Just Due It: The Entrepreneur’s Guide to Investor Due Diligence

Potential investors will undoubtedly do theirs on you. But do you know how to do the same with them?

Here at BuildGroup, we recognize that trusting an investor with your company is a big deal. We want to equip you with the knowledge it takes to vet investors so that you can make the best decisions for your company. 

Jim Curry, co-founder and CEO of BuildGroup, “Godfather of OpenStack” and Chief Banh Mi Enthusiast elaborates on key due diligence questions for founders to think about in this Q&A.

Q: What makes for a good institutional investor?

A: What you’re really looking for here is alignment. Let me tell you what I mean by that.

If your objective is to grow fast, burn as quickly as possible, there are investors for that. If you’re looking to convert the world from carbon to carbon free, there are investors for that. If you are someone that is more focused on longer term building, there are people like us.

You have to remember that anybody who goes onto the cap table… they’re a co-owner, just like you. That’s the biggest challenge. The number one thing I run into is serious strategy disagreements between investors and management teams. You need to avoid that as much as possible. 

The only people who can make the decision as to who they are going to allow onto their cap table are the entrepreneurs themselves. They need to be very careful in vetting investors and being picky to achieve alignment.

Even in a situation where you need to take capital from partners that may potentially be a bad fit, you need to be aware that there is a lack of alignment. You also need to be aware of the places where alignment does not exist and be willing to live with that.

Q: What are different types of investors and what’s good or not so great about each of these types?

A: Broadly, they come in all different types...here’s two that stand out to me.

There’s the Enthusiast. You could call the Enthusiast the original investor personality. 

The VC industry started in the 70s when investors were basically former entrepreneurs who loved tech, loved gadgets, loved software and wanted more of all of it made. They were always willing to write a check to get something built. It’s about bringing products to market.

They’re engaged. They’re passionate. They have lots of opinions. You need to be ready to work with them and have a partner. If you know how to manage them, you can get a lot out of them. 

There’s also the Dealmaker. Maybe they care about tech, gadgets, software, maybe they don’t. They’re neutral. They are dealmakers. 

They are all about making the money and they make the money by structuring the right deal on the entrance and the exit. The Dealmaker has fewer opinions on building the company’s platform, but they are experts in how to structure good deals. On the entry, that’s not necessarily great for you. But it’s great on the exit. It’s going to lead to a great outcome. They are going to help you build a company that’s sellable.

There’s a case to mix these together and have them both on your board. Personally, I like to work with enthusiasts, but it depends on what your objectives are. 

Q: How do you know if an investor is long term? How do I assess this?

A: Great question. You could argue that in the world of tech, it’s very possible we’re going to have a hard time holding a company for 5 years. The reason being it is a fast business. Acquisitions are a regular part of how an industry operates. As investors responsible for managing other people’s money, if somebody comes by and wants to pay an unreasonable amount for our portco, we should do that.

So just because somebody is selling doesn’t mean they aren’t building something for the long term.

Q: When you’re running the company, what’s the goal in how you manage it?

A: If the goal is to pass this off in 3 years to somebody else, then the investor wants to juice revenue growth as high as possible.

If the goal is to make long term investments, then the investor thinks about driving investments for long term power. Long term investors don’t necessarily think with regards to revenue growth or burn. They look at what gives the company power over a 10 year period. A lot of the investments the long term investor makes now won’t yield benefit for 5 years. 

Here at BuildGroup we use the 3 horizons model. 

H1 are existing businesses. H2 are experiments that yield revenue in 18-21 months. H3 are businesses that we’re working on now that won’t start yielding revenue for 4 or more years. Collectively, H2 and H3 should be 20% of your budget. If you’re short term, you won’t even think about this…

The best companies, in my opinion, are built for the long term. When you’re building for the long term, you get better exits. The investor needs to think about how to prioritize the work they do at the company.

There are structural, more tactical components to this. Funds have 10 year lives. VC funds are obligated by legal docs to liquidate after year 10. They can’t hold an investment for longer than 10 years. By definition they need a liquidity event to get out.

BuildGroup is structured differently. No imperative to liquidate.

Q: How many investors should I have on my cap table?

A: Well… it is not necessarily all about the number of investors, it is more about how they work together. It is important from the beginning to establish the person to whom the CEO will be deferring on big issues so there aren’t ‘too many cooks in the kitchen’ dealing with these immediate problems as they arise. It all ties back to alignment and management. 

One of BuildGroup’s first priorities when starting with a new portfolio company is to establish who on the cap table will take charge of big problems whose solutions can’t wait for negotiation. It's alright if BuildGroup doesn’t take the lead on some deals, but it is vital to the success of the portfolio company to determine this role before entering growth stages.    

Q: Should I invite celebrities onto my board or cap table?

A: This really depends on your company and the celebrity proposing to invest. Alignment is important here as well. You have to match your expertise to your investor. Ignore the celebrity factor and ask yourself if this investor has expertise in your business’s market. 

Celebrities can definitely be valuable from a promotional objective. You can certainly make your brand more visible with celebrity support, so there is reason to have them on your board or cap table. 

BUT just taking celebrity money for no reason is no more valuable than taking anyone else’s dollars. 

Q: How do I get the most out of my investors?

A: The number one thing is make them work for you. Engage with them. Over Communicate.

Overcommunication reminds investors of your agenda and your priorities. Put yourself at the top of their minds, because you never know when they might be able to help.

Know what your investors are good at and get them to do it. This can be everything from making introductions to having them help you with your sales model. You could even have them be the leaders on doing the next capital raise.

At the end of the day, it is a matter of if they are aligned to you and using this alignment to your advantage.

Q: How should I go about doing diligence on potential investors? What questions should an entrepreneur put on their Investor Diligence checklist?

A: Entrepreneurs often miss the chance to test investors in real time when vetting VCs. They come in and they’re asking very mechanical questions - what stage do you invest at, etc. You want to get a sense for what it’s like to work with these investors. 

They’re going to tell you whatever they want you to take away from that first phone call. We’re friendly, we’re great, we’ll do whatever you want. It’s hard to know if they really mean it.  

I think the best thing to do is understand how they think and operate. Tell the investors you're considering, “I’ve got a real-time business issue I’m struggling with. I want to brainstorm with you on it.” This real-time test will help you determine if the fit is right. 

You can customize based on the type of investor you're talking with, Enthusiast or Dealmaker. For the Dealmaker, approach them with a transaction type puzzle. Throw them off and have them engage in a series of case studies on your business. Think about the type of investor you are looking for, and ask them questions that force them to engage with you.

Remember too that you’re actively trying to find lovers and haters of the firm you are considering. Where are the bare edges of conflict? You’ll get much more value out of those reviews where things didn’t go well. Not to prove things are going to go poorly, but what you’ll learn is how they operate and whether it would be valuable for your business.

Investor Diligence Checklist

To make it extra easy for you,  we took Jim’s insights and created an in-depth Investor Diligence Checklist that you can use to quickly and confidently vet potential investors.

Printable Checklist

This content does not constitute or form part of an offer of any investment advisory services of BuildGroup Management, LLC, nor does it constitute or form part of an offer to issue or sell, or of a solicitation of an offer to subscribe or buy, any securities or other financial instruments, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.