Friday, November 30, 2007

Hazardous Attitudes: Disregarding VC Due Diligence

The FAA identifies five "hazardous attitudes" that have proven so dangerous to pilot decision making over the years that they are explained in the FAA "Pilot's Handbook of Aeronautical Knowledge" and included by reference in exams and regulations. These attitudes are Anti-authority ("Don't tell me."), Impulsivity ("Do it quickly."), Invulnerability ("It won't happen to me."), Macho ("I can do it."), and Resignation ("What's the use?").

Working with startups, I've seen entrepreneurs exhibit all of those attitudes when trying to convince others (and themselves!) that they needn't worry about VC due diligence.

I would advise those entrepreneurs -- and any wannabe entrepreneurs -- to read Rick Segal's fabulous post on due diligence. In addition to giving advice, Rick explodes a commonly held notion that VC due diligence is just a formality and that, if you get to the d.d. stage with a VC, you're all set, you can just wait for the wire transfer to hit your bank account.

Due diligence is real -- Rick suggests that one or more of three deals he's currently looking at will not close because of problems at the due diligence stage. Read that sentence until you believe it. Then, before you tell yourself that it doesn't matter because you're going to bootstrap, you'll never need a VC or a corporate investor, go back and read the five hazardous attitudes again. If you think success means believing in Plan A so much that you don't bother preparing a Plan B, the odds are you'll be laughing about this failure some time down the line over a beer.

Now that we've got that out of the way...

A couple of Rick's points that deserve emphasis:

  • Financial Forecasts. Of course they'll be rosy. What's important are the assumptions. Where did you get your data? How hard did you try to get good data? Is the logic that ties the data together sound?
  • Business Thesis and Assumptions. "... [W]hat do I have to believe?  What do you believe?  And, of course, what are the assumptions behind those beliefs. ... You have to have the same story, metrics, thesis, etc, from day one." If you change your execution plan a few times, that's to be expected. If your fundamental beliefs about the space are changing faster than you can execute, you have little chance.

At some point between the kitchen table stage of your startup, and the time when you walk into a VC meeting, the following things will become relevant. Plan accordingly:

  • "Understandings" or "Gentlemens' Agreements" with investors or employees. Unusual terms can be changed or dealt with at VC time, but I wish I had a buck for every time a CEO told me these issues would just melt away because everyone would be so pleased at the prospect of making a big deal or closing a round.
  • Questionable expenditures. This can either be a few big items or systematic spending that adds up. Don't do it, and if you do, don't try to hide it or hand-wave. I've seen a VC identify a six-figure sum missing from the books, and still make the investment. The firm identified the issue and decided they would arrange the deal so as to handle it and get it under control. It wasn't a showstopper for the company, but it was the end of the line for the guy who tried to cover it up.
  • Team issues. Although Rick says that not every VC would talk to all the employees in a small company (he would), it's a good bet that your core exec team -- and probably everyone in your first 8 people -- will get a good grilling regardless of the VC. The team has to be a team, and you won't be able to fake it. This doesn't mean everyone needs to agree or be buddies, but they need to function properly as a group. If you don't have a team, the VC will figure this out, and your funding is unlikely.
  • Product. Ok, this should be obvious. You can spin the marketing claims ("a better way to manage your contacts" could be anything) but you can't fake the technical claims ("syncs up to 5,000 contacts to any device" is either true or it's not).
  • Customers. Although some VCs seem to be trying to get all the risk out of their portfolios by investing only in companies with a solid customer base, that is their problem, not your excuse to pretend you have customers that are fictional, occasional, or just plain unlikely.

If you still think this is all hypothetical, or won't affect you, then take another look at the five hazardous attitudes and ask yourself: are you really planning for success? just closing your eyes and hoping? or fooling around and enjoying the ride?

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