Due Diligence
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Hello, Limited Partners, and welcome to Seattle, David. Yeah, it's great to be here. First time in the fully converted home podcast studio. The Wave Capital North slash Gilbert abode. It's looking really good. There's a lot of sound dampening happening in here. Yeah, you should up your listing price on Airbnb with this in here. Yeah, no kidding. All right.

I don't know if that would play well or not well if it was like, stay at this Airbnb, also a podcasting studio. It's like, I suppose you actually probably would be really nice if you were looking to do a podcast on the road. Well, having, we have acquired, you know, have traveled to our guests and looked for a podcast studio. If we could find an Airbnb that also has a studio. This could be the Impact Hub Santa Barbara of the North. Yeah. Yeah.

All right, Limited Partners, today we are talking due diligence and specifically about sort of what's normal in a fundraise for a firm to ask for. What's the sort of reasonable amount of probing to do? And the reason we thought this episode would be

particularly helpful or particularly sort of actionable is it's really easy when you're a startup that has limited time to let investors drag on and on and on and on because they're not frequently on a timeframe until it's a competitive deal or something, you know. And you also, especially in the early stages, don't really know what's normal. You know, you only do this a

limited number of times. We should be clear too, we're talking about due diligence for a venture capital financing round. Yes. Which is very different than due diligence for say an acquisition or another type of transaction. Yep. We will talk about sort of the due diligence at different stages, you know, starting here with Seed and then working later and later. The TLDR on that is that a lot of these sort of legal technical accounting stuff becomes more and more important the further you get, but we will get into that.

Getting back to really the mission here is sort of trying to get more information out there about what you can expect, what's reasonable, and frankly, like to prepare entrepreneurs for diligence is a time consuming process. But, you know, something that long term, everybody around the table and being involved in the company feeling like you all sort of

know the good, the bad, and the ugly together ends up being hugely value-creative for everyone. And so I think the right amount of diligence is a great thing for a company, frankly, whether there's investment or not. Yep, yep.

Thank you to limited partner Scott Elchison for suggesting this in the Slack. I think David and I had some ideas for what we wanted to do on this LP show, but Scott, when you sort of wrote this up, it just hit me like a ton of bricks that we should definitely do a show on this, and let's do it this time. All right. Should we dive in? Let's do it. Okay. So...

There basically are two types of diligence. The word diligence, quote unquote, when you're in a fundraising process, a venture fundraising process as a company means two separate things. You can be in diligence, quote unquote, with a firm or multiple firms in the preterm sheet phase where it's still the courting process on both sides.

And then there's also the diligence process, the very much more technical due diligence process that happens after a term sheet is signed. And that is mostly done by lawyers and accountants and the like. We're going to cover both on this episode. But first, we're going to talk about the primary process.

business diligence, it's quote unquote called, but the mutual courting process of a firm and a startup deciding that they want to get engaged with the term sheet. Yeah. And it's in the outline here that we're going to go through, we talk a lot more about sort of the diligence that the firm will do on a company. But I think it's important also to think about what's the diligence that a company should be doing on a firm as well. And we'll touch on both of those. Absolutely. Starts

Starting with what a firm, what a venture capital firm will do when they are looking at a company and more at the early stage, but at all stages, it really starts with the team. And on the team, it starts with the founders. We've talked about

a bunch on Acquired, both on the main show and the LP show, you know, it's a personal relationship that you're entering to when you take venture capital investment from a firm. And in many cases, that partner at that venture capital firm is going to sit on your board. You're going to work closely with them for a long time. And then with you, the personal aspect of this is kind of first and foremost, and that's just comes from spending time together.

As I was thinking about what's diligence and what's not diligence, you know, this starts the moment that you have an initial email exchange. It's what's the tone of the email? How does this person go about it? Of course, in your first second meeting, you know, you don't sort of think of that as being in diligence, but it's a type of diligence. And it's really the one where, you know, humans need to get comfortable with each other before they are

willing to sort of make big investments in each other, both time and money. It's kind of funny how we spend sort of years picking our friends and of course picking our, you know, romantic partners and yet you end up

trying to pick a board member and or company that could be life-changing for you as an investor in a matter of weeks and not even like spending a ton of time with each other in those weeks, like a meeting or two a week for a few weeks. Although they do tend to be very high fidelity interactions, especially as things get deeper. So I would say...

To me, the best way to describe this is, I'm going to borrow a page from the Jake Saper LP episode and what he said. And he had, I think, independently arrived at kind of the number one question he asked himself about any investment is,

could I see myself or my wife, Dani, working for this CEO? Separately, I think I said on that episode many years ago, I'd read a blog post by Bijan Sabet at Spark Capital. And he frames it as much the same question as, would I quit working at Spark and go work for this person?

That's really the crux of it. If you're a CEO out raising money, that is the lens that you should view every interaction that you have with a VC is you are trying to come across to them in such a personally compelling way that they are drawn to you. You know, in some cases might actually, you know, there are times when VCs,

quit their firms and go work at companies. It's happened many times. That's really kind of the bar that they are holding you to. Yep. And the things to think about, you know, there's many other things on this list, but if you're thinking about, okay, well, what can I sort of do to inspire an investor? You know, people frequently say, oh, it's all about the people.

