Perform Due Diligence on Potential Investors
October 18, 2009 Leave a comment
Entrepreneurs ought to vet angel investors and venture capitalists using a “reverse” due-diligence process. Here’s how to do it
By Tom Taulli
Before your company receives an infusion of equity capital—whether from a venture capital firm or an angel investor—an investigation into your operations usually takes place. The process is commonly known as due diligence, and it can be grueling since the investor uses it to try to uncover weaknesses, potential liabilities, and risk exposures.
I propose the following: why not perform a similar investigation on your potential investor? After all, she will essentially become your long-term partner. Knowing her background, in terms of prior deals, industry expertise, and executive stints, is important.
Assuming the investor will allow you to engage in reverse due diligence (and it’s a warning sign if she won’t), how you start the process depends on whether your investor is a VC or angel. It’s generally easier with VCs, since there will probably be more information available on the firm than on an individual or an angel group.
Let’s start with VCs. Here are my suggestions.
1. Visit the firm’s Web site and read everything. Who are the partners? Experience? What are the prior investments? Industry focus? If a VC does not have a background in your industry, then it can potentially make for a difficult relationship. For example, suppose your company develops enterprise software. It can easily take one year to develop the first version and another year to get a paying customer. If an investor is expecting revenue within the first year, this could result in a big fight.
2. Check out online resources such as LinkedIn for connections with information about the firm. From there, you can call on companies that the VC partner has been involved with. Pick up the phone and get in touch with as many companies as you can. Ask them: How was the experience? Were there problems? Another good resource is TheFunded.com, which has thousands of user reviews of VC firms.
3. Be careful with offshore investment funds. Cliff Risman, a partner at Gardere Wynne Sewell, a large firm with offices in the U.S. and Mexico specializing in business litigation, says there may be serious problems in taking such capital. Hypothetically speaking, let’s say the source of capital is from Latin America. What are the fund’s sources? In some cases, your company may need to get clearance from the State Dept., Treasury, or other government organization. If clearance isn’t granted, you may have to return the money.
4. Be aware that in light of the recession, VCs are getting much more aggressive on their terms. They will want more restrictive liquidation preferences (the amount VCs get when there is a merger or public offering) as well as more equity in subsequent rounds of financing (called anti-dilution clauses).
5. Be wary of aggressive terms. In the current economic environment, some VCs might try to take advantage of a company’s weak position and attempt to take over its operations. To get a sense of what’s reasonable, check out one of my previous columns on the topic. Be wary of a 2X liquidation preference (which means that, in the event of a merger or public offering, the investor will get at least two times the investment back before anyone else). Also, stay away from a so-called “weighted-average” ratchet clause, which gives a huge slug of stock to the VCs if the next round is at a lower valuation.
6. Build and maintain a relationship with the investor. According to David Brennan, the chief financial officer of venture-backed I Love Rewards, based in New York City, it’s important to have chemistry with the associates and partners of a VC firm. Since the investors will be involved in crucial decisions, there has to be an element of trust and comfort. “Meet as many partners and people from the firm as possible,” he says. “Build relationships with the partners. If your contact leaves, you want to work with someone who knows the company and has your best interests in mind.” (See this recent story on what to do if your VC does leave.)
Now, here’s my advice on angels:
1. When crafting the shareholder agreement, be extremely careful in deciding who controls what. For instance, if you give an investor veto rights over important decisions, such as on the approval of the next round of funding, this could be used later to pressure a company to provide better terms for him or her—or even get paid back on the investment.
2. Do a background check. A simple Google search can reveal helpful information, such as news stories about lawsuits or even criminal violations. Next, it’s a good idea to conduct a routine credit and criminal check. There are a variety of helpful services, including HireRight.
3.If possible, try to focus on angel groups instead of individuals. These tend to be local organizations made up of 30 to 50 investors. On each deal, anywhere from 10 to 20 angels will invest. They will also share duties, such as due diligence and deal structuring. Instead of taking your chances with one person, these groups usually understand the investment process and have members who are qualified (in terms of financial background and startup experience).
4. Put the agreement in writing. Eugene E. Mueller, a deal attorney at Laguna Niguel, Mueller Carey Group, based in Laguna Niguel, Calif., recommends that angel investors sign an “investment letter.” It should say that the investor has had access to company records/financials; is not buying shares to resell them; has not relied on outside representations not made in the letter; has read the investor documents; and understands the substantial risks involved and that he or she may lose the entire investment. For more, see my previous column on angels. Basically, the investment letter is a way to set the expectations of the investor. As much as possible, try to stress that growth companies are risky and can take years to produce a return.
It’s extremely tough to raise capital now. As a result, it’s tempting to take money from any source. But this can be a big mistake—there are just too many examples of entrepreneurs who end up with investors they don’t like. Complaints run the gamut from constantly pestering and complaining to funding competitors to deposing the CEO. So be vigilant and ask questions. To be successful, you need investors who understand the opportunity and are patient.
Tom Taulli is a noted finance author and blogger.