This part of the job is so important that we have devoted both this and the next chapter to the subject. In analyzing management, the investor has one basic objective—to determine whether the management team is entrepreneurial enough to execute the business plan profitably. There are virtually hundreds of thousands of small- and medium-sized businesses in the United States today. Some have management that is entrepreneurial; most do not. But first, let’s understand the term entrepreneur.
This term has undergone a change in meaning since the late 1800s, when it was used to refer to “the director or manager of a public musical institution.” Entrepreneur derives from the French verb entreprendre (to undertake), which had already entered English earlier as enterprise. Enterprise first appeared around 1430 and was commonly used to refer to an undertaking of a bold and arduous nature. The person carrying out the enterprise was known as the enterpriser, but this term eventually lost ground to entrepreneur, the primary meaning of which became “one who organizes, manages, and assumes the risk of a business or enterprise.” The term enterpriser remained primarily as referring to persons taking up a cause, usually warfare for personal gain.
In most instances, the enterpriser was someone who led a small band of men, perhaps a small army, in an attack on a town, usually to pillage. Enterprisers were also known for their ingenuity. Interestingly, some of these original meanings have not been lost. Today’s entrepreneurs set out to capture markets, to beat the competition, and to obtain profits. Not everyone has the passion and smarts to win. An entrepreneur does. Does the team you are going to invest in have that entrepreneurial spirit?
Entrepreneurs have been studied at some length over the past 30 years. However, researchers have been hard-pressed to differentiate between small business owners and entrepreneurs. They have had difficulty in differentiating managers in large companies and entrepreneurs. Indeed, researchers have had difficulty in identifying the characteristics of a successful entrepreneur at all. One book (which shall remain nameless) has described entrepreneurs as people who are of small physical stature and who have experienced some kind of physical illness in their childhoods, had acne as adolescents, and grew up poor and without good educations. The book in question strained desperately to name people who were short and had suffered physical illness but had overcome all of these in order to build great businesses.
Although it is wonderful to read about those entrepreneurs who have overcome their physical problems, it does not necessarily mean that all entrepreneurs have to have these attributes in order to be successful. We found that book very entertaining, but we found very little in it on which to base future judgments for selecting entrepreneurs. How would you apply this “new knowledge” if you were an investor? Think how silly it would be to measure your entrepreneur’s height, to ask whether the entrepreneur had a history of personal problems, to ask about that person’s physical health as a child, and to use all of that as a selection process for backing an entrepreneur. Nothing could be further from good investment management.
Another book (it shall also remain nameless) sees entrepreneurs as being loaded with guilt and having experienced great deprivation. These entrepreneurs are also said to identify strongly with their mothers. We always enjoy reading these psychological evaluations; they make us have a good laugh. This same book described entrepreneurs as mostly divorced people. In addition, the writer described their wardrobes and indicated that entrepreneurs would only be happy with shirts that did not have button-down collars and shoes that had very thin soles. Those individuals who wore wingtip shoes with very thick soles could not be entrepreneurs, or so the book hypothesized.
Imagine then, how you would analyze the entrepreneur from the investor’s point of view. First, you would need to do some psychoanalysis to determine whether the entrepreneur is loaded with guilt for not accomplishing the goals that the entrepreneur’s parents or peers seemed to expect. Also, you would need to determine the degree of deprivation that the entrepreneur has undergone to decide whether that person had risen from sufficiently low ranks. Finally, you would need to know whether the individual identified closely with his or her mother. After you analyzed the “inner being” of the entrepreneur, you would be ready to look at the entrepreneur’s clothes to see whether the entrepreneur had the proper attire; that is, thin-soled shoes and shirts without button-down collars. How ridiculous this approach is for an investor of serious money.
All of these descriptions of entrepreneurs are disastrous simplifications. If any investor used them as investment guidelines, he or she would soon be quite poor. Such oversimplifications will only lead you down the wrong trail. Your best bet is to develop your own knowledge base and apply it to the people you meet who have succeeded as entrepreneurs. First, determine what characteristics you think are important for an entrepreneur. Let’s look at a few that practicing VCs have used.
Many scientific studies of entrepreneurs have been conducted by social scientists. Most of this work has been reported in the trade press. Despite their problems, these studies have produced some very interesting results that we believe make sense when coupled with our experiences. The characteristics that they have discovered are the ones that we believe you should look for in the individual you are backing in an enterprise. These are broad characteristics.
In general, social scientists study two sets of characteristics:
Mental characteristics (such as the need for achievement, need for power, belief that one is in control of one’s own destiny, and risk preferences)
Behavioral characteristics (such as determination, resourcefulness, a sense of urgency to get things done, and a realistic approach to facts)
Generally speaking, mental characteristics have been studied more than behavioral traits. This is unfortunate because the average investor will find it easier to identify the behavioral traits than the mental ones.
Certain physical attributes of entrepreneurs are important as well, such as physical energy level, a better-than-average ability to speak and communicate, and mental stamina. Finally, there are some other characteristics that you as an investor will want in an entrepreneur, such as honesty, partnership orientation, and a desire for fair play.
Now let us turn our attention to the attributes most studied because they seem to be present in successful entrepreneurs that we have encountered over the years.
Every study of entrepreneurial individuals has demonstrated that entrepreneurs need to achieve. They are competitive to a fault. They must be first. This basic trait makes it very easy to identify entrepreneurs in a business. Start by looking at their backgrounds. Does the entrepreneur have past achievements? Where has this entrepreneur been spending the past few years? Has the entrepreneur been trying to accomplish something? What accomplishment is the entrepreneur proud of? Go through the personal background in detail and try to determine what achievements have been made. Ask references whether the entrepreneur is an achiever and a self-starter. If you cannot demonstrate to your satisfaction that the so-called entrepreneur meets your definition, it’s time for a quick dump.
One of the universal characteristics of every entrepreneur is the drive to be independent. The entrepreneur wants to be autonomous. The typical entrepreneur doesn’t need the support of any group, club, or clique. Most entrepreneurs do not need any nurturing by a mentor. Entrepreneurs need to dominate the situation, to be in control, and to direct others. As a result, some entrepreneurs may have poor personal skills. There are some who believe that everyone is motivated in the same way and that employees and associates do not need the kind of personal motivation that most skilled managers recognize they must instill in others. You need to be careful of those types of managers because they may alienate their employees and have a difficult time motivating people. Most successful entrepreneurs, of course, have excellent people skills. These entrepreneurs know how to be in control and at the same time motivate people to do their best for the company.
It will be difficult for you to see the entrepreneur’s drive for independence without knowing something about that entrepreneur’s past performance. That is why it is important to talk to the people acting as references and the employees of this new company. Also, if you continue to talk with the entrepreneur and see how he or she has behaved in the past, you will soon get a clear fix on whether the individual you are talking to has a strong desire for autonomy.
Most entrepreneurs are very confident about what they are doing. They seem to be emotionally stable and have very high self-esteem. Sometimes this is confused with self-centeredness, but most often their high self-esteem is merely an outward manifestation of their personal self-confidence. Because of this, most successful entrepreneurs exhibit good leadership skills and have the ability to set goals and work toward them.