Okay, well, what does that mean? What about the people? And I think what investors, at least what I'm often looking for is, is this person credible about the space that they're going after? It doesn't mean that they're crazy experienced in this space, but they've done their due diligence to know, you know, what are they getting themselves into here? What have they learned so far? How fast have they learned it? I shouldn't know more than they do about a given space if they're sort of pitching me and running a business in it. So there's credibility. There's... It's like...

Trip Hawkins was saying about the Don Valentine. What do I need you for? If you're not, you know, piping up in board meetings and like running this company, what the hell do I need you for? Right, right, right. And then another piece of that is compelling or inspiring. Often investors will use their own belief in understanding if you can recruit a really all-star team, if you can sort of make them ready to take the leap.

when I think about the best entrepreneurs that have pitched me, they've had me leaning in and saying like, gosh, have I made a mistake by doing what I'm doing rather than following this person? And I think to the degree that as an investor, you can feel that you can sort of proxy that into all the other people they'll be able to bring together. Because ultimately,

The job of a founder is not to do any one thing at the company, but to enable and group together the right set of people to do that thing. I mean, that's mostly what I'm looking for in the people at the stage. And this is to widen out into multiple stages here. When you get into later stage, and I say later stage, you know,

maybe series B, but really kind of series C and later for a typical lifecycle of a startup. This becomes less important in the actual interactions because the proof is kind of in the pudding at that point. Like what have you built? What team do you have to show for it? What do your customers say about you? And we'll get into all of those in a minute. But in the early stages, this is why

team and this relationship is so, so critical because you have to believe none of that exists yet. And so it's really, you're asking yourself as an investor, do I believe that this person or this team collectively is capable of, you know, willing into existence this presumably very difficult thing? Because all good opportunities are difficult if they're worth pursuing from nothing. I'll say, David, too, there's a middle ground there where like,

if it's a series A company, there's still a tremendous amount of team risk. So you're trying to assess, yeah, they've got a business so far. They might be doing a million dollars. They might have, you know, hundreds of thousands of monthly active users, something like that. But like it's,

You're by no means sort of like at escape velocity or sort of out of the woods, as they say. And so you are trying to figure out the people diligence at that stage is different. It's not just can I meet with you and be personally compelled by you and believe that you're credible. It's when I talk to the rest of your team.

do I get the same sort of feedback from them that you're a great leader and you're going to continue to keep this team together? When there's traction and there's product market fit, there's scale risk, like the market may not be big enough. There's some product risk, but it's mostly people risk that you're not going to be able to build an A-plus team to continue to execute on the little bit of traction that you have. And so that's when the people diligence starts to be broader than just the founding team. Yeah, and this is, I'm glad you brought up the point about...

It's not just the very, very important, probably of a primary importance is the one-to-one interaction or one-to-several interaction between the VC partner and the founder, CEO or founders. But I think something that separates in many times the...

average VC investors from really great ones is people that are willing to either see through their own instincts or dig a little deeper and look past those interactions into, and I'm thinking of Zoom, I'm thinking of Eric Yuan from Zoom. He had such a hard time when he went out to the institutional VC community raising money at first.

And of course, you know, I know for a fact that that had a lot to do with like his accent and where he came from and, you know, coming from being a hardcore engineer and all that. But if you looked a little bit past that and you saw, holy crap, there were 40 engineers from Cisco that quit their jobs and blindly followed Eric because they would follow him to the ends of the earth. Like that's what you're looking for. And sometimes that's not immediately obvious.

Sometimes, and especially if, like Eric, founders are humble, which is a great quality that you want to look for. But I doubt Eric walked into any pitch meetings with any VCs and was like, I'm so great, 40 engineers followed me. Sometimes it takes a little digging under the surface to find this. So it really, really is an art here. Yep, yep. And I would say one more thing to say on people diligence is if you are pitching a seed stage startup, expect...

the investor to reach out to all of your recent previous bosses, the number one sort of, and people that worked for you, because you want to get that sense of what's it like, does this person just manage up? Like, are they blowing smoke to me because I could potentially write a check? I'm interested in what their previous managers say, but I'm more interested in what people who worked for or parallel with them say. And so I think the number one thing that I tend to do alongside like a basic understanding of market, which we'll transition into

into here in a minute is really get sort of the complete constellation picture of what has this person been like in a professional setting in the past. Well, and one more, we're spending a lot of time on this, but we are because this really is, especially in the early stages, as we keep saying, the most important thing. You asked two seed stage investors to talk about diligence. They quickly run out of things to talk about. No, it's just that they talk a lot about people because that's the most important thing. I want to underscore again how much of an art this is.

One aspect that makes it that is what I said before of sometimes how people present in a formal pitch meeting belies strengths that might underlie how they come across on the surface. Another aspect of this is, you know, Ben, you were saying you want to find out how someone behaved in a professional setting. Some founders, again, depending on their personality and the opportunity,

have behaved terribly in former professional settings. And that can be a really good sign for them as an entrepreneur. I didn't say they had to be like straight and narrow at their previous job. They're going to make a call and then they're going to use that as information. Right, right. It's all... And that... Actually, that is it. As a...

investor, you want to be in information intake mode where you are trying to piece together all of the aspects of a founding team's collective personalities and then match that to both the market and how they're trying to attack the market and see if it all lines up.

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All right. So there's a couple of ways to do this. And as an entrepreneur, if you're pitching an investor, it's helpful to know if they have already done diligence on your space or not, because there's sort of the market map first perspective, which is an investor is interested in the space. They've already built internal documentation around what does the whole landscape look like? Not only who are the startups, but what does the value chain look like?

