How to do due diligence on a potential funding partner

I'm often asked to give advice on how to get funding. In most cases, the answer is: "it depends". 

Usually, the founder I’m talking to has put together a list (to the best of their ability) of people that could potentially be contacted and pitched. Usually, this list looks like a "who's who" of big VC marketing budgets seasoned with a smattering of personal contacts.

The founder intends to reach out to all these people, narrow down to those who show interest, then begin the process of pitching, follow up meetings and hopefully getting funded. 

There are often two underlying assumptions that the founder hasn't fully thought through at this stage:

• What kind of funding is right for my business?
• Who would be the best fit for my business (now and in the future)?

The first question requires a lot of self awareness and realism about the stage the company is at and its prospects. Many founders haven't thought beyond the "I'll get a venture capital firm to give me a big pot of money and then I'll build something awesome" stage. Not all businesses need or should aspire to take VC money. Working this out ahead of time actually benefits both the founder and any potential VCs they might pitch. Very few businesses get VC money, and even if you do, it doesn't automatically guarantee success.

Just as all entrepreneurs have unique businesses, all funders are also unique. While the colour of their money is the same, there are many differences between funders (including VC firms). For example:

• The amount of capital they will offer
• The standard terms they offer
• Their track record in delivering added value
• The people you will work with day to day
• Their networks and relationships with other funders
• Their ethics and strategy for realising value from their investment

Treating all funders the same fails to recognise the differences that exist and leads to a very transactional relationship between founder and funder. Even within classes of funders (eg VC firms) there are significant differences. For founders, failing to pick up on these differences may, at best cause friction, and at worst be a contributing factor to the failure of the business.

Fortunately, there are now an increasing number of VC firms, angel networks and alternative sources of funding out there including debt and debt hybrids. So how do you find the "best" one for you? A bit of work is required, but a more thoughtful approach will lead to less time wasted and a better fit between founder and funder.

Potential funders (particularly VCs) take their prospects through a due diligence process that may include questions, meetings, psychometric testing, third party expert opinions and customer reference calls. An entrepreneur should do their own due diligence on the firm they are contemplating receiving funding from and entering into a long term funding relationship. Some of this due diligence should be done on the potential funder ahead of making contact, while other parts can be deferred to later in the process when it seems a deal can be struck.

I’ve compiled a list of ways in which you can due diligence a funder arranged in, what I think, is the least to most reliable order:

• Get an impression from the "vibe" of their brand and marketing material

This is a pretty poor way and encourages funders to spend a lot of money on marketing rather than value adding to their portfolio investments. It also perpetuates myths based on past success that may no longer be true.

• Listen to gossip from people "in the know" 

Everyone will have their own impression or anecdotes about a firm and the people in that firm - unless these are first hand experiences they are likely to be warped. Personnel at competing firms will either tend to give you platitudes out of professional courtesy or mild criticism if there is an advantage to be had regarding the deal.

• Read their website, medium posts and other outbound marketing material

Usually these sources are a pretty good source of information but aim to represent the aspirations of the firm and are scrubbed of any negative material (eg watch for disappearing portfolio companies).

• Talk to current portfolio CEOs 

They will most likely steer you towards the most favorable referees but if you can you should talk to a CEO who was in a similar to your situation and find out how helpful they were in reality and what to ask for and avoid.

• Read their performance reports they give to their LPs/investors. 

It's unlikely they will provide this but it will give you a real sense of their own performance, how they see their business and business model and how they represent themselves to their investors.

• Talk to former portfolio CEOs 

This is usually better than current portfolio CEOs because they have nothing to lose by speaking honestly. For extra insight see if you can talk to a former portfolio CEO that had a "poor" exit and see how the funder behaved in a difficult situation.

• Talk to former staff at the firm 

This will often give you real insight into the personalities and limitations of a firm, their decision making processes and what their real strengths and weaknesses have been over time.

• Form your own opinion based on most of the above and through multiple interactions over time.

Ultimately its the founder's decision so you have the responsibility and incentive to weight and balance the competing considerations and information.

There is definitely an asymmetry between funders and founders, but its not unreasonable to ask them to prove their claims (at least the ones that are important to your decision). Those that can back it up will be keen to do so to prove their credentials. The best funding deals are those where both parties’ expectations and capabilities align (ie where there are no major surprises after a deal is done). So, do your DD on funders, because they sure will do their DD on you, and you don’t want to be the one later finding out your new partner(s) isn’t who you thought they were.

Making an informed decision about who you take money from is I believe more important than how much money you raise or even the valuation you raise it on. Once you are committed its very hard to remove a shareholder or unravel a funding arrangement. So take your time to get it right - you owe it to your employees, your customers, your other shareholders and yourself.

Lastly, remember that Salesforce didn’t raise it’s first funding round from VC firms (it raised ~$7M from angels). It is now has over $10B revenue and a $100B+ valuation. Did the lack of a VC firm hold them back? Hard to tell, but probably not.