Reverse Diligence Posts

Thanks to Walker Corporate Law Group, a boutique law firm specializing in the representation of entrepreneurs, for supporting Venture Hacks this month. This post is by Scott Edward Walker, the firm’s founder and CEO. If you like it, check out Scott’s blog and tweets @ScottEdWalker. – Nivi

It’s a new year — which means it’s time to make resolutions. Rather than write about my resolutions, I decided to put on my lawyer hat and advise entrepreneurs on what I think their New Year’s resolutions should be. During my 15-year career as a corporate lawyer (including nearly eight years at two major law firms in New York City), I have seen entrepreneurs make certain fundamental mistakes over and over again. So what better way to welcome in the new decade than to recommend the following resolutions to entrepreneurs…

Resolution 1: “I will create a competitive environment when I’m doing deals”

There is nothing that will give an entrepreneur more leverage in a negotiation than a competitive environment (or the perception of one). Every investment banker worth his salt understands this simple proposition. Not only does competition validate a firm’s interest, but also it appeals to the human nature of the individuals involved. Competitors can be played off each other and, as a result, the entrepreneur will be able to strike the best possible deal.

I learned this important lesson as a young corporate associate in New York City. As I discuss in my video post, Lessons Learned in the Trenches of Two Big NYC Law Firms, I recall having two M&A transactions on my plate: one was a divestiture — i.e., the sale of a division of a multinational corporation being auctioned by an investment bank; and the other was the sale of a private company to a competitor (with no i-bankers involved). In both deals, my firm was representing the sellers but, as we worked our way through the negotiation process of each deal, we ended-up with two completely different acquisition agreements with respect to the material terms.

In the auctioned deal, because the i-banker was able to play the prospective buyers off each other and create a competitive environment, the final agreement was extremely seller friendly and included broad materiality qualifications, a huge basket/deductible and a cap on seller’s liability of 10% of the purchase price. In the private-company transaction, however, there was only one prospective buyer — and the buyer’s principals knew that the seller was anxious to sell and thus were playing hardball. The deal terms ended-up being extremely buyer-friendly and included a large portion of the purchase price being escrowed and a cap on the seller’s liability equal to 100% of the purchase price.

The lesson learned is that you must create a competitive environment (or the perception of one) in order to have strong negotiating leverage. There is, however, one important caveat that entrepreneurs should keep in mind: this game must be played carefully and is better handled by someone with experience. The last thing an entrepreneur wants is to end up with is no deal at all.

Resolution 2: “I will leave my heart at home”

You have to think with your head, not with your heart — particularly when you’re doing deals. The best deal guys are masters at taking their emotions out of transactions and being extremely disciplined. They will just walk from a deal if they get out of their comfort zone (e.g., with respect to the price, risk profile, etc.), regardless of how much time and money they have spent.

On the other hand, most entrepreneurs become emotionally wedded to a particular transaction and are unable to maintain their objectivity as they move further along the deal process. They get all excited as soon as someone waves some money at them and allow themselves to get drawn into the money guy’s web. It is critical that entrepreneurs understand this dynamic. Entrepreneurs will generally be negotiating with guys on the other side of the table who are far more deal savvy than they are – venture capitalists, private equity guys, etc. – guys who are masters at playing on their emotions.

This is why it is so important for entrepreneurs to establish a game plan (i.e., dealbreakers) before the negotiating process begins and to have the discipline to stick to the plan and be willing to walk, if necessary. If an entrepreneur is seeking venture capital financing, he should sit down with his transaction team before reaching out to the VC’s to establish his dealbreakers with respect to key terms, such as valuation, the liquidation preference, board composition, etc. The same approach should be followed if he’s interested in selling his company: What’s the lowest purchase price you’ll accept? What’s the highest cap on liability you’ll agree to? Will you agree to escrow part of the purchase price? If so, how much and for how long? Once you establish the dealbreakers early on, you can take your heart out of the equation and think with your head.

