VC Due Diligence: The Audit of E

This is a continuation of my post about The VC Due Diligence Process and builds on The 3 Laws of Venture Capital. Both are commentaries of David Silver's book Venture Capital: The Complete Guide for Investors.

Continuing with the audits that VC's should perform when reviewing investments, the second of the five audits is the review of the entrepreneurial team.

The two team members that VC's should focus on are the entrepreneur and the manager partner. Entrepreneurs are responsible for the launch of the company while the manager is responsible for building the company into something that has value. Think of entrpreneurs as the technologist or visionaries and the manager partners as the "gray hairs" they bring on to make their dream a reality. Entrepreneurs generally don't select managers well and have trouble delegating. This is because entrepreneurs believe others can't do things as well as they can (and this is, in fact, usually true).

A great analogy that Silver uses is one of a stagecoach. Here's an excerpt:

The entrepreneur builds the stagecoach and charts the course. The manager drives the stagecoach. And the venture capitalist buys the team of six white horses. Assorted managers are brought along to feed the horses, shoot at the hold-up men along the way, repair the stagecoach if needed, but keep it moving at all costs. Inside the stagecoach is the product or service being conveyed by the team from its origin to its destination.

The Successful Entrepreneur

Silver bases his profile of the successful entrepreneur on hundreds of interviews he conducted for his book The Entrepreneurial Life. I found this discussion to be both the most amusing and interesting part of the book. The "profile" is not exactly the most politically correct way to approach evaluating entrepreneurs, but it's an interesting place to start a discussion about the topic. Silver outlines the superficial characteristics of successful entrepreneurs as the following:

Age: 27 - 33 years

Sex: 95% heterosexual male

Facial: Simple hair style, minimal upkeep required; frequently bearded.

Clothing: Loafers, no jewelry or extra buttons; comfortable, simple.

Physical: Thin, excellent health, no excesses, such as smoking, drinking or over-eating.

Marital: 65% divorced, 35% married to first wife, zero bachelor.

Speech: Speaks quickly, quick-witted, self-effacing

Residence: Lives in urban area

Automobile: 80% drive European cars, with minimal maintenance requirement

Politics: 80% vote liberal

A similar profile holds for female entrepreneurs as well, although they tend to be a few years older and are not married (but in committed relationships). He goes on in the book to outline ten substantive characteristics of successful entrepreneurs:

1. Middle class background
2. Childhood deprivation
3. Absent father; dynamic mother
4. Guilt that mother has been disappointed
5. Dissatisfaction-Insight-Energy
6. Creativity
7. Honesty
8. Courage
9. Communication skills
10. Happiness

Here are some additional details on the ten characteristics:

1. Middle-class background

Successful entrepreneurs grew up in middle class households - specifically households that espoused middle class values (i.e. the American Dream) rather than just households that financially were middle-class. Parents in those households pushed their children to become professionals via hard work; failure was attributed to laziness. Dream professions were lawyers, doctors, engineers, accountants.

Entrepreneurs rarely come from the upper or lower class. The upper class espouses values where "change is probably for the worse; one should never invade one's capital; and achievement is something one's ancestors accomplished". Lower class families on the other hand fostered environments where "success and achievement are condemned as the result of being lucky or having cheated". When things go wrong with a venture, these types of entrepreneurs are likely to give up, often taking the investor's money with them. Children of statesmen, professors, or classical musicians also don't have the right values as they seek "inner joy" in life rather than extrinsic success.

The question the VC should ask here is "What did your parents do? Tell me about the values of your family. Did they want you to be a lawyer or doctor?" It will likely evoke a lively response.

2. Childhood deprivation

The objective for the VC is to "locate the pain"! The VC is trying to assess if the entrepreneur has what it takes to get through the tough times. The question to ask is "What made you start this company, risking so much and sacrificing so much?". Successful entrepreneurs were deprived in some way as children - physical, ethnic, economic, etc. When their friends were completely happy as children, the entrepreneurs were in torment. They secretly thought to themselves, "I'll show you one day". Typical deprivations were:

1. Physical - Common examples include illnesses and lack of height or physical stature. Fred Smith (Federal Express) was kept in cructches for years due to cystic fibrosis. Francis Coppola (film-maker) was bed-ridden as a child due to polio. Many short people also are driven to become entrepreneurs - David Sarnoff of RCA, Gino Paolucci of Chun King Corp, Charles Revson of Revlon.
2. Ethnic - Children from ethnic backgrounds (e.g. immigrants) were unable to fully engage with their childhood friends due to 1) their family being different, 2) their language being different, 3) their clothes or customs being different, or 4) obligations to their families.
3. Economic - Economic deprivation (I'll show you that my family is better") combined with middle-class values (the American Dream) are a powerful driver.

