Startups: How VCs Diligence the Founders

A lot of investors talk about investing in teams. Many even suggest what characteristics are most “invest-able.” I wanted to list a few of the questions I like to either ask directly, or look for answers to indirectly as I’m doing diligence on a startup.

I don’t always ask all of these questions, and sometimes none (but figure the answers out in an indirect manner.) But this is a quick list of things I like to think about when figuring out if I can get excited about the team.

I hope this is helpful to other investors and founders alike. Please let me know your thoughts.

Where have you demonstrated excellence versus your peers in the past (in literally anything)? This is huge for me. I want to see that you are competitive, and that you keep score. I want to know that you have stood out in the past and that it was important enough to you to light up and get energized about it when I ask. You could have won your neighborhood hop scotch tournament at age 7, the thing you won doesn’t matter, but being the best does. When have you been the best?

What does being a leader mean to you? Do you understand the difference between “managing” and “leading?” How do you plan to do both at first, then delegate some of the management over time so you can focus on leadership and strategic direction? I love when a founder has a thoughtful and clear answer on this.

How can investors be helpful? I always get around to asking this in some way or shape. Nothing puts me off faster when someone tells me they want value-add investors, but then they can’t answer this question. This is really another leadership question. You have to lead your investors, and help them know how to help the company. This includes proactive regular updates, so that when decision making time comes, the backstory doesn’t have to be told (as much). Investors can only help you as much as you let them by guiding them and directing them to the places where they can be most effective.

Why are you the one to do this? Why are you passionate about it? What domain expertise do you have here? You or the team

How did you determine the equity splits (tells us how you handle conflict or tough topics as a team)? It’s not a problem if two founders are 50/50, but in the event that is not the case, I like to know why. If two founders are 50/50 then I like to ask a few questions about how they handle conflict and difficult decisions. It really comes down to what the internal process is going to look like when money gets tight, things are behind plan, and stress levels are high.

Integrity / Handling the hard stuff: Showing full command of the downside causes and outcomes comforts early stage investors. I want to know that when things get tough, you can clearly communicate the bad news, and think rationally through solutions without getting emotional or hiding the ball. I think most founders do not have integrity issues, but many people struggle to communicate bad news (not out of malicious intent). One way to show this in a pitch, is to highlight the risk factors early and discuss how you mitigate them. Maybe even highlight a couple of the risks that if the investor isn’t going to be OK with, then this risk profile isn’t for them.

Who are our mutual connections? This one is obvious and clearly everyone does this but if you’re at the seed stage in an industry I focus on, and you’re not connected to a few industry experts that I respect on social then I wonder either how hard you have been trying or if you’re not as far along as you suggest. Either are fine and we can overcome, but it is something I notice.

Do you associate with known winners in the ecosystem? Or do you spend your time with those who talk a big game, but do not deliver. Everyone knows who those people are in each startup ecosystem, so you should avoid them.

Timeliness and efficiency of communication during the diligence process. I’ve seen a few founders who are great at this, then after investment, go somewhat dark or are hard to get information from (or the right information). It’s rare that this happens. However, if there is any red flag at all in diligence phase that working with a founder, communicating with a founder, or getting information to help with decision making will be a challenge, that is an immediate pass for me.

Can you build a team of rock stars in the early days? Everyone says yes to this. However, hiring top talent at a startup when cash isn’t readily available is hard. Leveraging your investors here is always helpful, but I do like to ask about your plan to find, and successfully hire top talent. It’s OK if that plan is “I’m going to ask you for help” but you need to convince me that you can sell the top talent on coming on board for a low salary and some option.

Finance — sources and uses of cash during scaling (AR, etc.) — I’ll ask “what are some financial risks to rapid market adoption and scaling” and you should know that if you have a big top line growth month, you could see a large increase in AR which will be a use of cash. Most founders I talk to think through the P&L only and don’t discuss the balance sheet or cash flow statement part of their projections (if they have them). I’m not saying you have to have GAAP financial statements from day 1, but you should be able to think through the CFO or Treasurer duties until you’re able to afford to hire one. Worst case, you need to be keenly aware of your lack of knowledge here and that you need help (instead of dodging the topic or stumbling around it).

Stephen Hays is Managing Partner at Deep Space Ventures, VC firm based in Dallas, TX that focuses on both esports and B2B enterprise startups.

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Startups: How VCs Diligence the Founders was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.