In addition, entrepreneurs strongly believe that they can control their own destinies. They believe that fate is responsible for little in their lives. Although they may say that luck played a part in their success, they will also state that they took advantage of an opportunity. Some people believe fate will determine who they are and what they will be. This is not how entrepreneurs think. The responsibility for their destiny rests squarely on their own shoulders.
Most tests of entrepreneurs have shown that they have a high tolerance for ambiguity. As a result, they are nonconformists by nature and have no strong aversion to change, as long as it suits their objectives. Most entrepreneurs are creative when measured on any creative scale, and they are generally curious and interested in almost everything. They are able to judge risks accurately and, thus, are perceived as risk takers. Whereas most people would perceive something as a high risk, most entrepreneurs would have the good sense and analytical skill to see through the high risk to a safer way of accomplishing the goal. In doing your background work on the entrepreneur, you should look at the entrepreneur’s ability to judge risk and to take seemingly ambiguous situations and make sense of them.
In fact, entrepreneurs are not high risk takers. That is, given the opportunity to (a) take no risk whatsoever and have a small gain, (b) take moderate risk and have a moderate gain, or (c) take a high risk with high gain, entrepreneurs will opt to take moderate risk. It might seem more natural to you to equate entrepreneurs with high risk takers. However, many researchers have noted that entrepreneurs are moderate risk takers. Those researchers who have classified entrepreneurs as high risk takers fail to understand that entrepreneurs are analytical by nature and, thus, are usually able to perceive risk better than most people. This means that where an average person might see high risk, an entrepreneur might perceive only moderate risk. When you are studying your entrepreneur, try to determine the entrepreneur’s risk profile. If you sense that the entrepreneur is a gambler, don’t bet any money on the deal or you will usually have a loss. If you are interested in high risks, you may as well go to a gambling casino and place your money on the red 13 on the roulette wheel.
Entrepreneurs are a determined lot. They all seem determined to succeed. They want to accomplish things, and their desire to do so is strong. They are able to fix on a goal and reach it. This attitude can be seen in athletes who become “psyched up” about winning. A sports competitor will imagine that he or she has won an event and will put his or her mindset into a winning orientation. Entrepreneurs also exhibit this sense of determination and ability to see a clear win for themselves. Make sure that your entrepreneur is a determined person.
Entrepreneurs are very resourceful. When problems occur, they are geniuses at finding solutions. When a situation presents itself, they become consummate problem solvers, looking at every area and finding a way to win. They are resourceful to the point of making the rest of us look silly. With their creativity and inquisitiveness, they won’t rest until they find a solution. Make sure you know how resourceful the entrepreneur is.
Most studies of entrepreneurs indicate that they have a strong sense of urgency. They are constantly trying to beat the clock. They try to squeeze as many things as possible into each hour of the day. They seem to be in a race against time. They must achieve such-and-such by a certain deadline. Some entrepreneurs are driven to squeeze so many things into a single day that they end up being late for meetings and don’t accomplish anything. These entrepreneurs are out of control, and you should avoid them. Any entrepreneur who can’t be on time for meetings is most likely “out of control” and is not efficient at managing his or her time or accomplishing goals. Make sure you have an entrepreneur who is realistic about his or her own limits but who also has this sense of urgency to get things done.
One of the striking characteristics of entrepreneurs is their sense of what is reality. Entrepreneurs rarely fool themselves into accepting bad situations. They know they have a marketing program and a sales job to carry out, and they do it. However, they are not caught up in their own sales hype or their own promotional fever. They know that the real facts will determine the outcome of events. They have a keen understanding of what is real and what is fabricated. As a result, they can get to the bottom of an issue very quickly.
When you are discussing projections with entrepreneurs, see whether they are blowing smoke or have their feet on the ground. A good long discussion about their projections will demonstrate whether they are in touch with reality or are on “cloud nine.”
You can usually differentiate an entrepreneur from a dreamer. Dreamers hope a lot. They hope that what they want will happen. There have been studies of intelligent people who make poor decisions. These studies have tried to determine why smart people make mistakes. Time and again, the answer is simply because they want to. It seems incredible that a smart person would intentionally make a mistake, but that is the conclusion. In the entertainment business, one refers to the people in the audience who can “suspend disbelief.” That is, they know what they see is not real, but they suspend that disbelief and accept it as real so they can enjoy the show. The same thing is true for intelligent people. Even though they know some piece of data is incorrect or that doing something is not best, they do it anyway. They have suspended disbelief and accepted an incorrect fact so that they can do what they want to do. Make sure your entrepreneur does not like to suspend disbelief when it comes to looking at the facts.
Successful entrepreneurs must have a high level of energy in order to succeed. Being an entrepreneur involves enormous amounts of time and energy. Every successful entrepreneur that we have financed has had tremendous energy. If the person you are looking at doesn’t have a high energy level, you may not want to be the backer. Therefore, the health of the individual is important. If the person is not healthy, that person may break under the stress of being an entrepreneur. To determine the state of the entrepreneur’s health, ask whether he or she is insurable. Ask how healthy the entrepreneur is and how many times the entrepreneur has been sick in the recent past. You can easily determine the health of your entrepreneur by inquiring about a life insurance policy. The entrepreneur will need a physical to have the insurance. What you will have trouble determining is the energy level of the entrepreneur. This is another point to check with your references.
One of the things that we routinely do is to call entrepreneurs early in the morning. We call to see whether they are at work early. We also call late at night to see whether they are still working. Being an entrepreneur takes many hours of the day, and if your entrepreneur is a late riser or an early quitter, it will be difficult for the company to be successful.
Along with physical energy, most entrepreneurs have tremendous mental stamina. Usually, they can think about problems for hours on end without getting tired or giving up. It is not unusual for an entrepreneur to work long, long hours on problems. This mental stamina is a key skill of entrepreneurs, and it is used to their advantage. You will soon have an idea of the entrepreneur’s mental stamina after you have “interrogated” the entrepreneur about the many issues of the business. If, at the end of the day, the entrepreneur is physically exhausted and is unable to give you satisfactory answers, you will have your answer. If there is sluggishness, then this person may not be the type of entrepreneur you will want to back.
Most entrepreneurs have good social skills and are adept at persuading and conversing with people. You can spot these skills in conversations with the entrepreneur. If the entrepreneur is able to explain the business proposal in a simple style, this will be an outward manifestation of self-confidence and social persuasiveness. If the entrepreneur seems to have an outgoing personality and good presence, this, too, will indicate great self-confidence.
Also, if the entrepreneur seems to be emotionally stable, this will be evidence of strong self-confidence. As mentioned previously, some writers think that entrepreneurs come from broken families, are riddled with guilt about things in their past, come from divorced families, and usually end up divorced themselves. According to our perceptions, as well as the reports we have read on entrepreneurship, none of this is true. It is a common myth that an entrepreneur is so driven that the entrepreneur inevitably destroys the marriage and the family. In reality, divorce among entrepreneurs is no greater than in corporate America.
