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Venture Capital Due Diligence: The Management Test

This is part of GoingVC’s Research Series on Venture Capital Due Diligence that originally appeared on our GoingVC blog

Introduction | The Screening Process | The Market Test | The Scorecard | The Management Test | The Management Team | Product KPIs | Building Product Moats | Accounting 101 | Financial Valuation | Technical Due Diligence

Screening the Team

Previously we looked at how VCs can screen deal flow as part of the due diligence process. Next, we turn our attention to arguably the most important factor when deciding whether or not to invest: the management team. In this and the following post, we’ll provide a methodology for assessing the founding team and vetting the strengths and weaknesses of the key leadership roles within the company.

Why the Team Matters (why ideas are a dime a dozen)

There are many quantitative methods VCs apply to assess an investment opportunity, but for all the spreadsheets and number crunching, nothing may be more important than a qualitative assessment of the founding team. At the end of the day, a business is nothing more than the collective efforts and decisions of the team. For early stage ventures, especially when hard data is rarely available, understanding the backgrounds, skills, and abilities of the inaugural team are critical to the due diligence process.

A good baseline assumption to make as a VC is that no ideas are original. This means it is important to be confident that you are betting on the right people to solve the problem. Given the obvious conflicts of interest that arise by backing founders solving the same problem, VCs need to ask themselves, “are these founders the absolutely best chance to bring a product to market that will solve this problem?”

So how can VCs vet the team?

As Scott Kupor notes in The Secrets of Sand Hill Road, the general partners at Andresssen Horowitz bifurcate ventures into either “product-first” or “company-first” buckets. Product-first companies are those where the founder(s) experienced a problem first-hand and are seeking a solution. On the other hand, a company-first venture starts with brainstorming possible business ideas before envisioning a solution. Kupor endorses product-first companies given the more “organic” approach to bringing solutions to an audience of users.

Brian Cheskey and Joe Gebbia realized there was a supply/demand imbalance when trying to find affordable lodging options while attending a design conference, so they hustled together some air beds and launched a service for folks needing a place to crash. Today that of course has grown into everyone’s favorite hotel alternative, AirBnB.

Beyond the Genesis story of the company, what unique skills, networks, and experiences do the founders have that are relevant? Again, picture scenarios where multiple teams are setting out to solve the same problem, what gives this team the edge? What unique experiences are held within the team? How much can they empathize with the potential end-users of their products or services? How are they able to take these experiences and craft an innovative story for VCs?

Keep in mind, however, that fresh perspectives can add value as well. Sometimes problems exist due to a fresh pair of eyes.

Google’s 20% rule (where employees were able to spend one day a week on their own side projects) was an attempt to allow the smart folks within the company to develop innovative products and solutions. From this came such apps like Gmail. Similarly, Netflix was born out of Marc Randolph’s and Reed Hastings daily chats during their commute and intent on building a new company.

The last area of concern for VC due diligence on the team is assessing leadership capabilities. Not only do founders need to attract customers to their products, they need to attract teams of salespeople, engineers, and of course potential investors. How well do the founders communicate their vision, the problem and their solution, their passion and knowledge? How do they handle conflicts and failures? How much skin in the game do they have?

Management Test

The management test seeks to understand if the founding team and/or management have the experience and capabilities to make the business successful, and is almost exclusively a qualitative test. Evaluation of management risk is most often cited as the most important part of early stage venture investing, making this test a critical one for VCs. Good management evaluation looks at both the individuals separately and as a team by reviewing their backgrounds and personalities and taking into consideration how they behave and collaborate together.

VCs must rely on past experiences in making these cases of the founding team. This is why serial entrepreneurs and those with extensive backgrounds in similar roles often have an easier time raising funds from venture capitalists: the management risk is lower. Outside of the founding team, the VC must assess if all key management roles are filled, what those roles are given the life stage of the company, and if not, if a plan to address these roles moving forward is in place. Below are guidelines to assess the management of the company.

Quality and Experience

Before the impact of the product can be felt by its users, the brand developed, or growth can kick in, the management team must be competent and demonstrate an ability to work well together. While early-stage companies will rarely have a complete management team, the ability to look to an advisory committee or board of directors will play a large role in the ultimate success of the company.

This is why execution over idea is paramount. How well the the team is prepared to handle new entrants to the market, competing products, price wars, pivots, and other challenges that eventually face all companies should be a primary focus when performing management due diligence.

