Conducting customer reference calls: a perspective from a VC point of view (that may also be helpful for start-ups)

The most invasive due diligence step that VCs have to do before pulling the trigger on a new investment is the customer interview.

On the one hand, this is often the most valuable information an investor can get: it is very difficult to replace an actual customer giving direct feedback on how they chose to work with Company X, what competitors they considered, how their experience has been, etc.

On the other hand, this is incredibly difficult for the start-up. They don’t want to subject their customers (who are almost always busy people) to call after call from potential investors. Even worse, it potentially raises questions in their customers’ minds: will this start-up have enough funding to follow through on their commitments to me? Will they even be around a year from now? If the investor decides not to invest, it is embarrassing to the start-up and potentially really damaging to their relationship with their customers.

There are many things that start-ups can do to minimize this disruption. Some of the more common ones that I’ve seen include

• Creating detailed notes/ transcript from one investor who does a deep dive, and making those notes available to other potential investors
• Scheduling a group customer reference call: one investor leads the Q&A, while other investors can submit questions to him/ her

The above can work fairly well, but it only works for highly structured financing processes, which is not the case for most start-ups (who have investor interest trickle in over time).

A couple of years ago, we were looking quite seriously at a start-up. The founder had spent a fair amount of time with us, and she was very compelling. There were some questions about the business scalability, and we wanted to talk to customers to understand their implementation process, their potential growth with this start-up, and other questions that would speak to the future scalability of the opportunity. The founder was (rightly) reluctant to have us talk to her customers, and asked us to make this the “final step before we would make an investment decision”. We agreed, and held off on the interviews until we felt that we were close to a decision.

We conducted the interviews, and they were generally favorable. However, not favorable enough to get us over the top. In fact, the interviews confirmed some of our concerns.

When we sent the founder our rejection decision, she was livid, and I felt that her anger was justified. We had not made our expectations clear: in her mind, this was a process step (ie., we wanted to confirm that these customers were indeed working with her, and happy with her company). In our mind, this step would provide necessary content: if the customers could assure us of scalability, then we were ready to invest.

This incident led to some soul searching, and I think that we came up with a fairly elegant solution.

We are now very transparent about what we’re looking for with customer reference checks, and even create the parameters. Ie., we tell the founders: “pretty soon, we will need to do reference checks. Here are the range of things that the customer may tell us”… and then we create some paragraphs that express the sorts of answers to our questions that we might expect.

Then we ask the founder: “what do you think your customers would say? Do these potential answers make sense to you? Which would you guess they would choose? And, if you don’t see anything like what you would guess they would say, draft your own potential reply”

This has proven to be incredibly valuable. For one thing, it forces us to be honest with ourselves: what are we actually looking for customers to say? What would sway our decision one way or the other? It also provides a high degree of transparency to the start-up– they know that we’re not just on a random fishing expedition, and they can save us a lot of time. If they already know that the answers are not going to reach our “investment bar”, there is no point for us to disrupt their customer relationship.

Of course, this creates the counter problem of incentivizing the founder to coach their customers on exactly what to say. I am actually not worried about this, because it comes down to interview skills: you can always dig deeper into the questions to get to the heart of the matter that we really care about.

In the end, I strongly believe that investors and start-ups can help each other a lot through full transparency, and hope that this “note from the field” is helpful to folks on both sides of this particular table.