3. Absent father; dynamic mother

I think this quote from Silver sums it up better than I could:

When you are the only fatherless child on the Little League Team, the pain can be as deep as that of the bedridden child who cannot join the Little League Team. Sliding into homeplate and scratching your knee is a trophy if your father comes over to the dugout to wipe the blood away. If you wipe your own blood off your knee, it's not a trophy -- it's a pain, and you learn to treat your own wounds. Entrepreneurship is a lonely experience with many bloody knees that nobody except the entrepreneur will tend to.

Surprisingly, the opposite is true for female entrepreneurs. Successful female entrepreneurs have dynamic fathers.

4. Guilt that mother has been disappointed

Entrepreneurs generally drop-out of their profession to pursue entrepreneurship. It's very important that they feel guilty about that decision. If they're from middle-class backgrounds, their parents dream was for their child to become a professional - an engineer, doctor, lawyer, etc. Drop-outs from universities are also guilty. It's tough to name any successful entrepreneurs that are graduates of Princeton University, for example.

Entrepreneurs can be doubly guilty if they have chosen their company over their wife or family. The divorced entrepreneur is extra guilty because he couldn't keep his marriage intact through the launch period. Surprisingly, divorced entrepreneurs are great to invest in because they are extremely driven to "show her that she gave up on me too soon" (giving them a "second wind"). A similar level of guilt holds for those that are happily married. Given that they are away much of the time, their wife, husband, or significant other encourages them to work "smarter" so that they can make time for their family.

5. Dissatisfaction-Insight-Energy

There are plenty of middle-class, fatherless, deprived, divorced, guilty people out there. Why aren't they all entrepreneurs? Because entrepreneurs also have the important combination of dissatisfaction, insight, and energy. Dissatisfaction is related to seeing a problem and feeling strongly that it is not being solved. Insight is the ability to see the entire problem that they intend to solve, including all the subtle aspects of the problem. Energy is having an insatiable drive to solve the problem and to move to solve it quickly; if you ask an entrepreneur what their hobbies are, they should say none; what do they read - trade journals; how do they spend their weekends - working on the business.

Silver makes an interesting distinction between the artist, writer, consultant, and entrepreneur. The artist is dissatisfied and has insight about the problem. The writer, in addition, can see a solution to a problem and can articulate it. The consultant is dissatisfied and has energy, but doesn't fully understand the problem and solution. Only the entrepreneur has the critical link-up between all three of these aspects.

6 - 10: While characteristics 1 - 5 can be validated via discussions with the entrepreneur, 6 - 10 can only be verified by interviews and reference checks.

6. Creativity

This is obviously a subjective one, but the test for the entrepreneur is to see how thoroughly they have problem-formulated. In other words, they should have devised a multi-tiered approach to the market. There are multiple segments to the market, (in order of decreasing numbers) some willing to pay for information about the problem, others willing to pay to meet others who share the same problem so they can discuss it, others who will pay for information about the solution, and finally the smallest segment of those that are willing to pay for the solution.

7. Honesty

As Silver states, the entrepreneur and venture capitalists "must live together for about 5 years, and the marriage will not work if one constantly questions the honesty of the other". Conducting numerous reference checks should reveal how honest an entrepreneur is. It's wise to talk to at least six co-workers, six superiors, and six subordinates. It's also wise to confirm degrees and other claims the entrepreneur makes (e.g. if they claim a certain company wants to be a beta site, call them to confirm). It's also important to check references that are not provided by the entrepreneur. Ask references for other people to talk to - "Was there someone at work who was Joe's competitor?" After 30 calls or so, you'll have a good understanding of the entrepreneurs honesty.

8. Courage

Entrepreneurs will not stop trying until they win! A simple test is to ask the entrepreneur where they're going to get capital from? If their ownly response is "venture capital", be afraid. They should be pursuing multiple options and have fail-safe and back-up plans. Inspect and inquire about their fail-safe plans.

9. Communication skills

Great entrepreneurs also have a great ability to persuade others. They will need to hire and motivate a team, sign-up early customers, and evangelize their product. They don't necessarily need to be amazing speakers, but they have to have the ability to convince others.

10. Happiness

The last characteristic is that entpreneurs are happy. They should laugh a lot and be the least bitter of all people. They find pleasure in the little wins in life. An easy gauge is to listen for any bitterness in them - do they make any derogatory jokes? put others down? make any ethnic jokes? They shouldn't. Entrepreneurs view themselves as too low on the ladder to even fathom making such comments.

