You’d Better Shop Around: Doing Due Diligence on Your VC
For a first-time entrepreneur, dealing with a venture capitalist can involve an equal mix of excitement and apprehension. If the VC has any sort of reputation or prominence, entrepreneurs are often grateful simply to be pitching their idea in the first place. Should discussions get far enough along that a term sheet is offered, a new entrepreneur is usually thrilled beyond words.
Those certainly were my emotions back in my entrepreneurial youth, the first time I dealt with venture capitalists. It was one of the most exciting times of my life. But I also remember a few other, much more troubling, emotions, and I know that these, too, are part of being a first-time entrepreneur. These involve the vaguely-formed stories that many entrepreneurs hear about the dark side of the venture world; stories of VCs who weren’t trusted partners interested in growing a business, but who simply took advantage of inexperienced or unlucky entrepreneurs for a quick, unsavory gain.
I fortunately never had to deal with that caliber of VC, and I don’t think you will, either. Telling one kind of VC from the other is much easier than you think, even if you are a first-timer. The task requires entrepreneurs to use a little common sense, and to do some of the same sort of the due diligence with their VCs that their potential VCs are doing with them.
First, the common sense. If you’re lucky enough to be dealing with a top-tier venture capital firm, you have much better things to be doing than fretting that your venture firm is plotting to steal your company away from you. The technology world seems sprawling from the outside, but once you are actually inside, it’s a rather small and tight-knit community. No venture fund can get to the top of this world via a career of double-dealing.
But what if a potential VC partner doesn’t have an obvious bit of Silicon Valley pedigree? This is where due diligence becomes important. Every VC lists their investments on their web site; give some of those investments a call and ask your counterparts what their experiences have been like. Good VCs won’t mind being “checked up on” in this way; to the contrary, they will view it as an indication of your seriousness and thoroughness.
If you end up doing business with a VC, the interaction will be based on the term sheet that spells out the particulars of the venture firm’s investment in you. Term sheets can be extremely complicated documents, and you’ll need the guidance of an experienced lawyer to help you with your side of it.
I am not that lawyer. But there is one element of a term sheet I’d like to mention, in part because it seems to confuse many entrepreneurs, and in part, I regret to say, because I have occasionally seen unscrupulous venture capitalists use it to their advantage.
A “no-shop” clause is often, but not always, a standard part of a term sheet. During the period covered by the clause, the entrepreneur agrees to not go looking for a “better” deal from a different investor. The purpose should be obvious: to allow VCs to complete their due diligence on a company without having to worry that the entrepreneur will be using the time to find more favorable terms from some other VC. That’s fair and proper.
There is no “average” length for a no-shop clause. In some cases, they needn’t be longer than a few weeks, while in some deals—such as when final funding depends on a key technical hire, like a CTO—they can stretch out for several months.
It’s these longer no-shop clauses that should be cause for concern. Again, there are many cases when a period of 60 or 90 days is entirely justifiable. But I am also aware of a small number of VCs who, when working with companies who are precariously funded, deliberately write in a long no-shop clause into a term sheet.
At the end of the period, the company is out of money—exactly as the VC envisioned. Since the entrepreneur at this point is out of options, he/she is basically forced into a new round of financing that essentially gives away control of the undertaking to venture “partners.”
Fortunately, these stories are exceedingly rare. In fact, at Claremont Creek Ventures, we sometimes have short duration no-shop clauses or skip them altogether. Like most VCs, we are as excited about great companies as the entrepreneurs with whom we’re working.
Our goal is to convince an entrepreneur to partner with us not on account of a few lawyerly paragraphs in a term sheet, but by persuading them of the great things that can be built by marrying their passion with our experience and our passion for great ideas.
The bottom line is to remember you want to work with venture capitalists who think like entrepreneurs and with whom you can build a long-term relationship. That’s the key to success.