshit me!” He said in a stern voice that said he meant business.
“I know everything about you,” he said waging his finger at Randy. “How many wives have you had?”
“Uh, four.” Randy answered meekly.
Fortunately, Randy’s answer didn’t derail the investment. A week later, Donald Ventures presented us with a $12 million term sheet.
Technical diligence is like Russian Roulette.
In my experience, Venture Capital firms are mostly horrible at performing technical diligence on potential investments.
For example, when we were raising our Series B round, a very well known investor wanted us to meet with his, so called, "expert" to perform technical diligence on us. I looked the fellow up on LinkedIn, and the problem was he wasn’t that strong technically.
“How should we handle it?” Jeroen, my co-founder and VP Engineering, asked me.
Many times, VC technical diligence turns into a business review.
“I’ve been to this movie before,” I said. “Let’s prepare our standard technical overview, and I’ll prepare for the business review that he’ll likely want.”
“How do you know he’s going to want to do a business review?” Jeroen asked me.
“Look at his background,” I said. “Do you think he has the capability to go toe to toe with you technically?”
“No, he doesn’t.” Jeroen said quickly.
“So he has to report something back to the investor that he perceives will help the investor. Better said, it’s so that he can look like he’s adding value.”
“Why do VCs do it this way?” Jeroen asked me. “It seems like such a waste of time.”
VC networks vary greatly in terms of their capabilities.
“I hear you,” I said. “My take is they (VCs) have a check list of items they need to complete before they can get approval from their partners to invest.
“Technical diligence is one of those items. So, they do their best with what they have.”
Jeroen nodded his head. I continued on, “Dobby (Bob Dobkin, CTO of Linear Technology, recognized as a guru in our space and an angel investor in our company) said to me about (another company in our space that got funding) ‘they (the investors) should have talked to me, I could have saved them a lot of money.’
“I think that says it all. Remember, you and I wondered about how they got funded because we knew that their idea wasn’t technically sound.”
VC technical diligence is a crapshoot.
“It seems pointless,” Jeroen sighed.
“I know,” I agreed. “I don’t think you were part of the company yet, but Gill (one of our investors) had this person do ‘technical diligence’ on us, and it was a joke.
“The craziest thing about this is this guy shit all over us, and Gill still funded us.”
“How do you know that?” Jeroen asked.
“Gill told me,” I laughed. “I saw the same thing happen when I was an EIR (Entrepreneur in Residence at a VC fund). They (the partners) would use whomever they could in their network to help with diligence.
“Most of the time, if the diligence was negative, they would ignore it if the partner really wanted to invest. It’s a joke.”
“Have you ever seen it (technical diligence) be good?” Jeroen asked.
“Yes, and you’ve seen it too…”
Jereon interrupted me and said, “’Raul’.”
“That’s right, Raul is really strong technically, so he was able to do his own diligence on what we were doing,” I said.
“And he nailed it,” Jeroen said.
“Yes, he did,” I said.
When it comes to technical diligence, you should be prepared for anything.
The diligence meeting happened the following week. As I predicted, the technical piece was a joke.
And, just as I thought, the meeting evolved into more of a business review. We were open and honest throughout the meeting, but I could tell he (the person conducting the diligence) didn’t like our plan.
A week later, the VC gave us a term sheet. LOL. It was Russian Roulette, and this time we survived.