And sort of where do we think power will be able to sort of concentrate in the value chain? And we want to make sure to invest only at places where we feel can be high leverage from, you know, production of the raw thing all the way to the finished product that touches consumers. And as a side note, that is a very classic approach to series A and series B investing. Most

investors at those stages take that approach. Yep. And have theses about spaces that they want to invest. The most classic from the Uber episode being, you know, Bill Gurley almost investing in Uber three times before he found Uber. His half a decade long search for Uber. Yeah.

But the other one, yes, the other one, which is going to be more common for me at PSL Ventures, where we have a Northwest focus, or David at Wave, where you guys have a marketplace focus and a focus on sort of the people coming out of Airbnb and Uber and DoorDash and a lot of these sort of marketplace companies. Which isn't to say we only invest in those people. We will invest. The latest team we invested in had no previous experience. And, you know, similarly, like

Of course we are Northwest based. We're also thematic. We're not just saying like, Hey, you know, whatever company, like we, we, we have no belief in what the future is going to be. It's, you know, you can have a sort of boundary around the things you invest in and be thematic within that boundary. And I think that in that scenario, it's,

likely that someone will have done diligence on your space from a previous deal that they looked at, but unlikely that they have proactively made a market map searching for companies to back in that specific domain. Yeah. The way we think about it at Wave is, I don't want to say we don't think about markets and opportunities and spaces. You know, we certainly do, but we do much, much less of it than would say a Series A firm. And we focus much more on the people aspect.

like we were talking about a minute ago. And the reason for that is just simple. At the Series A stage, it is possible to say, I have a thesis on a space. Now I want to go find all of the companies that are operating in that space, meet with them, decide which, if any of them, I like and invest in them. At the seed stage, you can't do that because there are no companies yet. The companies are just, they're little, little sproutlings that you're going to water the seeds. And

And so if we were to take that approach and say, we want to go meet with all the companies in X space, and we tried this when we were first starting and we realized it was a fool's errand because there's no way to even know. A much better approach, we think at this stage, is start with Teams.

Couldn't agree more, David. Like on the PSL website, on the individual pages, we've been trying to put like, hey, here's the interest areas that I'm personally interested in. And I'm, you know, I have productivity, there's computational photography, there's digital health. But frankly, like my partner TA is much better at digital health. And he spent a decade building a brand around, hey, I'm a digital health guy in this area. So all digital health stuff flows to him. But absent sort of duality

doing that for a long, long, long time where everybody is referring you to a single seed stage investor and saying, oh, if you're building, you know, at this point, David, I feel like you guys have actually done a tremendous job. Oh, you're starting a new marketplace business. You should go and talk to Wave. The seed stage investing is much more about

who do you already have a first or second degree relationship with and much less about, oh yeah, these seed investors specifically go after this domain. And really for that reason that you said that it's, the companies haven't been operating for a long enough window. There's not enough data to run searches on, but I would say,

as we thought about it with marketplaces at Wave. And by the way, if you are starting a seed stage marketplace or thinking about it, please come talk to us. And whether you worked at Airbnb or any of these companies or not, for the marketplace aspect for us, we find that is a great, A, it's what we have expertise in, but we can say that's a really functional way for us at the seed stage to say,

if you are building a marketplace and looking for seed stage investment, come talk to us. Like that's, that's a great way to get who we are out there. I feel like we're bleeding into like VC sourcing strategy here, which really, I mean, should tell you all you need to know about how VCs think about the world, but in the diligence phase, but yeah.

So given that, how can a seed stage entrepreneur, so I want to make sure that we do diligence from both the venture side and the operator side. How can a seed stage entrepreneur make sure to find the right VC for them given a certain landscape that they want to operate within? Well, it's very simple. That VC is Wave Capital or it's not. Of course, I'm kidding. So I think there are a few options.

of this that we can riff on. First and foremost is that relationship that you develop during the process of getting to know a partner and a firm. And you can't overstate how important that is. You are making, especially at the seed stage, a very, very long-term commitment to one another. It's often said, but we'll repeat it here. This is like a marriage that you cannot get divorced from. It is perfect.

permanent. Yeah. And the average successful company takes two to three times longer to exit than the average American marriage. Yeah. Think about that as you head into the process and take some pause and take your time and make sure you're finding the right partner. So I think that is the most important thing is that, that personal relationship and, and,

To say a word more about that, I think it doesn't. Some people interpret that as like you have to be friends and compatible with your with your investors and vice versa. I don't think that's the case necessarily. I think what's much more important is a shared vision for what you are building towards and what the company can be.