As far as guilt is concerned, the successful entrepreneurs we have backed have not appeared to be guilt-ridden or to feel that they had to achieve to satisfy their parents. They did not seem bent on overcoming some past problem in their lives. All of the successful entrepreneurs we have known have had different reasons for their own success, and it’s usually been something that comes from within rather than being based on some incident in their childhoods.
Most entrepreneurs are honest in their approach to the world. Of course, a number of entrepreneurs have cheated and lied their way through life. As an investor, you want to make sure that your entrepreneur is honest and straightforward. If you invest in a dishonest entrepreneur, somewhere along the way you will pay for it; the entrepreneur will get rich but not the investor. To determine an entrepreneur’s honesty, during your interview you can ask the same question twice but at different times and in a slightly different way to see whether the entrepreneur answers the same way both times. Sometimes an entrepreneur who lies will trip up in answering the same question. Also during the interview, you may find that an entrepreneur is avoiding a question. Question avoidance is a sure sign that the entrepreneur is hiding something.
In checking the references of entrepreneurs, one of the questions you should always ask is, Do you think the person is honest? Although the more conservative references will avoid answering the question directly if they think the individual is dishonest, you can usually tell whether the reference is giving the entrepreneur an unqualified recommendation in the area of honesty. Credit records, too, will reflect his honesty. If the entrepreneur has a history of not paying his bills, what makes you think he’s ever going to give you any money back? As an investor in a venture capital situation, you can never be too careful with entrepreneurs. It is much better to have an entrepreneur who is honest than one who cheats and lies.
However, it’s not unusual for an entrepreneur to use what business schools call constructive deceit during negotiation. This means that the entrepreneur and you as the investor have the right to “tell white lies” in order to advance your negotiation position. In negotiations with an entrepreneur, you may not want to give the real reason why you aren’t going to proceed with a certain situation because you might destroy the relationship between you and the entrepreneur. So, as a negotiating position, you use constructive deceit. That is, you tell the entrepreneur that your board of directors would not approve something and that you can’t go forward for that reason. In this way, you can avoid a confrontation with the entrepreneur and maintain your personal relationship.
You should also expect the entrepreneur to use the same kind of constructive deceit to protect his or her position. Don’t be surprised when you find that the entrepreneur hasn’t been honest to a fault and that you have caught the entrepreneur in a little white lie. It is usually harmless and not worth mentioning. Studies have shown that telling white lies does not prove that the person is a thief or a crook. The facts and circumstances are needed to make a jump from using constructive deceit to being a liar.
Another term used in this regard is intellectual honesty. This means that the person expresses only views and examples that the entrepreneur believes in. There are, of course, those who will say or do things in order to sway your opinion. For example, a car salesperson may tell a potential buyer that the buyer looks terrific in a red car when the salespeople doesn’t think so. Or the salesperson may say that a product is the most beautiful ever made, when the salesperson really believes it is quite ugly. In our society, we expect salespeople to be intellectually dishonest when they offer subjective opinions. We know they must sell a product to earn a living, so we expect them to be intellectually dishonest when giving their opinions on the product they are selling. You should expect your entrepreneur to be intellectually dishonest about his or her business. The entrepreneur’s product may not be judged the best product by others, but the entrepreneur will “believe” it is the best.
Intellectual dishonesty becomes a more serious matter when it applies to the performance of the product or to facts that can be proved. For example, the car salesperson who tells a prospective buyer that a six-cylinder engine is as good as an eight-cylinder engine can be proven wrong. Sure, it may be just as good in stop-and-go traffic, but not on the freeway. The entrepreneur who tells you the performance of his or her product is as good as that of a competitor’s product in the face of objective evaluations that say otherwise lies. Don’t fault your entrepreneur for trying to convince you of the worth of the product, but do avoid those people who can’t accept the reality of the effectiveness of their product.
The entrepreneur you are backing should see you as a partner and not as an investor. You can do this by spending a good deal of time with the entrepreneur so that you become friends and establish that you are both seeking the same goal—to make money for the both of you. In this partnership, your side of the equation is as important as the entrepreneur’s. You must do your part in the partnership and not try to sandbag the entrepreneur with some special legal provision that reduces the entrepreneur’s equity or places the entrepreneur in a weak position. You need to maintain your relationship as partners and work with the entrepreneur. Make sure your entrepreneur wants to be a partner. It is the best kind of relationship in venture capital deals.
Also make sure that your entrepreneur is seeking fair play from you and that the entrepreneur knows that you are seeking fair play in return. Explain any problems that arise or any situations that come up that might suggest you are not playing fair. If you pull a surprise on the entrepreneur along the way, he or she will believe that you are not working in good faith. If you ever find yourself pitted against the entrepreneur, remember that the entrepreneur has most of the advantage and that after you try to pull a fast one, you will from that moment on have a hard time working with the entrepreneur. Seek out the entrepreneur who has a high sense of fair play and honesty, and you’ll be on stronger ground.
In reviewing an entrepreneur’s background, it will be hard for you to determine whether the entrepreneur has all of the characteristics mentioned above. To get a proper perspective of the entrepreneur, you will have to adopt a special way of thinking.
The problem with the venture capital business is that when we analyze people, our perceptions are usually wrong. Perhaps not entirely wrong, but at best the judgments we make of entrepreneurs are vague and unverifiable. Unfortunately, we tend to tag people with traits that summarize past behavior or current observations that we believe will predict future behavior. The problem is that specific behavior may not necessarily be repeated and cannot be used to generalize or to predict future behavior in other areas. We observe a single incidence of a person’s behavior and try to generalize from that. We try to place a general “trait tag” on an individual after observing only a few specific instances.
The classic example of a trait that people are often tagged with is honesty. We say a person is honest or dishonest on the basis of a few observations. The label implies that the person will be honest or dishonest in all future relationships. Trying to determine whether an entrepreneur is honest is difficult because there are so few opportunities for us to observe the entrepreneur’s behavior. We dig into the entrepreneur’s background and references, looking for clues. But most often we lack enough data to determine whether an entrepreneur is honest or will be in the future. We assume that because the entrepreneur has been honest in the past, he or she will be honest in the future.
Even when you do have more data, there is usually conflicting evidence. The problem with trying to test someone’s honesty is that, according to most studies, we all have done things that could be used to tag us as dishonest. Most people are not honest to a fault. They do some things that could be considered dishonest but will not do other dishonest things. For example, a person might keep an article lost by someone and found on the street, but that same person might not lie about athletic achievement. Some people might lie about their athletic achievements but might not cheat on exams. In the retail trade, there are employees who might take store merchandise home but might not take cash from the register. How many people take their employer’s paper and pencils home for personal use? How many people actually give the company a full eight hours of work (not goof-off time) every day? So who is completely honest? How can we judge anyone to be honest? How can we predict that a person will be honest in the future?
Other traits, such as persistence, dependence, conformity, aggressiveness, and so on are just as difficult to measure as honesty. Furthermore, some traits we decide to look for in entrepreneurs don’t have much predictive value at all. In our own description of entrepreneurs, we might think in terms such as “good,” “kind,” “fair,” and “nice.” With these vague words, we are not describing the person; rather, we are expressing our approval of the person, saying that we like him or her. This type of personal opinion doesn’t have much predictive value.
