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Due diligence: mine, yours, and ours
Via Scale Finance, Nick Hammerschlag of Open View Venture Partners writes about the different expectations a VC and an entrepreneur bring to the due diligence process after the term sheet is signed. It’s well done and written from the perspective of helping the entrepreneur understand the “timeline and scope” of the typical requests a venture capital firm will make.
We’ve written on due diligence from the opposite perspective: what types of requests entrepreneurs should make as part of their due diligence. In The fate of control we point out that most firms will have a good ‘rap’ so it is absolutely essential to verify through your own independent efforts that the partner you choose will be a good fit:
Entrepreneurs who are raising growth capital (i.e. bringing on a long term partner) as opposed to selling their businesses (i.e. get the best valuation) should invest a lot of time conducting due diligence on their prospective financial partner. A credible partner will let you (indeed, encourage you) to talk to as many of their previous entrepreneur partners as you want to get a feel for what they are like to work with.
Entrepreneurs should ask for references from successful investments, unsuccessful investments and current investments. Ask for the venture firm’s entire list of previous and current investments and randomly call a number of them. Find some independent sources on your own who weren’t provided as references but know the venture firm…
Establish a solid foundation for the relationship early: Will you share the same vision? Agree on ground rules?
Once the honeymoon is over, will you collectively put forth the constant effort required to sustain the relationship? How will you resolve conflict? Are communications open and largely free of clashing egos? Does the quality of the arguments make the outcomes better? U2 credits their longevity to a “group ego” that “trumps everything else.“(Beginning at 16:45 of the interview, “Edge” riffs for just under 2 minutes on the success of the band’s long term partnership.)
Fred Wilson of Union Square Ventures, in an outstanding post at his blog, describes one key to successful long term relationships: “shtick tolerance“. You don’t have to accept everything about your partner – outside of integrity/honesty – but you must be able to more or less tune some things out over the long haul. You’re patient with their shtick because they’re patient with yours. It’s hard work.
The entrepreneur-VC partnership is a long term one, with shared skin in the game, and so the incentive is to communicate good news and bad forthrightly and in real-time, with both partners promoting transparency and honesty. That begins during due diligence, when it’s critical to resist the implicit pressure to sugarcoat the negative, and carries through to what legendary venture capitalist Bill Draper calls the “Oh sh- meeting.”
“When an entrepreneur has a first board meeting, we called that the ‘Oh sh—meeting.’ That’s when the VC finds out the bad news he didn’t know when he made the investment. How the VC reacts to that defines the relationship – it either becomes more brittle or closer.”