For example, Marc Randolph, in his book That Will Never Work: The Birth of Netflix, details why he agreed to, after Netflix grew from an infant to a toddler, step into the President role and allow Reed Hastings to come on full time as the CEO. Not only was Reed a skilled and experienced business leader at that stage, he was able to recruit other top talent and his presence alone allowed Netflix to raise capital from other investors.

Ideas, products, and capital are always available — but it takes a great team to assemble them into an incredible company. At the earliest stages, VCs should look to the quality of the management team in addition to the potential market size as the two primary factors when performing due diligence. Do management teams need to be completely in place before being investable? No. VCs should have the strength and network to fill in gaps or make recommendations as part of their value-add as few entrepreneurs have access to the same resources as VCs — and should be primarily focused on identifying the market, gathering feedback from potential customers, and other things at this point than filling in the org chart.

Justin Camp, in Venture Capital Due Diligence, outlines two primary investigative methods to gather the necessary information to assess management team quality, the direct method and the indirect method.

The Direct Method

The direct method is the most obvious and robust method and requires, unsurprisingly, meeting directly with the founders and management team. These meetings often involve intensive Q&A (especially where there is no previous relationship) in addition to observing the team in practice, the latter of which requires keenly deducing information from interactions, signals, and behaviors.

Camp uses an example from Ann Winblad, founder and GP of Hummer Winblad Venture Partners, who uses what she calls the ‘Excalibur Test’ — where she sets forth a substantial task that must be completed before progressing in the process. These often include hurdles such as signing up a significant customer, bringing on an important management team member, or aligning with a key partner. “We don’t necessarily require them to complete the Excalibur Test, but we want to throw them in the thicket,” she says, “ and see if they come back out with the sword versus all beat up and scratched from the bramble bushes.”

The Indirect Method

A less hands-on approach falls under the indirect method, which focuses on checking references and performing background checks. These checks can be a timely but a rewarding experience for VCs. It is important to note that there is often an inherent bias towards positivity (i.e. most people do not want to say bad things about friends), so VCs should keep background checks and inquiries to those who have actually worked with the person in the past. These people can be past associates, bosses, customers, etc.

The following list of questions, compiled by Arthur Lipper, former editor of Venture magazine, can be used when checking references:

  1. When did you first meet __________ and under what circumstances?
  2. What was the nature and quality of the relationship?
  3. Are you still in contact with __________ and with what frequency?
  4. What bad things can you tell me about __________’s performance under pressure?
  5. Does (s)he seem to seek stressful or comfortable situations?
  6. How does (s)he handle failure or situations that do not develop as he planned or would have liked?
  7. In instances of failure or problems, does (s)he tend to blame himself, others, or circumstances beyond his control?
  8. When (s)he fails to succeed, how long does it take him/her to bounce back with alternative means to accomplish the same goal or with a new idea? Does (s)he get “frozen” into one approach?
  9. What can you tell me about the family relationships of __________?
  10. Can you think of anyone who might question his/her integrity?
  11. Do you know any people who dislike or have disagreements with __________?
  12. Other than the names of such individuals, can you tell me anything about the problem or disagreement?
  13. What are the best things or strongest points you can tell me about from the perspective of a future partner or investor?
  14. Have you been able to observe how __________ works with other people? Does (s)he work better with peers or those he is supervising? How does (s)he relate to superiors?
  15. Does (s)he complete projects undertaken or does (s)he become distracted?
  16. Whom do you know who is closest to __________ or in a very good position to provide insights about him/her?
  17. Did you expect this contact and have you had others of a similar nature? If so, from whom? Did you tell them the same as you are telling me?
  18. What do you think __________ will be doing 10 years from now? What do you think (s)he really wants to be doing 10 years from now?
  19. If you had an opportunity to invest, alone or with others, in a business to be managed and possibly controlled by __________, would you invest?

The above should be used in conjunction with the direct method as direct observation is a critical component of assessing management. Personal interviews that discuss past failures can uncover what really motivates someone and this, combined with non-verbal cues, can help VCs formulate a well-informed opinion on the founding team. Inquiring into the individuals understanding of the market, customers, problems and solutions, and all things related to the business help generate a more complete assessment of not only attitude, but ability.

Next Up? Filling the Gaps.

Now that we have a framework in place to assess the quality of the management team, we will turn next in our series on Venture Capital Due Diligence to identifying the key roles and attributes necessary for the executive team.



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