Resolution 3: “I will work my balls off”

This is the advice a senior partner gave me when I was a young corporate associate at a major New York City law firm: “If you want to be a great lawyer, you have to work your balls off and make practicing the law the number one priority in your life.” He explained that this means everything else in your life has to be pushed aside, and you need to “work, work, work.” And when you’re not working, he added, you need to be reading treatises and articles discussing the deals you’re working on to get a deeper understanding of the significant issues. When I explained to him that, after three months, I had been working nearly every weekend and that my girlfriend was ready to leave me, he told me that I need to get a new girlfriend.

I received similar advice from Harry Hopman, my old tennis coach (and the winningest coach in Davis Cup history), when I was playing tennis in the minor leagues after college. He preached to me that: “It all comes down to one word — desire. How badly do you want it? How much are you willing to sacrifice?” And he was right. When I was traveling and playing tournaments in Europe and South America, I noticed that the best tennis players were generally the hardest working; the qualifiers were the ones going out drinking every night, not the top seeds. Sure there were exceptions — like John McEnroe — but the exceptions were rare.

I have seen this same pattern during my legal career: the most successful clients tend to be the hardest working. The private equity guys and hedge fund guys I represented in New York City were animals; working around the clock and cranking out deal after deal. I attribute a lot of their success to just plain hard work. In 2005, I moved out here to California to help entrepreneurs, and it’s been a mixed bag in terms of the work habits that I’ve seen. Some of my clients are intense and put in the long hours; others, however, are just dreamers — and they are the ones who struggle. In short, there are no shortcuts to success.

Resolution 4: “I will not let my investors screw me”

Here’s the advice I give all my clients to avoid getting screwed by their investors: do your due diligence prior to accepting any money. The number one mistake I have seen entrepreneurs make in any deal is the failure to investigate the guys on the other side of the table. Remember, you will, in effect, be married to your investors for a number of years. Accordingly, entrepreneurs must do what any bride or groom does prior to tying the knot — date for a while and, of course, meet the family.

What does this mean in practical terms? It means surfing the web and learning everything you can about the particular firm making the investment and, more importantly, the particular individuals with whom you are dealing (and who, presumably, will be sitting on your board for a number of years); it means breaking bread and having a couple of beers with the potential investors; and it means getting references and talking to other entrepreneurs and founders who have done deals with them. Issues to address include: How have they treated their other portfolio companies? Are they good guys or jerks? Can they be counted-on and trusted? Do they share your vision for the venture? Will they add significant value (e.g., through contacts, domain expertise, etc.)?

There is an outstanding video discussion on between Brandon Watson, a smart entrepreneur (currently at Microsoft), and Andrew Warner, the founder of Mixergy, as to what could happen if you don’t adequately diligence your investors. Brandon is extremely candid and discusses how he got “bullied” by his board. Moreover, he expressly notes in the comments to that post that, “the diligence factor was that I knew them, but had never taken money from them. It’s hard to know how people are going to react when they are at risk of losing money because of something you are directly responsible for until you are actually at that point.”

Resolution 5: “I will retain a strong, experienced lawyer to watch my back”

This is obviously a bit self-serving, but every entrepreneur needs a strong, experienced lawyer to watch his back. There is just too much at stake for entrepreneurs to be (1) using sites like LegalZoom, (2) pulling forms off the web and trying to play lawyer, or (3) retaining the cheapest lawyer to save money. And as the Madoff affair and other recent high-profile cases demonstrate, there are a lot of unscrupulous characters out there trying to take advantage of unsophisticated entrepreneurs.

There are also more subtle potential problems entrepreneurs need to be protected from, including the inherent conflict of interest that certain service providers have. For example, entrepreneurs need to be careful with investment bankers, who generally only get paid if a particular deal closes. Indeed, a middle-market i-banker’s entire year can be made or broken based on whether or not he can close one or two deals.