When we judge people, we are indicating what standard of behavior we expect or the standard that we live by. We develop these ideas about how people should behave through years of experience. In making our judgment, however, we do not analyze the pros and cons of someone else’s behavior at great length. Normally, we react spontaneously and depend on intuition to be our guide. But intuition is fallible. Still, it is the way most of us apply traits to various people. In essence, intuition is a skill that has been so thoroughly learned that we use it unconsciously. Thus, when people lie about their athletic skills, we judge them to be dishonest. When another person keeps a lost pen without asking who lost it, we may approve that action and not brand that individual as dishonest. All of us subconsciously consult a particular list of behavioral traits to test honesty, and we apply it intuitively, without questioning our underlying assumptions.
Intuition rapidly evaluates the data that we receive and allows us to form an opinion. Some people require more data than others before they are ready make a judgment; others are quick to reach a decision, sometimes on the basis of only one event (a snap judgment). Most people take written information, references, interviews, and any other information they pick up and feed it into their minds, where they match it against the set of tests that they use in judging people.
The problem is that as we learn more facts about an entrepreneur, it is unlikely that all of these facts will point in the same direction. For example, some information may suggest the person is honest, whereas a small amount may indicate dishonesty in certain situations. So we begin to weigh each piece of information for its predictive value. Intuitively, we set up a checklist and put pluses and minuses alongside each item, according to whether it’s a good point, an irrelevant point, or a bad point. Then we add the points to see whether the entrepreneur has passed our test. We may even use a very complex system wherein certain items are given much more weight than others on the grounds that they are much more important to the prediction of behavior or for this investment situation. We use these pluses and minuses intuitively because we have done it many times in our daily interaction with others. Although intuition may be a reliable guide for someone who has interviewed thousands of entrepreneurs, we also need to approach our evaluation of entrepreneurs analytically.
What makes evaluation more complex is that every VC has a unique system of judging entrepreneurs based on personal experience. One VC may decide that a certain entrepreneur is honest, whereas another might not give the entrepreneur the tag “honest” because the entrepreneur failed on one point that the VC considered critical. The way to handle this situation is simple. After you have investigated and interviewed an entrepreneur a number of times, you should make a list of items that you have observed about the individual and see whether you can use them to reach a logical conclusion about the traits reflected by these items. Appendix C lists examples of traits that a VC would be concerned about.
Look at the traits in Appendix C and decide whether you agree or disagree that each is descriptive of the entrepreneur. Make sure you have a basis for tagging the entrepreneur with each trait; question each judgment. Once you do this, you will better understand the individual. If two VCs have interviewed the entrepreneur, compare trait lists. Talk about the entrepreneur to get a good feel for the individual. As soon as you think you understand the entrepreneur, try to answer the following three sets of questions:
How will the entrepreneur treat you and your venture capital fund? How will he or she treat you if the company is in trouble? How will he or she treat you if the company is going to make a ton of money? Will he or she be happy that you are making money too?
Are the traits of the entrepreneur the ones needed to be successful in the relevant industry? How will the industry react to this person? Do these traits match up with the keys to success in the industry?
Are these traits the ones that will make this specific business successful? Will these traits be accepted by employees? Will they be accepted by professionals such as lawyers, bankers, and accountants?
This approach should help you put some thought into the judging of entrepreneurs. It is not scientific, but it is a logical approach that is bound to be more reliable than snap decisions.
One of the VC’s greatest sources of information is the interview with an entrepreneur. However, interviewing won’t produce much in the way of information unless it’s done correctly. Here are a few pointers on how to improve your interviewing skills so that the interview will yield more information.
Make a list of the information you want to learn from the entrepreneur during the interview. What precisely are you looking for? An interview that rambles through a person’s background and business situation won’t reveal nearly as much as one that has a specific focus. So make notes as you read the materials supplied to you by the entrepreneur and organize your questions around these notes before you meet with the entrepreneur.
All good interviewers approach the interview with a clear mind. Research shows that an individual who has a clear idea of what he or she is trying to determine and whose mind is not cluttered with other problems or situations will come away with a great deal of information.
So enter the interview with a clear mind. If you are worried about missing a plane or another meeting, or if you have other things on your mind, your questions will be less effective and the answers less informative than if you are “tuned up” with sharp questions and “tuned in” to each answer.
An interview should not be constantly interrupted or conducted in an environment of distractions. Hold telephone calls, stop people from barging in, and don’t interrupt the interview yourself to do something else. Don’t hold the interview in a public place, such as a restaurant. An uninterrupted interview will yield much more than one punctuated with interruptions. Likewise, if the entrepreneur is constantly being interrupted, it could be a negative sign.
Always go into an interview with more than enough time. One long interview per day is about all that anyone can accomplish, so don’t plan more than that. An interview can’t be completed well if you are in a hurry or have something else on your mind. Also, make sure the entrepreneur has plenty of time and has scheduled the interview as the major event of the day. Plan your interviews well, and they will yield golden nuggets of information.
Effective listening means encouraging the candidate to talk openly about his or her situation. Candidates who feel encouraged will provide better information than those who do not. Also, an interviewer who can see a candidate accurately can encourage him or her in the proper direction. During the interview, try to establish an atmosphere in which both you and the entrepreneur are in the right frame of mind. Be sure you have enough time to get to know each other.
One common mistake often seen with investors is interrupting when the entrepreneur is talking. Don’t try to show how smart you are; let the entrepreneur show you how smart he or she is. Talk just enough to get the entrepreneur to open up and tell you what he or she really means. A nice joke will often show that you are friendly and let the entrepreneur “open up.”
Use silence constructively; that is, don’t feel you have to keep the air full of questions. Let the room fill up with silence, and usually the entrepreneur will volunteer more information. When the entrepreneur talks, pay attention, and look as though you are paying attention. If you aren’t listening, it will show, and the entrepreneur will say less.
A very unusual process takes place when you interview an entrepreneur. You carry out several mental tasks simultaneously and switch from one to the other. A good interviewer focuses on specific points and has a rational approach to things. At times, an interviewer might let intuition come into play in order to pick up on some nuances or rationalizations made by the entrepreneur and bring those back into the question-and-answer session.
At other times, you might need to step back and see the whole interaction to determine whether additional questions are needed and where holes need filling in. You may ask the same critical question twice in an interview just to see if it is answered the same way both times. Inconsistency may be a sign of dishonesty or lack of knowledge.
Interviewing is tough work. It can be a tremendously complex event marked by both strain and exhilaration as you push forward, looking for information.
There are two types of interviews. The first type is a panel or group interview. For example, a group of VCs may interview one entrepreneur or two or three of the top management. In the latter situation, the entrepreneur is facing several interviewers at once and may be more formal and less open. On the other hand, when a group of questions is being asked, the interviewers tend to be sharper and more focused, and are able to probe into the situation due to the interaction of the panel members.
