Q: What is the proper way to do due diligence on a VC firm?
Here are the things IMHO and IME that are most important.
First, if you want to do it right, you should diligence both (1) the firm and (2) the individual partner leading the deal.
Importantly, these days, more and more established firms aren’t able, or choose not to, raise another fund.
And these days, more and more partners with “hot hands” leave and start their own firms. The bull run and hot hands have created 600+ new funds since 2015. Most of these are started by folks that used to work at other, more established firms. If the partner leading the deal leaves the firm to start her own, this can leave your investment as an orphan, which can be a significant disadvantage.
- What are your top investments, and how much did you own in them, and at what stage did you invest? It’s not that hard to put $50k-100k in a hot start-up. Owning 10%+ in a successful start-up, and investing early, proves at least the firm knows how to spot winners. This question also shows stage alignment.
- Where would this investment be in the current fund? Beginning, middle, or end? It is better to be in the beginning, all things being equal. Because then there likely will be more “reserves” left for bridge fundings and later rounds. Not a huge deal, but ideally, you don’t really want to be the last investment in a fund unless it’s a later stage deal or one that doesn’t need a lot more capital. Funds run out of money, and as they do, there is triage for what is left.
- When will you raise the next fund? How big will it be? If you hear hesitation, the firm may not be able to raise another fund, or may be choosing not to. This isn’t the end of the world, but it is definitely suboptimal. Folks will start to fade away at a fund if it isn’t going to raise another one. They are on to the next thing.
- When do you do pro-rata? This will give you a sense of how sharp their elbows are.
- What are some examples of deals where you didn’t do your pro-rata? This is a tough question, almost a mean one, and a really good one. Really good. Investing is to make money. There’s no obligation to invest again, and you should never expect a second (or third) check. But learning how the fund works here will prove helpful down the road.
- What are some examples of investments where the start-ups were funded again, but you chose not to invest or only invest a small amount? A variant of the prior question.
In the end, the investment though is just as much about the partner as the fund.
Some good questions for the lead partner her/himself:
- Will you be a partner at the fund in 10 years? No one asks this. Ask this. If you are going long, you’ll still be running it in 10 years. Will they still be the one managing the investment?
- What is your favorite investment? You will learn a lot.
- What founders would not give you a strong reference, and why not? Everyone, even the most seemingly beloved VCs, has some CEOs that don’t love them. Find out why.
- What is your average check size? You’ll learn where you stand as an ‘average’ investment?
- What would it take for us to earn a second investment? Find out now.
- What’s a deal you wanted to do, but your partners vetoed, or otherwise didn’t get done? You’ll learn how much power they have at the firm, or at least, how much they used to have.
- What value do you really add to your investments? It’s often less than you might think.
- What investments have you done where the investors replaced the CEO? What happened?
- What happens if this investment for some crazy reason is a write-off (it won’t be, but what if it were)? Would your job be on the line? It’s good to know. It might be good if their job is on the line, they will care more. But they will also stress more. Maybe a lot more.
- What are a few partners at other firms you like to invest with? Which deals? Can I talk to them? A fun one.
- Can you intro me to 3 of the founders you’ve invested in? Yes, do off sheet reference checks. This will get you started, however. And the most important question to ask them is, Do You Trust Her/Him?
Some good ones.
Most of them, no one ever asks. Brand matters. But it isn’t everything.
And you should expect to hear some tough responses, if you are doing diligence right. I’ve done about 26 investments. I think, I hope, 23 of those founders will say I tried harder, helped more, and cared more than the rest. But I worry 2 won’t, maybe 3. Even though I did.
And a few related points here: How a Venture Financing Can Implode Post-Term Sheet | SaaStr