Unfortunately, I experienced this issue first-hand shortly after moving to California when I got pulled onto an M&A deal in which an i-banker stuck his finger in my chest and warned, “We’re going to get this deal done despite you fucking lawyers.” He then later complained to the managing partner (who had the client relationship) that I was blowing up the deal because I had retained special environmental counsel from my old NYC law firm and we were pushing too hard on the environmental indemnity. Good work by the i-banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for environmental problems that it inherited as part of the acquisition.

The bottom line is that a strong, experienced corporate lawyer will sober the entrepreneur and lay out all of the significant legal risks in a particular transaction; he will then push hard to negotiate reasonable protections. If the deal sours and lawsuits are filed, well-drafted documents with appropriate protections become a kind of insurance policy to the entrepreneur.

If you like this post, check out Scott’s blog and tweets @ScottEdWalker. If you want an intro to Scott, send me an email. I’ll put you in touch if there’s a fit. Finally, contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi

Yesterday, I was brainstorming a list of things-to-do with an entrepreneur who is getting ready to sign a term sheet.

After searching through the Venture Hacks archives, I realized one of our posts already covers it: How much diligence should we do before signing a term sheet? I think that post mostly stands the test of time—problem solved.

I revised the post to include this question for prospective investors:

“Do you agree with our plan for the next two/three/four quarters?”

Discussing this before you sign a term sheet has a few benefits:

  1. You learn what it’s like to work with the investor—before you marry him for the life of the company. If you don’t like working with him, he may not be the right husband-for-life.
  2. You discover if your investor agrees with your plan. If he doesn’t agree with your plan or you don’t agree with his revisions, why do you want him to join the company? Are you really going to put someone on the board who doesn’t agree with what your plans?
  3. Getting agreement on the plan before the financing is normative leverage. If your investor wants to change the plan in the future, you can ask him to justify the change: “We agreed on a plan, how have the circumstances changed since we agreed on a plan, and why does that require us to change the plan?”

Completely unrelated (or is it?):


Q: Everybody is telling us to raise smart money. What’s the difference between smart money and dumb money?

“The best assumption to make is that your VC’s primary value add is the cash they are investing. Then you’ll always be surprised on the upside.”

Marc Andreessen

Summary: Smart money is money plus the promise of help that’s worth paying for, dumb money is money plus hidden harm, and mostly money is mostly money. Weed out the dumb money with diligence. Evaluate supposedly smart money with the smart money test. Finally, assume your investors are mostly money: unbundle money and value-add to get money on the best terms possible and value-add on the best terms possible.


If smart money is money plus the promise of help that’s worth paying for, then dumb money is money plus hidden harm, and mostly money is mostly money. All three provide what entrepreneurs primarily want from investors: money.

  1. Avoid dumb money: you don’t hire harmful people—so don’t marry them for the life of the company either.
  2. Most investors are mostly money but very few of them act like their primary contribution is capital. They spend too much time selling you on their value-add and not enough time getting you a quick yes or no.
  3. Smart money is rare—after all, would you work with most investors if they didn’t bring a piggy bank? Also, too many investors think the “smart” in smart money means “we know how to run your business better than you.”

Weed out the dumb money with diligence.

Don’t assume any investor won’t be harmful. Do the diligence to prove otherwise:

  • Do you trust him?
  • Will he provide his pro rata in the next round? (Not so important for seed funds and angels.)
  • Will he support you if the company is going sideways?
  • Does he have impeccable references?
  • Does he want control?
  • When it comes time to sell the company, will he let you?
  • Will he let you expand the option pool to hire someone great?
  • Does he want to replace you as CEO?
  • Will he try to merge you with a dying company from his portfolio?
  • Do you want to marry him for the life of the company?
  • Is he committed to investing in startups and does he have a reputation to protect in the startup world?
  • et cetera

Evaluate supposedly smart money with the smart money test.

After you’ve weeded out the dumb money, do the smart money test on everybody else:

Would you add the investor to your board of directors (or advisors) if he didn’t come with money?