You will probably become friends with this person over the journey, but it would be a mistake, I think, to evaluate the relationship through the same lens that you would like, would I enjoy going out to dinner with this person? Because sometimes people you wouldn't enjoy going out to dinner with are the people who are going to push you to be the best in a professional setting. Totally. And I think one other important thing or a litmus test that you could think about here as an entrepreneur doing diligence on the investor as it applies to your space is,

Do you, after your conversations, feel like your future board meetings are going to have people around the table nodding? Or do you feel like leading up to future board meetings, you're going to get emails a couple days before saying, hey, did we try out this other initiative yet or this other direction yet and keep pushing you to do a thing that you don't want to do? And I had a friend who very recently –

signed a term sheet and took investment from an investor that was, for example, super excited to go into crypto. This company was not a crypto company. And so before each board meeting, there was a conversation around like, hey, so have we thought any more about that? And like, that can be fine. Like it can totally work out. But there are, you know, that is just one sort of like very obvious example of where there's sort of mismatch on

the way the space will and should evolve and your company will evolve within that going into operating the business. And I think it's helpful in, in here to, I think as an entrepreneur frame, if you have,

the choice among investors and you always do to some extent even if you only have one choice for investment you always have the choice to expand the universe of people you're talking to oh yeah um god knows there's enough uh new venture firms in the last couple years that have been started seriously two in this very room um

But I think it's helpful to frame this question in terms of opportunity cost. If you take an investor like that who, you know, maybe fine, but it's probably not going to be great if this person is always trying to force you or this firm is always trying to force you into something you don't want to be or do and trade that off versus, you

what your ideal investor and partner would look like and what your interactions, your business interactions with them over the coming 10 years would look like and think about that delta. Because I think if you just think about what's the best that's on the table in front of me, it can lead you to one set of decisions. But if you take a step back and think, okay, what is going to be the most value maximizing relationship and partnership for my company that can push you to something bigger?

Yeah. So let's bounce back one more to founder, sort of the person diligence for the entrepreneur doing it in the direction of the venture investor. David, to pose a question to you, what's the best diligence that a founder has ever done on you to decide if they want to take money from you? This sounds simple and you would think that every founder does this.

yet it's actually fairly rare. And it's just simply call up every other founder that this VC has ever worked with and ask them what the experience was like and would they work with them again? It's kind of like references when you're hiring. Most founders will do one or two of those calls.

The best founders will do all of those calls and will call everybody you've worked with, not just the people that you tell them to call. Not the people currently listed in your Twitter bio, but the people that they can find that you were previously invested in that you're not doing victory laps on Twitter about. Yep, exactly. And it's helpful to get both perspectives. Well, really, I would say it's helpful to get all three perspectives. One of companies that have succeeded. One of companies that have failed.

And probably also, just as if not more important, is companies in the middle. Because that's where you really see what... It's almost like we joke about that the best case scenario for an investment is it does great. The second best case scenario is it's clearly a failure. The worst case scenario is when it's unclear and in the middle. For a long time. For a long time. Because that is both time consuming and frustrating. When a person is pushed to their limits, that's when sort of...

the version of them that you really want to be evaluating, that's where it comes out. So talking to those entrepreneurs and hearing about what their experience was like with, with the investor, I think is really important. There's another piece of diligence that I would recommend for founders about investors that is also rarely done. And actually, um,

I don't think I've ever been asked this proactively by an entrepreneur. I've always, I always volunteer when, when we're in kind of a diligence process and that's where does the money come from? Yeah. And it's, this is very, very important. You're starting to get a lot more now, particularly because of some of the sovereign wealth funds that have, have backed a lot of these companies, but.

Yeah, I'm shocked that that doesn't come more often and that, frankly, the entrepreneurs are totally satisfied with the answer. It's a lot of big institutionals, you know, it's some universities, it's some endowments, it's some pension funds, and people just sort of nod and go, okay. Yep, yep. There are, I think, two levels of answers to where is the money coming from, and you really want to get both. One is the level you were just referring to, Ben, which is...

simply where does the money come from? Like whose money is in the fund? Who are your LPs? Do I agree with their values and who they are as institutions? And, and that's very, very important because ultimately, you know, you are as a founder and a founding team are working very, very hard building this company. You know, it's your, you know,

hopefully your life's work and a large, large portion of the financial returns that come from that are going to support the LPs that are, who are your investors. So that may be university endowments. And then that money is going to support research. That's going to support scholarships. That's going to support new building on campus, expansion of the student body, those sorts of things. It could be, you know, foundations that are making grants. It could be wealthy families that are, you know,

that's great. And they may be, but then they may be doing things with the money and like, that's fine. That's great. But it also could be, you know, sovereign wealth funds and then you're supporting governments and like also nothing wrong with that, but you should think about what governments you're supporting. Yeah. I think, I think,

The entrepreneur at this point in the fundraise has so much going on and so many priorities. It's really hard to take time to focus on this. Yeah. And to me, the most important, like if you only actually had one answer that you cared about to this question of like, okay, who are your investors? What you want to know is if it's basically single LP or not. And firms will behave very differently when it's like one person's money that

that just hired a bunch of people to make investments on their behalf versus a fund that operates with sort of standard reporting to their LPs, they're going to make decisions a lot more systematically than if it's sort of these single family office, you know, solo LP. Maybe the GP is the LP and the person making the investment actually has all the money in the fund. You know, those things get made a lot more on gut and don't

tend to require as much follow through. They can also be incredible because a person can decide to pour an outsized amount of their time into your company, but it's really good to know. Well, so what you're getting at here is the second aspect of where does the money come from? And this is really important. And again, really, I've never had it asked and it's critical. The way to ask this is you ask where the money comes from, but then also ask like, what is your model as a firm? And

This starts to unpack what the incentives are for both partner and the firm around your company and your investment. So this is a takeaway, for example. We have a $55 million fund.

Most of our capital comes from institutions. That means that a diverse set of institutions. They care a lot. Wave is the riskiest, longest term investment that they have made in their portfolios. So what do they want from us? They want to give us $55 million. They want us to give them back a very large multiple of that a very long time from now.

