Why you need to do reference checks on your VC.
Early-stage fundraising often appears to be a one-sided struggle, in which the founders are knocking on dozens of doors in order to finally raise the money they need. However, it really should be a two-way street as it is with any other type of relationship. VCs provide way more than just money, of course, they also bring in their expertise, network and support to the table, which sometimes can make the difference for the startup. In addition, they also bring a new form of power into an early-stage company, which makes the founder's decisions partially depend on someone else for the first time.
VCs typically have extensive control rights over the startup, including board seats, veto power, and investor majority approval rights. These control rights can significantly influence the startup’s strategic decisions and potentially limit your ability to pursue your vision. This includes decisions around your upcoming financing, hiring key positions, your business planning and of course discussions about potential exits. In the end, your VCs can become so influential that they can drive the founders out of the company - in the worst case without any financial compensation (e.g. bad leaver vesting).
Luckily, we didn’t see a lot of struggle with our founders and their VCs, but they definitely do exist. In the end, it’s really about human relationships and these do have a tendency to sometimes not work out after all - as we all know.
More Than a Marriage
The fatal point here is that relationships with your VCs can’t be untangled easily and normally there is a lot of monetary interest on the table. Unlike a marriage, however, separating from a VC is almost never happening.
Therefore, it becomes imperative to make an informed decision to avoid potential conflicts and difficulties down the road. Of course, the best way is to really get to know your prospective VC in the process. Build a long-term relationship early on by getting in touch before you actually start your fundraising, share your updates with them and allow them to get to know you. In turn, you will also get to know them and build a relationship.
VCs Do Reference Checks - And So Should You!
However, this normally only involves “casual” elements of the relationship and not how things could turn out in rough times. VCs know this and will conduct reference checks on you as a founder once they enter the Due Diligence (DD) process. This means they will ask your peers, colleagues, bosses, customers, etc. and talk with them to find out how you really tick.
However, it’s important to note that a VC’s strategy includes the highly likely option of your company to fail. Hence, ultimately they are most likely less dependent on you, than you are on them. Especially because of the potential power imbalance and the huge influence of the relationship on your startup, we urge all founders to actually do reference checks on your VCs as well!
How to Conduct Reference Checks:
1. Focus on Your Partner and Investment Manager
While the reputation of the VC firm is crucial, regarding the relationship it’s even more important to evaluate the specific partner or investment manager who will be directly involved with your company. Of course, this includes your personal fit and their character, but also other criteria:
a. Consider their political capital within the VC firm, as it can impact their ability to advocate for your company's interests effectively. This is often a “book of seven seals” for founders, but internal VC politics can be extremely influential on your company. Here it’s important to have a counterpart that is both able to exert influence and has the authority to make decisions within the partner circle. Read more about it here from Mark Suster.
b. Assess their willingness to stand up for their beliefs and to put in the work for you, particularly when it comes to championing your company within their firm and among their peers. It’s important to see that they are willing to assist you beyond financial backing, e.g. by doing introductions to potential customers, helping with your fundraising or guiding your strategically.
2. Request a Good and Bad Reference List
Once you start to collect references from your VC, ask them to provide both positive and negative references. This approach allows you to gain a well-rounded perspective on their relationships, especially for what happens in bad times. Speaking with entrepreneurs who have experienced challenges or setbacks while working with the VC will tell you how they support their portfolio companies during difficult times, for example, if they continued to help and find solutions together with the founders.
It will also reveal a lot about their individual characters - as everyone is happy as long as the sun is shining, but the truth is revealed when dark times hit.
3. Go Beyond Their List
In addition to the references provided by the VC, conduct your own research to identify startups that did not work out. A lot of VCs do not actively communicate their failures (e.g. see our own failures here) Use platforms like LinkedIn to find people from failed companies and ask them about their relationships and how they went down. By going beyond the recommended reference list, you can uncover additional perspectives and information regarding the VC's character, reputation, and attitude.
Dare To Make Reference Checks Yourself!
Selecting the right VC is a crucial decision for entrepreneurs, as it can significantly impact the trajectory and success of your startup. Thorough reference checks provide valuable insights into a prospective VC's track record, values, and commitment to supporting their portfolio companies. By focusing on the partner or investment manager, requesting a balanced reference list, engaging with companies that faced challenges, and conducting independent research, founders can make informed decisions and forge strong partnerships. Reference checks are a critical step in ensuring a fruitful collaboration between entrepreneurs and VCs.
Are you a founder and currently raising?
Hit us up, we are happy to connect: www.jvh-ventures.com/pitch