Due diligence is the legal term for research done by investors prior to investing in a startup. When entrepreneurs think of due diligence, they think about large repositories of corporate paperwork (shareholder agreements, incorporation papers) and reams of internal projections (market size memos, competitive analysis, financial models), and while that is all true, it misses the number one thing that kills a lot of deals: ongoing interpersonal interaction.
Remember, startup investors are minority shareholders in the company. As such, they are susceptible to the whims, decisions, and predications of the founders. All sophisticated investors protect their legal rights through a unanimous shareholders' agreement, and the promise of follow-on funding can keep founders focused, but in truth, investors have little moral suasion when it comes to entrepreneurs they have funded. Because of this, VCs and angel investors take time to get to know the founders throughout the process of due diligence.
As an investor, I view due diligence not as a gate that founders must pass through, but as a prolonged courtship where all parties get to know each other. Yes, it is an investigation of all the relevant facts surrounding the venture and the opportunity, but it also about the people. Startup investors know they will likely have to hold their stake in a privately held venture for up to a decade to reap the return. So most are wary about who they back, since they will, for all intents and purposes, be "stuck" with those founders.
At Ryerson Futures, the seed fund where I'm a partner, if we smell even a whiff of a troublesome founder, we will likely shift from legal due diligence to working due diligence (sometimes called "living due diligence"). Unlike legal due diligence, which can take three to six weeks, working due diligence takes three to six months, and has the potential funder working side by side with the founders. During this time, the investors are able to witness the founders in action, providing information dynamically (as opposed to legal due diligence, which tends to be about reviewing static material).
Continuing the marriage metaphor, this is the "let's live together first" option that has become popular in courtships over the last few decades. This allows all parties to "try before they buy" and ensures that all parties can work together for the long-term success of the business.
Here are some of the red flags that have made me decide not to invest:
- Cagey: Founders who aren't 100 percent transparent are non-starters for me.
- Uncoachable: My assumption is that founders who aren't open to constructive criticism from an investor probably won't be open to hearing it from customers. And in the 21st century, entrepreneur-customer collaboration is required for success.
- Gameplayers: If you time when you send your emails, or tell me about all the other investors you are meeting, trying to play investors off each other, you disqualify yourself.
- A--holes: Life is too short and starting a startup is too hard for an investor to commit to supporting a jerk for seven years. Simply put, I don't want to work with a--holes.
- Ungrounded optimists: As Jim Collins shared in Good to Great, you have to believe wholeheartedly in the possibility of startup success but never take it for granted. Those that are unrealistic in their optimism are a concern for investors, as it shows naivety at best and blinding overconfidence at worst.
So what should you, a startup founder looking for investment, take away from the above?
- Be proactive, honest and forthcoming. Don't wait to be asked the tough questions. Be comfortable saying "I don't know" or "let me get back to you on that."
- Be a real human, not an entrepreneurial caricature. Money talks, but people are the ones who give it you. So treat people with respect and empathy.
- Adopt grounded optimism. Remain faithful that you can accomplish your big goals but don't lose sight of the brutal facts of your reality (i.e., it is going to be extremely hard).
- Be easy and open. Put your ego aside, and listen twice as much as you talk. Hear others, and when challenged see it is an opportunity to revisit what you already believe to be true.
- Have a sense of urgency. That doesn't mean stalk the investor or ask "are we there yet?" 20 times a day. But be proactive on follow-up items. This shows that the relationship is important to you and that you respect the investor's time.
Landing an investment is hard, but the most successful founders make it easier by following the "No A--hole Rule."