And so they're aligned. They're willing to wait a really long time. They have other investments that are shorter time horizon. They have a broad diversified portfolio. They're willing to let us take and companies take as long as it takes to maximize our outcome. And let's be clear. When you say a very long time, it's like 10 years, not 20. Plus. 10 years plus.

Is there an expectation that people start getting a little antsy after 12 years or so? So our fund is 10 years with two one-year extensions, which is pretty typical. However, I would expect with our LP base and most LP bases of this type, if there are some big companies like many of these A-plus companies that we're covering on the main show that take longer than 10 years, they're totally fine.

at that. That is really important on the where the money's from coming from. But then there's also the how have you modeled your investment activity as a firm around those goals for returns? One approach is to invest a relatively small amount in a relatively larger amount of companies and then let the winners bloom over time. Another approach is to invest a relatively larger amount in a relatively smaller amount of companies.

And as you start to figure out that investing model for the firm, that means for you as an entrepreneur, really, it's how much attention am I going to get from the VC firm? And you may want more or less like there is a I'm not saying one is necessarily better than the other, but you want to make sure their incentives. Again, if you're like at Wave, we're going to have call it 15 or so portfolio companies in this fund.

over three years, you're going to get a lot of attention from us. We are at the very, very small end of portfolio size. Other firms that are at the larger end, you're going to get relatively less attention from them. Yep. Makes a lot of sense.

All right, so we've covered bi-directional for both the people and the market. Now let's get into product. So obviously with seed stage, and you know, seed can mean a lot of things. Seed can mean literally you have a PowerPoint deck. Seed can mean, you know, you have 10, 20K ARR of, or MRR of traction, and you have a product in market, and obviously you've built out a little bit of a team. It can sort of mean a lot of things these days. But let's say it's this sort of

one and a half to $3 million, quote unquote, seed stage round where you've built a little bit of a product, but there's really not enough to show that like there's definitive customer traction. There's a little bit of customer traction. I mean, I think the only really way to describe it is raising that one and a half to $3 million round. The most recent investment we made had

significant revenue traction, you know, more than many great series A companies. But the team and the company around it was like, unbuilt, you know, and so they wanted to raise a seed and came to us at Wave because we could help them build that foundation of the company around it. They weren't ready to absorb a large round. Right. Yeah, it makes a lot of sense because there's still sort of a foundational, the company sort of skipped a level on

How big of a business can we build without a lot of structure? And then it turns out we still have to go and build. So there's all sorts of, I mean, I used to a year ago, I would have agreed with you and said you could find, you know, you could roughly put guardrails on what a seed round would look like. Now, I think the only guardrails are just the dollar amount. And it ranges from one person in a PowerPoint to, you know, millions of dollars a year in revenue traction. Yep.

So this is an interesting question, which is, what can you expect investors to do diligence on in your product, particularly if it's not a consumer app or a consumer website? In the vast majority of cases, you're pitching an investor on a product that is not for them as the customer. And so...

Of course, they can ask you for some credentials and log in and play around and make sure like, oh, look at all these links like this sure feels full featured. Wow, this workflow, it's significant and well built out. But really, the proxy for this is our customers happy. And so this is when it's very,

very, very typical to ask, hey, can I have the phone number or email of one or two of your customers? You know, an investor also may not ask if they're feeling like, well, I'd rather I have a relationship with someone who is in the space who could be a customer or already is a customer and just sort of do their own, you know, diligence on this. Don't be surprised. It's extremely common, not only in sort of A, B, where you would expect it, but in seed stage stuff as well. And it's especially true at the kind of series A

Series B stage where you're going to get a lot of customer diligence that the VCs are going to do and both of people who are currently your customers and people who are not your customers. And that's very important. At the seed stage, there's some of that, but it's also it's more of an art too, because and the reason is at the seed stage, most

most potential customers of your product will never have heard of you and never thought about, in many cases, never even thought about the whole category of solution that you're offering. And so while, you know, we will at Wave and SeedStage VCs do talk to those people, you need to keep in mind like, uh,

that fact. And so you may get a lot of, I would never use that from people, but that may be a false negative. Yep. That's, I think that's, that's a super astute point and absolutely true. I, I've had several calls with people that I'm looking at like, Oh, they could be a customer of this thing, especially in these B2B companies. The most likely thing is that they've looked at previous iterations with poorer technologies that have come before and they're

decided that it doesn't work and written that sort of thing off. And they'll tell you, you know, I've looked at this before. It's just not for me. It might be for other people. It's not for me. And it's sort of dangerous because whenever somebody tells you it could be for somebody else, but it's not for me, you end up being like slightly encouraged. You're like, well, I might just not be talking to the right person. I usually read that as like,

And that's a flat no, and it's a no for everybody else that I know also. But that's why it's important to then go and have the conversation with the company and say, okay, who are your highest potential customers or current customers? And I will say the number one thing that I ask on that call, which can be a scary thing if you're a startup to have an investor call your pilot customer and ask them this question, if the product went away tomorrow, what would your reaction be? Would that be okay?