The Successful Manager Partner

The picture of the successful manager partner is quite different from that of the entrepreneur (and no it is not Michael Scott from The Office). The manager partner is all about turning the entrepreneurs vision into a reality. While the entrepreneur has "childhood pain", the manager has industry experience. While the entrepreneur is "creative", the manager is detailed and thorough. It's very important that VC's find excellent managers to turn their investments into real businesses. As was mentioned earlier, entrepreneurs are often not good at selecting great managers, so VC's need to intervene to ensure the best possible team is put together.

The typical profile of a successful manager partner is the following:

Age: Approximately 16 years older than the entrepreneur; mid-to-late 40s.

Residence: Well-kept suburb; owns home.

Marital status: Approximately 82% married.

Has assets: Yes.

Voting preference: Conservative.

Typical car: American-made sedan

Shoes: Lace-up

Hair: Conservative; styled

The characteristics to look for are:

1. Corporate achiever
2. Dissatisfaction and energy
3. Heart
4. Practicality, thoroughness, and capacity for work

Some additional commentary on each follows.

1. Corporate Achiever

The key characteristic of the manager partner is that they are a corporate achiever. They are generally older than entrepreneurs because they have significant experience in the corporate world. Start-ups face competition from large corporations, so it's important to find someone that knows how the "enemy" thinks. Managers from non-corporate backgrounds don't fit the bill - accountants, lawyers, university department heads, military - none of them really make the cut.

The question to ask these folks is - "What is your goal over the next few years for yourself and this company?". The correct answer is - "Build this company into an industry leader with sales of over $100M". The corporate achiever has experience picking products out of a line, building a team around them, setting up a marketing plan, implementing the plan, and generating sales of $10M, $30M, $60M over three years. Reference checks will confirm this track record of success.

Entrepreneurs rarely have the ability to do this (hence why there are very few entrepreneur-CEO's). In fact, managers rarely have the ability to do this. Out of the hundreds of resumes VC's review, maybe 1% of them have the combination of experience and other characteristics (below) that make a successful manager partner.

2. Dissatisfaction and energy

This is related to the earlier discussion of Dissatisfaction-Insight-Energy. The manager partner should be dissatisfied (see the problem) and have energy (to solve the problem), but they need to find an entrepreneur that has the insight (solution). They may be consultants for several years before connecting with an entrepreneur that has created a great solution.

3. Heart (they want it back)

The corporate achiever, in achieving all that they have in the corporate world, have lost their heart in the process. They have grown dissatisfied with the politics and back-stabbing and desperately want to escape. An interesting (albeit troubling) excerpt from Silver: "A tip that he has entered this period of searching is usually wandering from the nest, disintegrating relations with his spouse, and perhaps marriage counselling. Until he finds, through an entrepreneur, the insight that he lacks, he will continue wandering." Reminds me of reaching impasses in your life and getting unstuck.

4. Practicality, thoroughness, and capacity for work

The entrepreneur will normally have the limelight, but its the manager partner that's pulling the strings making things happen. For example, when the entrepreneur suggests 10 possible new markets, it's the manager that will reject all but the best ones. They are detailed, thorough, while at the same time able to step back and see the big picture.

Terms of Employment

As you've likely gathered, the manager partner has been very successful. As a result, they generally don't come cheap. Although they are willing to take 20 - 25% salary reductions, expect to give up between 5 - 10% of the company. In addition, they may also negotiate perks such as moving costs, rental costs, and tuition differences for their kids. If the manager asks for sales or earnings bonuses, however, they are likely not a corporate achiever; they lack the knowledge of the process and prefer easy money to company building. Their stock incentive usually vests over 4 or 5 years with terms related to being removed for "cause" (where they have to sell back shares at cost), leaving voluntarily before the vesting period is up (where they have to sell back their shares at the greater of cost or book value), or liquidity events (where their stock vests immediately upon an acquisition or IPO). The usual role they'll take on initially is CMO, with a path to CEO. Titles should not be more grand than that.

As an aside, if you find them through an executive search firm, expect to pay 30% of their first year salary as a fee. Again, they are not cheap to find or hire, but they are absolutely necessary to the success of the business.

Summary of the Audit of the Entrepreneurial Team

This is the most important of all the audits, so should be accorded significant attention. Reference checks should also be done on other key personnel - CFO/controller, VP sales, Chief Production Officer, etc. In all cases, their honesty must be impeccable. A "failure on the part of a key person to present his background, warts and all, is a red flag". As was mentioned earlier, an investment is like a marriage. You have to know who you're going to spend the next 5 to 10 years of your life with.