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Good vs. Bad VC Due Diligence
I remember early on in my VC career, I chatted with an entrepreneur turned VC who remarked “as an entrepreneur, time is your enemy. As a VC, time is your friend.”
What I think some VC’s mean when they say this is that investors typically have limited incentive to move quickly. Unless there is a forcing function like a competing term sheet, it’s usually preferred to spend more time doing diligence on an investment mainly to get to know the founder better, watching the company make more progress (or eliminate risks), and getting buy-in from others in one’s firm.
One of my current partners calls this “hanging around the hoop”. It’s a good strategy in basketball, but I think it’s pretty lame as an early stage investor, and specifically at the seed stage.
I was chatting with another successful entrepreneur today who is also an active angel investor. He emphasized the high value he places on speed of decision-making, and remarked that being known for speed will lead to positive selection bias.
This is particularly true for repeat entrepreneurs. Often, successful founders can fund the early stages of their company themselves. But if they are going to raise outside money (to provide feedback, help, and leverage on their dollars), they are more likely to go to folks they know will move fast and make decisions on rational dimensions that will actually help the company. They will avoid investors who hang around the hoop, or send entrepreneurs on assignments that aren’t truly productive. The truth is all VC’s can make fast decisions if they need to, they just need pressure to be applied properly.
It’s hard to force an investor to move quickly unless you create competition. But what you can do is try to tell whether the VC is doing good vs. bad due diligence. ”Good” due diligence doesn’t take up entrepreneur time, burn the time of their valuable references, and are usually productive towards the goals of the company. They include:
1. VC’s doing backchannel due diligence on the team. This is good practice as an investor, and doesn’t burn a lot of cycles for the entrepreneur. Usually if the VC is reaching out to their own networks, it means that they care enough to burn the time of their own contacts.
2. Introducing the entrepreneur to real prospective customers and partners and seeing if they can close. This is very informative for the investor and entrepreneurs want to sell to good customers.
3. Introducing the entrepreneur to executives with deep domain knowledge in the space. This is a real opportunity for the entrepreneur to learn and the person may end up being a valuable advisor or even a member of the team.
4. Meetings with a purpose. The investor and entrepreneur want to get to know each other better. But these interactions should be structured and constructive. Debate business models, discuss product priorities, interview the founders to understand their strengths and weaknesses… these are all good, but definitely have a purpose and prepare to dig in deep at a level that the entrepreneur finds beneficial.
5. Quick “no’s”. It’s counter-intuitive. But if a VC gives a quick “no” but with a very clear reason that seems addressable, there is no better due diligence than seeing if the entrepreneur responds and comes back having addressed the issue. It happens rarely, but if the feedback was genuine, responding to the feedback will create genuine interest.
Bad due diligence looks like:
1. Calling all an entrepreneurs references just to go through the motions or for selfish gain. This does happen a lot. The investor may know they are very unlikely to invest, but they think person x,y,or z on the reference list is interesting, so they’d love to talk to them.
2. Multiple meetings rehashing the same information. Lame. It’s part of the difficulty pitching to large partnerships, but you’d hope that an investor would sufficiently brief his team so that conversations go deeper each time into the critical levers of the business. Not rehashing generic stuff. Also, this is a signal that the entrepreneur is hanging around the hoop. They are waiting to hear an update and aren’t prepared and focused towards driving to a decision.
3. Making entrepreneurs fly to partner meetings when they aren’t extremely enthusiastic about the investment (particularly a danger for junior VC’s). Total waste of time and money. The investor in this case is not only hanging around the hoop, they are trying to take the temperature of their partnerships to see if they should spend more time with you. Remember, junior VC’s get “credit” for perceived activity, so they are more likely to do this so their partners know they “saw” the investment even if they know it won’t get through the partnership.
4. Doing due diligence to inform an investment in a competitor (obvious and happens a lot, surprisingly).
5. Lame introductions to irrelevant people. Of course, VC’s can’t always assess what kinds of customer/partner/executive intros would be fruitful, but their ability to get close is a) a signal that the investor “gets it” and b) really will be able to help. But when there is a generational/industry gap between an entrepreneur and an investor, you are more likely to get intros to random or ill-suited people. For example, there has been more than one example of Boston consumer internet companies in need of technical leadership talent that got directed to really old-school enterprise software executives. Those types of cases are a waste of time at best, and truly harmful to the business at worst.
As an entrepreneur, it’s not always easy to tell whether the VC is doing good or bad due diligence. Hopefully these signals help. But I would say that overall, speed is a great indicator. If they are making progress quickly, that’s great. If it’s taking a long time, it means they are hanging around the hoop. And this is what should happen to people who hang around the hoop.