And the answer that you're really looking for is that would be a big problem for us. But the most common answer is not. What Santi said in the Zoom episode about I would quit my job and go work at another company. And go work at a company that had this product. Yeah, the most common answer is, well, I mean, we were getting by before. Yeah, I've really adjusted to this thing that I like. And that's why seed stage investing is an art. Because like the customer set in all likelihood doesn't have conviction yet that. Well, and the product is bad.

probably, you know, at the seed stage, if there is a product yet, like very, Sequoia uses the phrase that it has warts on it. It has a lot of warts. Yeah. Gigantic missing feature areas. But you can get at this, you know, even still, like you should be able to assess kind of the core value there. I also think the, especially in cases where there isn't a product yet, the

Really the best way to try and get at this is just, again, through conversations with the founding team and really pushing them on what...

insight they have about or think they have about the market because again you know in most cases if it were obvious it would have already been built like they need to have some non-obvious insight uh or some unusual depth of insight uh that you haven't heard before non-consensus and correct indeed should we title the show uh one more thing on the the product component is uh uh

It's extremely unlikely at seed stage, but obviously in A or B or later, expect a very deep probe into your analytics. Yes, yes. And I think to double click on that a little bit, you should expect, again, it depends what type of company you are and who your customers are, but broadly, you should expect that double click to be across three key areas.

acquisition, where are you acquiring your customers through what channels, how much are they costing you, conversion, and how many of them are converting, what are the dynamics around converting, how well do you understand that, and then retention. Maybe with in-between conversion and retention, again, depending on your product, activation. If, say, you have a freemium version or even if it's a

even if it's a free product, what do you view as activation where like, okay, now somebody is a fully active user versus a not yet active user, an onboarding user, and then retention. And retention, especially at the Series A, is going to be probably the most important of those metrics because... Because you'll just start to have those early cohorts that are showing long enough data to really have you form a good understanding. And everything up above the funnel is more easily improved and optimized than retention. Retention is the best...

proxy for the true value of the product. If people are canceling after having becoming fully activated, then that's a sign that the value just isn't there. Yep. Great point.

Okay. So the next thing on my list was customers. We talked about that. David, do you think it's time to switch into sort of the term sheet has now been issued and there's the diligence that happens afterwards? Yeah, let's do it. So the thing to think about here is typically what has happened is the investor and the investor group has now gained conviction in the team that this market is a thing, that your product is the sort of correct concept to enter this market. You've negotiated and signed a term sheet, which...

Lord knows we've got a whole episode on that. And you're now at this place where you're moving to close. And this is anywhere from two to five weeks where you're turning the term sheet into final documents. But there's still some diligence to be done here. And this diligence sort of...

can be kicked to after the term sheet because substantially you've agreed to a deal. You've agreed that the investor absolutely wants to invest in this company and team. And this is really just about making sure that everything the investor thought was true mechanically is true. And so you want to tackle the buckets of those? Yeah. So broadly, you could put all of this, all of these activities into three buckets, legal, accounting, and technical due diligence.

Technical due diligence is

I used to see happen a lot more. I often don't see it really happening these days, maybe at mid to later rounds it'll happen. So we'll cover it quickly. This is, you know, things like doing a source code audit, looking at the actual technology and engineering behind the product. A big thing of this used to be, and I haven't seen it at all recently, but documenting your open source libraries. This was like a really big thing in like 2010 to 2013, 14, or at least, I mean, that's when I was operating in this world.

of making sure that you sort of had the right permission to be using all the software that you were using. I have not seen that really matter much recently, at least in the early stage. Yeah, me too. I mean, I can't even remember the last time I saw this happen. I think the reasons are twofold. One, that...

software development has become more of a, and software products have just become more of a, maybe a commodity is the wrong word, but like a known art, you know, it's not like that crazy to believe that they can be built, you know, and Bill Ryan, there's so many good tools for like managing all aspects of software from Stripe, you know, on down. So I think that's one aspect. I think the other aspect is that perhaps because of that and enabled by that,

again, the proof is in the pudding, right? Like you can tell a good product when you use it versus a not good product. Yeah.

Yeah, the area where I will say that this still happens a lot is frontier tech. Yes, I would imagine so. You know, that's the loosely defined as things like VR, blockchain, AIML. And this is when a firm will typically have someone who's either a venture partner, or maybe it's a very technical partner at the firm, or maybe it's a CTO of a portfolio company. In fact, could be a paid consultant or what they call an operating partner. You see that a lot.

who is going to, you know, get into your GitHub and spend a bunch of time in there and figure out if that really novel breakthrough that you had in using this neural network in that unique way, if that's the real thing or not. That's a really good point. So if that's a big part of your value prop in your pitch, some deep technical aspect, you should expect this. For us at Wave and the types of things we invest in, like, I can't imagine us ever doing this. Yep.

There's a good segue into legal here with oftentimes that will also come with reviewing any patents that you filed or any provisionals that you've put in and trying to understand, you know, who is the IP attorney that you use? Do we have a relationship with them? Do we know someone that has a relationship with them? Is that, you know, is that going to end up being defensible or did you just sort of file that because you thought that would look good during a fundraise? I've seen that come in. That's somewhere halfway between technical diligence and legal diligence. But a good bridge. So let's dive into...

legal. Well, actually, we'll save legal for the last because it's the most important. Accounting, this is simply, you know, will range from at later stages, you know, seeing you at that point should have audited financials. So reviewing audits from your past years of financials at the earlier stages, this is, you know, as much as you have, right? And, you know, we're comfortable with like

give us access to your QuickBooks. And like, we just want to see that, you know, you have, if you have revenue, that it actually exists, that you're booking it in some form. You know, if you have raised money in the past, that that money is actually in the bank account, those sorts of things. Yeah. And this is more finance than accounting. But I'll say another thing that's pretty common is everyone's got a slide in their deck that ends up being some percentage wrong of what their future financial forecasts are.