If the answer is no, he is mostly money (see below). If the answer is yes, subtract some dilution from his investment since he’s eliminating the cost of a value-add director or advisor. You’re paying for the smart money investor—with his own money!

A smart money investor can be very valuable because he is good enough to be an advisor or board member and he owns enough to really care about the company in good times and bad times. An advisor or independent director won’t own enough of the company to really care if the company is in trouble—his career isn’t on the line like an investor’s.

But! If the investor you thought was smart doesn’t add value, you can’t fire him like an advisor or director and get your money back. You can only hope to ignore him. Which is why it is safer to…

Assume your investors are mostly money.

Whether you raise smart money or mostly money, you should raise money as if your investors were mostly money. In other words, unbundle money and value-add. Get money on the best terms possible and get value-add on the best terms possible.

You can buy advice and introductions for 1/10th of the price that most investors charge. An investor will buy 15–30% of your company. An advisor or independent director will require 0.25–2.5% of your company with a vesting schedule of 2–4 years.

An advisor or independent director will be hand-picked from the population of planet Earth. He should be more effective than someone picked from the vast pool of investors who want to invest in your company.

He will own common stock, unlike an investor who owns preferred stock with additional rights.

And he won’t have conflicting responsibilities to his venture firm, other venture firms, or limited partners.

Money-add first, value-add second.

Value-add is great but it comes after money-add. First, find a money-add investor who will make an investment decision quickly, who is humble and trustworthy, who will treat you like a peer, who shares your vision, and is betting on you, not the market.

Got a question for us?

Send your questions to We read every question and answer the most interesting ones here!


Q: Is the venture capital industry doomed?

No. Venture capital invested in the U.S. is increasing and VCs are a critical part of the startup ecosystem—I’m grateful they exist.

The rate of innovation is increasing and that innovation needs capital to get in customer’s hands. Capital invested in startups is going to increase, not decrease.

It’s wonderful that you can start a web-based software company with little capital. But after that early stage, even these companies need significant capital to reach their customers and beat their competition.

VC is not doomed but it is changing: see Y Combinator, Idealab, Hit Forge, Squid Labs, and others.

Q: Do investors hate Venture Hacks?

No. Smart investors like educated entrepreneurs. But that doesn’t mean they agree with our advice.

Q: Who’s the best VC in the world?

A limited partner can tell you who was the best VC in the world with fund performance data from institutions like Cambridge Associates. He can also tell you that past performance may not predict future performance in venture capital; see Don’t Bet the Farm on Serial Persistence.

But entrepreneurs shouldn’t select their investors based on how much money they have made for their limited partners.

The best VC for an entrepreneur is a partner who doesn’t care what other investors think, doesn’t take up the entrepreneur’s time with a lot of diligence, doesn’t pull out his Blackberry in meetings, and doesn’t ask dumb questions.

The right partner makes investment decisions quickly, shows up to meetings on time, pays attention, lets management run companies, treats the entrepreneur like a peer, and conducts himself with humility and trust.

We avoid criticizing or applauding specific firms on Venture Hacks but I will give a shout out to Atlas Venture and their General Partner Jeff Fagnan who supports me while we write Venture Hacks. And a shout out to Naval, my Venture Hacks partner, and his Hit Forge fund. I’m lucky to be working with both of these guys and I recommend them both.

Q: Who works harder: investors or entrepreneurs?

Entrepreneurs and VCs both work hard before and after an investment.

Investors are typically personally wealthy and draw a very comfortable salary from their management fees, in addition to their potential carry in a portfolio of startups. Entrepreneurs are often strapped for cash and fully invested in a single startup.

In theory, investors prefer investments that require no work, have no risk, and have a tremendous return. In practice, investors are part of the team that makes a company succeed or fail.

Early stage companies should expect a venture capital investor to spend about one day per month on their company. Most VCs spend the rest of their time working with other companies, looking at potential investments, marketing their firm, and working with limited partners.

Note: These excellent questions are adapted from Ashkan Karbasfrooshans’s Venture Hacks interview.

Image Source: The Filter.