Asking the Right Questions

VCs won't put money into startups until they know who and what they're dealing with. Smart entrepreneurs play by the same rules

By Gabor Garai

Venture capitalists are big believers in due diligence, the process whereby they investigate the track records of the entrepreneurs under serious consideration for receiving investment funds. Understandably, venture capitalists (VCs) want to do everything possible to reduce their investment risks.

Entrepreneurs tend to be so thrilled to be under consideration that they pay little attention to the track records of the VCs who are considering providing funds. Yet in my experience, entrepreneurs would do well to perform their own due diligence.


  Once they invest, VCs have a huge amount of power, to the extent that they can force changes in management and determine whether there will be followup investment funds available to keep a startup going. To reduce the risk of getting in with the wrong crowd, entrepreneurs should ask some pointed questions of their own, including the following:

• How much "value added" is the VC firm likely to provide? VCs are fond of arguing that entrepreneurs gain all kinds of "intangibles" in exchange for selling stock to the professional investors -- business advice, networking opportunities, key contacts -- and that these actors help justify a lower valuation, vs. what an entrepreneur might have obtained from family or angel investors.

• What will be the nature of the VC's representation on the company's board of directors? VCs will insist on at least one person from their firm sitting on the board. But beyond that, they may also demand a free hand to designate additional directors -- even to the point of dominating the board. Such control, of course, gives VCs the power to make major decisions about company strategy -- including whether or not to fire the founding management team.

• To what extent will VCs provide additional financing? Startups that receive initial venture capital invariably require a second round, and even a third round, over subsequent years. Ideally, the VC firms that provide the initial round will reserve funding in their portfolio planning for additional investments. Moreover, this additional money should come at a higher valuation than the first round, assuming the company has been meeting growth targets (See BW Online, 5/9/03, "How Much Is Your Outfit Worth?")

• How can entrepreneurs obtain answers to these questions? First and foremost, entrepreneurs should examine the performance of other companies in the portfolios of venture capitalists. Ideally, you want to see that a significant majority of the companies have been successful. That tells you the venture capitalists likely do provide the sort of value-added elements they brag about, such as business consulting and access to important contacts. It also tells you that the venture capitalists likely work with management to work through problems rather than firing founders at the first sign of trouble.

• entrepreneurs should question the VCs about their approach to investing. Ask for the names of individuals who would be designated to join your board of directors. You need to meet those individuals and determine whether you feel comfortable working with them. You also need to determine if representatives of the VC outfit have the seniority and clout to be heard should the going get rough.

• Develop a list of scenarios about how your business might evolve, and quiz the VC firm's representatives about their likely responses. For instance, supposing you are lagging six months behind sales targets, thus requiring $2 million of additional financing, but still seeing strong market acceptance. How will the VCs respond? If it emerges that they have replaced management in similar situations, how were those founding executives treated in terms of severance pay and stock options?


  Finally, speak with other entrepreneurs who have received funding from the VCs you are investigating. Make it a point to speak with entrepreneurs who have gone through some kind of a crisis. How did the venture capitalists react? What actions did they take?

The reality is that every question may not be answered to your satisfaction. For example, it may be a relatively junior representative of the VC firm who is assigned to sit on your board. But if all other things seem okay, you may be prepared to accept that situation. What's most important is that you'll be going into the financing well informed.

Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.

Before it's here, it's on the Bloomberg Terminal.