It's less interesting to look at that on a slide and more interesting to see what's the model that built it. And that is typically a part of diligence, showing that investor. And this can be preterm sheet as well. What is the financial model that

What assumptions did you make in that model that led you to believe that this thing was possible? And I'm going to revise my statement. This is definitely something that happens before a term sheet. We view this aspect not as quote-unquote financial diligence, but more as just part of our investing process. We do this with every company we invest in. We construct a financial model together around milestones and North Star metrics and all that. To me, the post-term sheet is much more

Like, like the, the most important thing is if you have been operating, if you have revenue and you have made claims during your fundraise about what that revenue is, just verifying that like, you're not lying about that. Or, and, and, uh, it doesn't even have to be malice, but, but just, are you misconstruing something in there? Yeah.

Yeah. Okay. So legal, the most important part. This is 95% of the work, at least in a typical scenario that happens after a term sheet. And the biggest part of this is, I think we covered on the term sheet episode, translating that term sheet into a set of definitive documents that are much more verbose and cover many more things. And there's lots of back and forth between both parties there. But the actual diligence is things like, um,

Is the equity on the cap table? Is it all allocated properly? Has it been distributed? Are the share certificates correctly held? Often in Carta these days, things like do all of the founders and employees of the company have IP assignment agreements to the company?

Anybody that had been involved with the company before, have they signed over their IP agreements or is there something outstanding? Contractors. The last thing an investor wants is to put a million dollars into the company and have it instantly manifest in a lawsuit by somebody that didn't have an IP agreement that was there at the founding that actually has substantial claim and then none of the money gets to be used to build the company. I think we saw this in the Square episode, right? Yep. Yep. Employment agreements are a big one.

A lot of times part of a term sheet and part of definitive documents will also sort of reset things that had been previous set like founder vesting or vesting schedule or put vesting in place at all for the founders. You'll often see customer contracts looked at where you want to make sure that your software does

doesn't, you know, allow for a license to a customer in perpetuity for a one-time payment or something like that. I'm remembering the, what Tripp said on the episode, the episode about Steve Jobs and Microsoft. Yeah. So there's, there's all sorts of things where, you know, frankly, when you're not a funded startup, you're not using necessarily the best, most buttoned up legal in a lot of cases. And, you know. And to be honest, that's okay. The, especially at the seed stage, part of this post-term legal diligence process is

is not adversarial. It is helping the company clean up mistakes that might've been happening. Like just because there are mistakes or something is wrong or not done right, doesn't necessarily mean the investors are going to back out. It's like, okay, great. Like let's fix it. That's part of the value add of bringing on an institutional investor is that, you know, you get to be a little bit less cowboy at that point. And that comes with the capital. Yep. The other big aspect of legal diligence, we

gets manifested in what is called representations and warranties that the company will make. Sound like a lawyer over there. Yeah. Reps and warranties or just reps is how they're referred to. And these are things like, um, what it is is that the company and founders as organizations,

officers of the company are going to legally represent that certain things are true or not true. For instance, one of these is there is no outstanding litigation against the company, or if there is that everybody knows what it is and is willing to accept that risk.

So you will, assuming there is none, you as a company and founding team will legally represent as part of the fundraise to the investors that there is no outstanding litigation against the company. And if you lie about that, then that is, you are legally bound by that. And then that is fraud. And you can be both sued civilly by the investors and also potentially go to jail for that. So.

Take that seriously. And it's not just litigation. It's a whole set of things that you will represent as part of this. And it's fairly standard. Your lawyers will help you through it. The most important thing I would say about

all of this, and we covered it on the term sheet episode, I think too, is make sure in this transaction that you are using a experienced, reputable venture law firm. For lots of one-off legal work at startups, it's often advisable to use really good individuals, contract attorneys, what have you. But a financing process, a venture financing process is something you want to use. There are

a handful of firms, Perkins Coie, sponsor of the show, being a great, great one among them, that are experienced that handle all of these transactions and you want to use one of those. Yep. I think this may be on an upcoming sponsorship thing, but it's a sponsored recording that I was doing the other day when I was like, oh, that's actually very interesting and very underrated that

And what I tend to do and what I was doing for Taunton when we were getting our seed funding is I kind of removed myself from the driver's seat at this point once we signed the term sheet and handed it over to the lawyers and said, look, you're a great law firm. I trust you. Run the process and keep me involved by email. Like, let me know every day how it's going, you know, whatever.

when there's substantive red lines that come back that we need to make business decisions on, but you put together the data room, which these days is a glorified name for the Dropbox that gets shared between all the different lawyers and people involved. Or the box, yes. And, you know, that has all this stuff that we're talking about, all the contracts, all the cap table, the incorporation, all that stuff. But the really great part about this is as an operator, you can kind of breathe easy and say, look, I have great counsel who's not only doing the legal work, but is managing, they're the project manager for this process. Yep.

Such a great point for all of these aspects. Once the term sheet is signed, you should and your investors should be aligned in wanting you to get back to running and building the business at this point. It should all be on, you know, relatively autopilot. And if you feel like it's not on autopilot with the lawyers or accountants or other firms you're working with, you need to switch your service providers. Yep.

