Even though the color of their money is always green, all startup investors are not the same. Struggling entrepreneurs are often so happy to get a funding offer that they neglect the recommended reverse due diligence on the investors. Taking on equity investors to fund your company is much like getting married – it is a long-term relationship that has to work at all levels.
Investor due diligence on a startup is not a mysterious black art, but is nothing more than a final integrity check on all aspects of your business model, team, product, customers, and plan. Reverse due diligence on the investor is a comparable process whereby the entrepreneur seeks to validate the track record, operating style, and motivation of every potential partner.
If all this checking sounds a bit paranoid and unnecessary, it may be time to take another look at some questionable investor practices and onerous term sheet requests. Beyond the technical issues, if the chemistry isn’t right, the impact on your startup and future business is likely to be similar to that of a bad marriage. It’s no fun for either side.
Thus, here are the minimum steps that I recommend to every entrepreneur in completing an effective reverse due diligence effort:
Get a perspective from peer investors. Of course you need to discount any investor competitive positioning, but local investment group leaders will quickly tell you the strengths and terms of active investors in your area. If your investor is unknown, or peers offer no positive attributes, take it as a red flag. A sample of three views is adequate.
Personally visit another startup funded by this investor. Through networking with other entrepreneurs, you should find one or more to visit that have relationships with this investor. Another approach is to ask the investor for references, where their involvement has made a real difference, leading to success.
Do research on investor visibility via Google and social media. Start by checking the profile and credentials of investor principals on LinkedIn and industry associations. Check for positive or negative news articles, press releases, relationships, and support of community organizations.
Invite the investor to dinner or fun-related activity. Outside of work is where you can best evaluate the chemistry match, and decide whether you can enjoy and learn from the relationship. Enjoy a sports event together, or find common non-profit causes to participate in. As with any relationship, it doesn’t pay to close in a heated rush.
Conduct a routine credit and background check. Look for investor experience in your business domain, as well as evidence of integrity and trustworthiness. Check the content of the investor’s website, and pay particular attention to the source of funds. Personal funds imply the most commitment, and offshore funding is most suspect.
Investor agreements should always be reviewed by an attorney who is familiar with startup equity investment deals. To get the terms you want, it’s better to start with your own term sheet. It’s even better to let the attorney do the negotiating, since many innocent-sounding protective and governance provisions can have long-term negative consequences to you.
While I recognize that there continues to be a shortage of venture capital for new entrepreneurs, compared to the demand, don’t succumb to the temptation to take funds from investors that you are not totally comfortable with. The result will likely be business demands that you can’t meet, loss of key personnel, potential lawsuits, and certainly not the fun lifestyle you expected.
The only successful entrepreneur-investor relationships are win-win ones. That means you and your business must benefit from both the money and mentoring from the investor, and the investor will win from getting a larger return sooner. Win-win relationships get better over time, whereas win-lose go downhill fast and rarely survive the honeymoon period. Know your partner well before you get married.