The second type is the individual interview. It can be more intimate and offers the entrepreneur an opportunity to open up and provide personal information that isn’t normally talked about in groups. Usually you can get more personal information in a one-on-one interview.
Both of these types of interviews are useful, but the individual interview is a must. It is the only way to really get to know that person.
After every interview, you should document your discussion. Keep a piece of paper handy while you are interviewing and make notes to yourself. Later, you may want to dictate a memo for the file. Make copious notes during the interview, although you will probably find it advisable to keep the paper on which you’re making notes out of sight of the entrepreneur. When people see you taking notes, they tend to be more formal.
In summary, you should enter an interview with a clear and extremely alert mind. You can’t have distractions. Also, you’ve got to review the entrepreneur’s material beforehand so that you will know what you’re looking for. You should have read the business plan and looked through the person’s resume. You have to be prepared. Walking in and wandering through the business situation is a very inefficient use of time.
The cardinal rule for an interviewer is to be an effective listener and to encourage candidates to continue to talk.
In assessing the abilities of an entrepreneur, you can gain information about the effective techniques from some of the industrial psychologists. For your enjoyment, Appendix D includes a psychological assessment of the current president of a major company. Most of us do not have the skills of industrial psychologists, but we can learn from the things they do.
The industrial psychological approach does not try to tell you why people act the way they do; it tries to tell you how able a person is. The industrial psychologist tries to avoid relying on many of the outward appearances of the individual. There is a considerable body of evidence holding that in some situations, people are motivated either consciously or unconsciously to present themselves in what they believe to be a favorable light. This kind of “play acting” can lead you to misread a person. Therefore, industrial psychologists try to identify factors that truly reflect the individual’s character. For example, an expert will not automatically rate a lively, outgoing conversationalist higher than the shy introvert or consider the highly educated person to be more clever than one who may not have had the same educational opportunities. Likewise, a successful business record is not taken at face value by a probing expert. Like the industrial psychologists, investors need to hone their techniques so that they are not misled by outward appearances.
The aim of the industrial psychologists is to discover not only how intelligent a person is but also how effective that person is in applying his or her abilities in various contexts. They try to construct an overly simplified model of the person that can be used to predict how he or she will behave in doing the required work. In applying this model, industrial psychologists are not trying to discover the causes of any particular behavior but are simply hoping to predict behavior. In essence, they are trying to predict how the person (in the most important job in the company) will react to various situations.
Industrial psychologists usually administer a large set of written tests to an entrepreneur. Although such tests have been used by some VCs, they are not fully accepted and are probably not something that VCs can use to any extent. This leaves you with the interview and conversation with the entrepreneur. An important point to remember is that people normally speak at 125 words a minute, but you can think and comprehend conversation at 500–600 words per minute. This means that you have ample opportunity during interviews and discussions with the entrepreneurs to pick up many of the subtle clues and basic information that will lead you to a sound decision about the person.
The first thing to do when you are spending the day with an entrepreneur is to outline what you expect to do during the day. This may put him or her at ease and give you more information about his or her approach to life. One of the things industrial psychologists ask the entrepreneur to do is to describe his or her life history. Initially the entrepreneur may be a little slow, but after a little encouragement, most people enjoy talking about where they grew up, their parents, their outlook on life, and how they arrived at the position they find themselves in now.
Most people will give you a detailed history of their business experience. It is very important to listen. You must stop yourself from interrupting an entrepreneur while he or she is talking. Industrial psychologists frequently use open-ended questions and encourage the entrepreneur to talk freely. In this kind of open and friendly interview, attitudes and opinions of the entrepreneur will inevitably emerge, as will many facts about the person’s behavior. If you are a good listener, evidence in the form of recurring themes and patterns of behavior will reveal themselves. For example, the person who has consistently made major decisions for himself or herself in the past is likely to continue to do so in the future, and the person who has always led an essentially solitary life is unlikely to change into a highly gregarious person.
The industrial psychologist usually concentrates on three basic areas that will help you with some of the things you should be looking for.
Here you are trying to compare the manager with the entire management population you’ve ever known in order to determine whether this manager is in the top 5 percent of those you have worked with. The following questions will help you establish his or her intellectual effectiveness:
Is the entrepreneur a quick learner?
Is the entrepreneur a conceptual thinker?
Can the entrepreneur work quickly and accurately with numbers?
Does the entrepreneur have good verbal skills?
Does the entrepreneur have the ability to communicate verbally, as well as in writing?
Is the person an objective thinker or is the entrepreneur strongly influenced by personal emotions? There is now a considerable body of evidence that successful executives are able to be more logical and objective than are the less successful ones.
Is the entrepreneur really a critical thinker or does the person let preconceived notions set the pace?
Is this person able to produce original ideas?
Is the entrepreneur imaginative or strictly conventional?
Is the entrepreneur a generalist or is the entrepreneur detail-minded?
Does the person believe in having a thorough knowledge of minor matters or does that person dismiss detail items as irrelevant?
Does the entrepreneur recognize priorities and know which things are important and should be put first?
In the decision-making approach, is the entrepreneur impulsive or cautious, slow or confident?
Just how does the entrepreneur go about making decisions?
What kind of strategist is the entrepreneur?
Is the entrepreneur a long-term planner or a short-term tactician?
How energetic is the entrepreneur?
Is the person restrained or explosive?
Is the entrepreneur vigorous, efficient?
How does the person tolerate pressure?
Is the entrepreneur stable, or is this person easily pushed off the edge?
How would the entrepreneur react to emergencies?
Is this person calm or frustrated?
How would you measure this person’s ambitions, and how important is success to the entrepreneur?
Will the entrepreneur sacrifice the interests of others?
Will this person sacrifice investors’ interests to meet the objectives?
Are this person’s aims realistic?
How flexible is the entrepreneur?
Can the entrepreneur handle a number of tasks at once?
How adaptable is the person?
Can the entrepreneur adjust to different environments?
What kind of relationships does the entrepreneur have with supervisors and upper management?
Is the entrepreneur frank, stubborn, loyal, and amenable?
What relationship does the entrepreneur have with peers?
Is the entrepreneur friendly, cooperative, tolerant, a team person, highly competitive, a loner?
What relationship does the entrepreneur have with subordinates?
Is the entrepreneur domineering, protective, decisive, and sensitive?
Is the entrepreneur willing to delegate responsibilities?
What relationship does the entrepreneur have with outsiders?
Is the entrepreneur confident, careful, courteous, or disdainful?
When an industrial psychologist is finished, he or she usually summarizes the person’s traits and lists the positives and the negatives as they relate to the job opportunity. For example, the psychologist might say that the person is industrious and energetic, that the entrepreneur is flexible and can adapt to change, that the person is decisive, above average in ability to communicate clearly, and imaginative, and that the person makes a good first impression.
The psychologist might also list the individual’s limitations. For example, the psychologist might say that the entrepreneur’s basic intellectual power is a little below average, that the entrepreneur’s judgment of emotionally toned situations is suspect, and that person’s analytical skills are below average; the psychologist may say that the entrepreneur is unstable and insecure, hypersensitive and quick to take offense, unable to sustain a seemingly cheerful and friendly manner, and would not be a good team member.