Okay, one last thing to say on this post-term sheet diligence. This is a relatively quick and painless process for a seed stage company. This is an extensive process for a series B, C, D plus company. Yes.

It's not just reviewing sort of the founders or maybe a couple of early employees. It's reviewing hundreds of people's employment agreements and making sure that everybody is part of the 2018 compensation approved plan by the board, you know, that there's not a single share that's misallocated across hundreds and hundreds of people on the cap table. There's just so much.

So many, all these different customer contracts, everything gets reviewed. That's why closes can take much longer in later stage fundings and legal bills can be way more expensive. Yep. Yep. And also the accounting aspect becomes much more...

much heavier too. You know, hopefully the best case scenario is you're already doing audits and good hygiene as a company and board as you get to mid and later stages is to be proactively doing audits every year, preparing not only for future fundraisers, but for going public or M&A eventually.

But if you're not and you get to a later stage financing, very likely the investors are going to require you to do an audit and they're going to drop ship one of the big four accounting firms into you and do that process. And that is going to be very heavyweight. Yep. And this post-term sheet diligence in the seed and series A is typically run by the CEO in tandem with that law firm. After that, it's typically the CFO in tandem with that law firm and then looping in the CEO as needed. Yep.

So one thing that I did want to bring up as a point of discussion before we bring this one home is...

All deals do not contain the same amount of diligence. And diligence, I will say, as someone who's been in some hot deals recently, is a luxury that you don't always have. And as an investor, you have to decide when there's a really, really competitive opportunity to fund a company for this stage, and there's a short time window to do that, you decide what diligence is important to you before the term sheet. And you just

frankly, take on more risk. The idea there being, if it's extremely competitive, it's a founding team that you're more comfortable taking more risk with. But the ideal amount of diligence, you know, I think is the full set of things we just discussed. It's not ideal to be doing more. If an investor is doing more than that, they're probably wasting your time. But there are lots of times where there is less preterm sheet diligence done than we've talked about on this episode. Yes, exactly. This is the like...

Both parties are doing a extended courting period, really taking their time, getting to know each other. To be honest, I don't know about you, Ben, but this is probably the minority of deals that get done. More often than not, it is abbreviated, accelerated. Some kind of hurry-up process where you're deciding what risks you're comfortable taking. Yeah. Yeah. And...

that mostly accrues to founders' benefits. And I think this has actually been a huge change in the market over the last 10 years, really, especially the last five years, where that has shifted the balance of power to founders away from investors, which is there's so many more investors out there these days. It used to be 10 years ago, you could probably count on all your fingers and toes the number of like,

Yep.

It forces the venture investors to be smarter about what diligence they do and to find high leverage ways to spend the time and diligence rather than just having the luxury to just go back and forth on email and get one more meeting. I mean, it really forces you to say, what's the most high leverage customer I can call? What's the most high leverage reference on this person? And make a decision. Yeah. Yeah. And quickly, quickly form a point of view. Which is...

in the bad old days, VCs used to drag out these processes forever and it was terrible. I will say, you know, to go back, I don't think walk back from what I said about this all accruing to founders benefit because it does it in that it, it gives founders more power. A mistake that many founders make with this is running a

too quick of a process for their own good. 100%. And that comes back to what we were saying in the beginning of the most important thing, especially in the early stages, is the relationship. And so as a founder...

Whatever control you and relative power you have in the process, I think the most important thing you need to do is leverage that power to make sure you get the best possible relationship. Yep. I've had some painful experiences with this on the operator side where you try and run too fast of a process and put the pressure on too heavy. And it's...

I have bruises. And I think it's a thing where you can rub someone the wrong way. I would imagine bruises both from investors pulling out of the process and probably getting the wrong investors sometimes, like actually consummating. Yep. And people saying, look, I don't have...

I can't make a decision that fast. That's not a thing that I'm going to be able to do. And so, you know, maybe it's not right for us. Then me kicking myself later and saying, hey, I messed that one up. And I think it's really important to remember that there is an amount of tremendous financial responsibility that these people are stewards. Venture investors are stewards of other people's capital. And, you know, you can really only hurry the process up so much.

And so it becomes, especially for first-time founders, it becomes a real dance of figuring out what's the right amount of pressure to apply to make sure that you're not spending months and months and months and months doing this, but also to make sure that...

you allow for a process to happen. Yeah. I mean, you said it already. Dance is the best metaphor to describe this. That is very much what it is. And I think I just always come back myself as an investor and advice for founders always is just view everything in that partnership lens. Like you are...

consummating a partnership. If you take that approach, things will almost, will typically go well. If you, if you take a transactional approach,

Sometimes things will go well and sometimes things will not go well. Go meet the parents first. Yeah, exactly. Well, Limited Partners, thank you for sticking with us on another one. We hope this was valuable or useful. We love feedback, so feel free to put it in the Slack or acquiredfm at gmail.com or at acquiredfm. We have locked down the handle, I guess, everywhere we are.

where we hang out. Um, and if you like this, of course, uh, feel free to share it with your friends and share that you're an LP. Yeah. And thanks again, Scott, for this great question. Yeah. Uh, this was super fun. Hopefully you all enjoyed it too. We did. Yep.

Yep. Well, I think this will probably come out after the wrap from season four. So I will say if you have not yet filled out the acquired season four survey, you totally should. There is a link in the show notes. This is extremely important to us because it really helps us understand, hey, who's listening out there?

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