This does not suggest that you should employ an industrial psychologist or that you should try to become an amateur industrial psychologist. However, it is interesting to see how professionals go about their tasks. All VCs can learn something from these situations that will help them become better at judging entrepreneurs. Although industrial psychologists can give us a general understanding of the individual, they cannot determine whether that individual will perform well in that person’s chosen field or executive position. They are guessing, just as any investor is. You can look for general characteristics in an entrepreneur, but by themselves these will not indicate whether the individual is going to be successful in a given field. What you have to do is determine the keys to success in the business situation and in the industry you’re looking at and whether the individual has the matching personal traits. Entrepreneurs should have certain general traits. However, some specific traits are also required for success in each industry.
Generally speaking, the answers of entrepreneurs fall into two categories. The first category concerns individual characteristics and the second the experience of the individual.
The following is a list of characteristics that come up frequently.
Staying Power. VCs want an entrepreneur who is capable of intense effort over a long period of time. VCs know that 99 percent of every venture’s success comes from perspiration, not inspiration. They know that if a small business is to succeed, the management team is going to have to work long hours to compensate for the lack of employees at the company.
Ability to Handle Risk. VCs look for an individual who has the intellectual power to evaluate risk and knows what to do after the evaluation. Every small business twists and turns many times during its life, and the early years are the most traumatic. An entrepreneur must be capable of analyzing situations, evaluating the probability of success, and implementing a plan. Unless they are able to evaluate risk and analyze complex situations, small businesses usually remain small businesses.
Verbal Ability. VCs need an entrepreneur who can articulate an idea. Many people have tremendous minds but lack the ability to explain their thoughts to the outside world. Without an accurate and convincing voice, most small businesses will fail. In the early years, an entrepreneur must persuade vendors to give the small business credit, persuade banks to make loans to the business, persuade employees to work long hours, and persuade government authorities to stay off them. It is this verbal ability that sets most entrepreneurs apart from scientific inventors. If your entrepreneur lacks the ability to persuade, you are probably making a mistake by investing in a business run by him or her.
Detail Orientation. Some find it almost contradictory that VCs want an entrepreneur who knows the details. Most of us think that good entrepreneurs worry about the big picture and hire other people to handle the details. This perception couldn’t be further from the truth. Entrepreneurs must carry an inordinate amount of detail around in their minds and be able to use it all to the best advantage of the company. Details about numbers as well as the situation will need quick reactions and an individual with the ability to do it. Without this attention to detail and knowledge of the specifics, most small businesses can’t grow.
Compatible Personality. Believe it or not, VCs most often invest in an entrepreneur who has a personality that is compatible with their own. Compatible personalities may not be at the top of anyone’s list, but entrepreneurs are not financed unless they are compatible with their venture capital source. It is indeed like a marriage. Most people don’t get married unless they like each other. VCs don’t “marry” entrepreneurs unless they like them. Even if an entrepreneur is capable of meeting many of the problems in a situation, a VC will not invest unless the VC can stand “living with” the personality of the entrepreneur.
One VC, for instance, was considering a restaurant situation, which the VC would have invested in, but found the entrepreneur obnoxious. The VC said, “I knew I would not be able to stand working with this obnoxious ass over the ensuing years; therefore, I didn’t make the investment.”
The following are a few items that you may want to look for in an entrepreneur’s experience.
Market Knowledge. VCs don’t have the time to learn about a marketplace in detail. For this reason, VCs want to know above all that the entrepreneur has a thorough knowledge of the marketplace. It is rare that a VC will back an entrepreneur who has little or no experience in a business area. It is common knowledge that an individual needs at least five years to understand an industry. No one wants to finance on-the-job training for an entrepreneur.
Track Record. Along with market knowledge, VCs would like to back people who have a track record, especially a track record relevant to the situation. Ten years ago, we were about to back an entrepreneur who wanted to buy a business that was a “turnaround.” The individual seemed to have the proper background, in that the entrepreneur had turned around several businesses and made a substantial profit for the investors. The difficulty was that the entrepreneur had not been involved in a turnaround in this particular industry; therefore, we felt we should not invest. The track record of an entrepreneur is something that a VC will investigate time and time again. The VC will look for achievements in the individual’s background and for achievements in the specific industry in which the VC is about to invest. This is a key point for every VC.
Leadership. Every VC is looking for a leader for the company. Any time a VC backs an entrepreneur without leadership, the VC has inevitably had trouble and has had to replace the entrepreneur. Therefore, VCs look for entrepreneurs who have been in leadership positions in the past and who have demonstrated their abilities conclusively. Without leadership, the company is probably not going to go anywhere.
Reputation. VCs are looking for entrepreneurs with outstanding reputations. They want trustworthy people. They are about to give a great deal of money to a business run by the entrepreneur, and they want to be sure the manager of that business has a reputation that is above reproach. Every VC in the business can give you a long lament about some entrepreneur who took money out of the business illegally. If there is any hint that the reputation of the entrepreneur is not 100 percent solid, experienced VCs will not invest.
In trying to differentiate a small businessperson from an entrepreneur, one important aspect usually shines through. Although a small businessperson wants to build the business, he or she actually has a more immediate concern: to take as much cash out of the company as possible. The small businessperson will usually run the company as a subchapter-S corporation. The small businessperson will have a big car and a great many perks and other items of self-aggrandizement. All of these factors indicate that the individual is interested in taking money out of the company rather than reinvesting it in the growth of the company. This usually means that, as soon as the business starts to grow, the company will run into a cash crunch. And it is at that time that the individual usually ends up on the doorstep of a VC, seeking additional capital to do the things that he or she should have been doing with his or her money in the first place.
In one situation, two individuals had come up with a unique line of cosmetics. It was a product line that could be duplicated by others, but this group probably had a two- or three-year jump on the competition. The group enjoyed a great reputation after making this cosmetic discovery. Instead of using the huge profits that the company generated in the initial years to hire a chief marketing person, an outstanding sales manager, a good controller to keep the books accurately so that an audit could be taken, and a staff that could provide good quality control, these two entrepreneurs began to draw such enormous salaries that the company’s main purpose became to pay their salaries.
At the end of three years, they approached us for investment capital. Having each taken over $5 million out of the business and invested it personally, they felt secure. The only problem was that by the time they had reached us, three major competitors were offering the same product, and a giant cosmetic company had just introduced a similar line. Instead of having a two-year time horizon in which to build the business into a great company, these two were stuck with a hopelessly small company with little or no chance of growth.
In addition, they were eagerly pawing over a registration statement that had raised $20 million for 25 percent of another small cosmetic company. The other company had started two years after they had begun their operation and had copied their concept completely about a year before. The difference was that the entrepreneurs behind this second company had plowed everything back into the business and built it into a money machine. Sales had more than tripled in three years, whereas in the company that had sought more investment capital from us, sales had remained flat. It is a sad sight to see two individuals who could have been worth $300–$400 million instead having only their nest eggs of $5 million locked away. They had missed a great opportunity.
In reviewing small business people and entrepreneurs and trying to differentiate between the two, you will find that the immediate need for cash and status is a sign of a small business person, whereas the desire to plow money back into the business and take a long-term outlook toward capital gain on sale of the stock at some future date is a characteristic of an entrepreneur. An entrepreneur builds a team to run a great business.
When you are analyzing the entrepreneur, you should first record five things you like about the entrepreneur and five things you dislike. As you begin your relationship, you will find the numbers in the “like” column adding up. Most of them should be in the areas outlined above. If you find a lot of comments in the “dislike” column, you should not make the investment. Every investment that our company has ever made in which we had reservations about the entrepreneur has turned into a very difficult situation for us. When you find something negative about the entrepreneur, try to understand the circumstances and ask yourself whether you would have done the same thing the entrepreneur did in that situation. If the answer is yes, you probably have to overlook it and continue your analysis.
If, however, you find a situation in which you don’t believe you would have done the same thing as the entrepreneur, outline what you would have done differently. Then confront the entrepreneur with the situation and ask why the entrepreneur didn’t go forward in that manner.
There is a good reason to make this confrontation. Sometimes in a relationship with an entrepreneur, you will uncover things that seem to be quite negative. If you don’t ask about these negatives and just go your merry way without making the investment, you may have missed a great opportunity. You may face several situations in which potential negatives come out in the reviewing process. Appearances are not always what they seem. You need to dig behind almost everything, especially the negatives in an entrepreneur’s background.
Now you need to develop the background information on the entrepreneur in an organized fashion. To this end, we have the following areas to analyze and develop information. Every great VC has a system of getting information on entrepreneurs. You need to develop one, too.
Ask the entrepreneur to supply references, beginning with personal references. These will be people who know the entrepreneur but are not part of the entrepreneur’s business relationships. They are usually friends, relatives, and teachers. They may know a great deal about the individual but not much about his or her business.
These references should supply information about the personality of the individual and about the entrepreneur’s personal habits. You are trying to discover whether the entrepreneur indulges in alcohol or drugs or is involved in asocial behavior that will be detrimental to your business. For example, in checking one personal reference, we determined that the individual was highly asocial. When we asked him about this, he admitted that he had a problem, and he was understanding when we declined the investment. This kind of risk was far greater than the expected return on this investment. Once you have finished a personal reference, you should prepare a written record of the inquiry, indicating how that person answered the questions you asked.
You also want to ask the entrepreneur for a number of business references. These are people who have been in business situations with the entrepreneur and know how that person operates. There are three basic groups to consult for this information.
The first group consists of inside references. These are people such as superiors, associates, or subordinates in the entrepreneur’s current business position or past business positions. Someone who was the entrepreneur’s boss for ten years may give you great insights into this individual’s past. A cohort with whom the entrepreneur worked five years ago can also be helpful in determining the entrepreneur’s business ethics. One VC once asked for a business reference about an entrepreneur said: “I don’t know why the little S.O.B. gave me as a reference. He worked for me for two years and did nothing more than ride around in his little sports car and got nothing done. He was a disgrace to my organization.” It’s not often that you will find such references, but every now and then even a good entrepreneur makes the mistake of giving a bad reference.
The second group of business references consists of outside references. These are people such as competitors, suppliers, or buyers of the entrepreneur’s product. They are the ones who come into contact with the entrepreneur in a business relationship that is not inside the business. Quite often, the competition will know a great deal about the entrepreneur, especially if the entrepreneur has moved from one competitor to another. This kind of inside information can be very revealing, but always take it with a grain of salt, particularly if it is from the competition.
The third type of business references comprises professional references. These are bankers, accountants, and lawyers who have worked with or for the entrepreneur in some business relationship in the past. Sometimes the entrepreneur will give you the name of a consultant the entrepreneur has used as a reference. Consultants can tell you whether an entrepreneur used their services efficiently or ignored their recommendations. This information will tell you whether an entrepreneur is willing to take advice from experienced people in the business.
Some references may not give all the information that you want, but nonetheless will speak in reasonably positive terms about the entrepreneur. Therefore, you should ask each reference who else might know the entrepreneur well. In this way, you can generate other references on the entrepreneur and find out whether they think the same way as the primary reference. Sometimes an entrepreneur will use as a reference a boss to whom the entrepreneur merely reports but does not work for directly. If possible, you should try to determine who the direct supervisors are and seek them out. They may be left off the reference list because they have some good information that the entrepreneur doesn’t want you to know.
Credit reporting agencies can be used for obtaining additional information on the entrepreneur. Some, such as a credit bureau, specialize in personal reports. These give you information on an individual’s personal credit. They can be quite interesting to read, especially if you find that the entrepreneur has amassed a large amount of debt and has been extremely slow in paying it back. Also, bankruptcies occasionally show up in these credit reports.
In addition, reports put out by agencies such as Dun & Bradstreet and Standard and Poor’s can be used to evaluate entrepreneurs who have had previous small businesses. These can give you very insightful information on the payment history of the small business that the entrepreneur worked for. You can see how the entrepreneur ran the past small business from a financial viewpoint.
You can consider engaging hiring agencies, such as US Investigations Services or Bishops Reports, to collect detailed information about entrepreneurs. These companies specialize in doing extensive background checks on people. They can even go to the county courthouses where the entrepreneur has lived and find all suits and court actions. They can verify whether the entrepreneur has attended the schools that he or she claims to have attended and do credit checks. Although this is a more expensive approach, it will provide you with a detailed credit history of the individual and will uncover criminal behavior.
Private investigators usually are not hired to check out the background of an entrepreneur. However, from time to time one is forced to use this method of obtaining information. If you are thinking of hiring a private investigator to check out an entrepreneur, it most likely means that some basic things are wrong and that you probably shouldn’t invest in the entrepreneur. However, private investigators can be used.
A private investigator once helped determine that the entrepreneur had had a drinking problem in a past job and that he had been fired for being an “alcoholic.” However, when confronting the entrepreneur with the situation, he explained that at the time he was going through a divorce. It had been an extremely emotional and stressful experience, and he had turned to alcohol for a short period. He demonstrated conclusively that he was no longer alcohol dependent and had been involved in this lifestyle for only a short period in his career. This was an acceptable answer, and it checked out with later investigations.
You earlier considered the issue of psychological tests and the hiring of industrial psychologists to conduct them. Some of these tests have proved quite fruitful in reviewing middle management in large corporations and even upper management to some degree. They have been used on a very limited scale by VCs. Basically, most VCs believe that they are adept enough at assessing entrepreneurs to do without psychological tests. It’s also quite demeaning to ask entrepreneurs to take psychological tests to determine whether they are good entrepreneurs. However, this is changing, and it is more common today to hire such mental investigators. A good company in this field that has made investigating VC-backed enterprises is G.A. Smart & Company in Chicago. Goff Smart surveyed a lot of VC funds and inquired as to how they conducted their investigations. He later wrote his doctoral dissertation on the subject and founded a service to help VCs. He runs a great business.
The entrepreneur will provide you with reams of written information, some of it containing details about the entrepreneur. There most likely will be brochures about the business and blurbs about the entrepreneur, along with copies of articles that have been published in newspapers and trade magazines; these articles will also describe the business and the entrepreneur. These sources contain information about the individuals that you should not overlook. Reviewing them will give you some inside scoop on the entrepreneur.
In addition, you should ask the entrepreneur to provide a detailed resume for each of the key people in the organization, including the entrepreneur. This resume will summarize the history of the entrepreneur and the other key principals in the company, from early schooling through the current period. The resume should lay out in chronological order where the entrepreneur has been. If the resume doesn’t have all the years filled in, ask the entrepreneur to put together a resume in that manner. This way, you can make sure there are no unexplained gaps in the entrepreneur’s background.
A VC once told of an entrepreneur who presented the VC with a resume that hadn’t covered three years of his background. All other credit references had checked out completely, and everything seemed to be in good order. However, as the VC pressed the entrepreneur for more information about this three-year period, the entrepreneur grew vague and said he must have put the wrong dates down. Because this was more than ten years ago, he was not sure of the dates and would have to get back to the VC on that. This intrigued the VC, and the VC checked further on the individual’s background.
After talking to a lawyer in a town where the entrepreneur had been located, the VC found that the individual had been involved in a fraud and had been sent to prison for three years. None of this information had been revealed in credit reports or any of the other references that the VC had checked. It was only by closely examining the entrepreneur’s background year by year that the VC was able to detect this fact about the entrepreneur’s background. The bad deeds had been committed over ten years in the past and had been expunged from the entrepreneur’s record.
Nor should you take the written information presented by the entrepreneur at face value. Entrepreneurs have been known to “exaggerate” their achievements. In telephoning colleges and universities to confirm an entrepreneur’s credentials, most VCs have uncovered at least once that a claim to have graduated was false. This, along with other factors, helped to kill the deal.
There is also the story about an entrepreneur who presented a detailed resume to a group of VCs. Records at his high school and everywhere else indicated that he had graduated from that school and that he had gone to college in a good Midwestern town. Supposedly, he had also taken an advanced degree from that college and had worked for a good number of years at a solid Midwestern company. The VCs decided to invest in this new West Coast company. To their utter amazement, a few days after the money went into the business, the entrepreneur disappeared with the money they had placed in the business bank account. After checking with the FBI, they were told that the individual had been a two-bit mobster from New York who had ratted on organized crime members and sent a number of them to prison. The authorities had provided him with a false background as part of its witness protection program. This crook had used his pristine background to lure VCs into his new business and took off with their money. He was never found.
In your conversations with the entrepreneur, you will be able to pick up things that will help you evaluate the entrepreneur’s past performance and your ability to place your trust in the new business for the future. Encourage the entrepreneur to talk about the past, where the entrepreneur grew up, the type of parents the person had, whether the entrepreneur had a paper route, and what type of high school the person attended. All of these details provide background information that you should write down at your earliest convenience and put into your file. This kind of information will help you determine whether the individual has the characteristics that you are looking for in an entrepreneur for this business.
At some point in interviewing the entrepreneur, most VCs say, “Look, during the next days we are going to conduct a detailed check on your background and will specifically look for bad points. If there is anything out there that we are likely to pick up, would you tell us about it now so it won’t come as a surprise?” By being candid with entrepreneurs about your background checks, you can often induce them to open up about their past. One individual once turned bright red when ask this question, and then admitted that he had been arrested. When asked, “Oh, what for?” he looked back and said, “When I was in college, I was in a bar one night and got pretty drunk and tore up a piano.” From the other details on his record, it looked as though he had sewn all his wild oats on this one night. It was an act that had no bearing on this person’s ability to run the company.
Many times when investing in a small business that is not located in your area, you might call on a VC in the city in question or another contact in the area. Ask them to find out whether anyone has heard anything good or bad about this individual. It is generally easier for someone who lives in the same town to find the contacts who can tell you what kind of person you are dealing with. They may have heard something in their business dealings or they may have seen something about the individual in the local newspapers some years back. They can supply you with local information about the entrepreneur that you would otherwise be unable to obtain.
If the individual you are investing in has been involved in a public company, the SEC files can provide additional information on the individual. If the person has been involved in radio or television, the FCC will have files on the stations that the individual has worked for, and there may be some information about the person in those files. This public information can usually lead you in the right direction.
Customer checks are an important part of due diligence, but they can also be important in assessing the entrepreneur’s ability. When you are talking to the customers of the business, be sure that you ask about the entrepreneur. Many customers will know the entrepreneur because he or she has been helping the company sell the product. They may give you some insight into the entrepreneur’s personality, ethics, and reputation.
Other investors in the company can also give you some background information on the entrepreneur. You will want to contact other investors and find out why they invested in the company and whether they are happy with their investment. Also ask them where there is anything they would want to change, what problems they have had with the entrepreneur, and what they liked about him or her. Get to know these investors and find out what they think about the entrepreneur you are investigating.
Finally, ask employees of the company about the entrepreneur. What is it that they like about the chief executive officer? What is it they dislike? Don’t despair if most of the employees say that they like the CEO and do not have any criticism. At some point, you will find the one who is willing to give you an earful. You will find the “mole” who will give you the inside information you need on the company and the CEO.
Usually it takes more than one person to make a corporation go. You will want to investigate the number-two and number-three people in the firm almost as closely as you will investigate the CEO. It is important for you to know whether they can fill the shoes of the CEO if the CEO should die or become disabled. You will also want to determine whether there are any disagreements among members of the management team. Find out if any problems are brewing. Review the experiences of the management team to see how they fit together. Are they the same age, do they have the same background and experience, or do they have a diversity that will let them handle a multitude of problems? Do they work well together or is there constant bickering and conflict? Be sure to ask all of them how they feel about the chief executive officer. Also ask each one of them how he or she feels about the others.
It is very important to understand who exercises the authority. Is the CEO making the decisions or does the CEO share power with the board of directors and the management team? Does the board function as a committee or is it merely a sounding board for decisions that have already been made?
Determine the duties and responsibilities of each person on the management team. Who has defined these duties? Who has determined whether they are carried out correctly? Has there been sufficient delegation of authority? Have the authority limits been defined adequately? Does the organization depend on only one or two people on the team? Could it function without several of the key employees? Make sure you understand the decision-making process in the company. If the entrepreneur does not have control of the direction of the company, it may be a sign not to invest.
When you have finished asking questions, you should document in detail all the significant points you have uncovered. Also make sure that you have all of the items that you want or that management will be sending them to you. Appendix A contains a list of items that you should probably have on any company that you plan to invest in. What you may find particularly interesting are the reports used by management to manage the business. Once you have those, you can see the business the way the entrepreneur sees it. If you see it in that light, you will probably have a better understanding of the business.
At the end of the day, you should always try to list the strengths and weaknesses of the CEO and the management team. This helps you to assess the risk that lies behind every deal, because the management team counts for so much. Management counts for at least 20 percent of the business, and in most circumstances it counts for 50 percent of the business. In essence, if you do not have a good management team, you will probably not succeed, no matter how good the product or service.