Practice varies, but quite often the last two due diligence items a VC will want to do before offering a term sheet are (1) personal references and (2) customer references. These should be done last because it's easy to "burn out" the person(s) giving the reference(s), and, so, entrepreneurs should not deplete that resource unless the prospective investor has done all their other due diligence and is on the verge of making an offer. That is, the entrepreneur should get the VC to commit that these are the last two due diligence items they intend to do (other than legal due diligence, which is always done after a term sheet is proferred).
There are certainly risks in personal reference calls going badly, but most people in the business world have made, and given, reference calls, so I'm not going to spend any time on that topic.
Customer reference calls, however, can go off the rails if not prepared for properly, and here are some tips on how to maximize the chances they go well.
Person Seeking the Reference: It is entirely within the bounds of propriety for the entrepreneur to review the questions that the VC plans to ask of the customer reference. The entrepreneur should note that the VC is free to request to ask anything the VC wants. The entrepreneur's choice is to comply, negotiate away the question (very unlikely and risky from a "makes the VC nervous" perspective) or get money from someone else. But, that said, the entrepreneur should understand what the VC is planning to ask about so the entrepreneur can prepare the customer for the call.
Customer Giving the Reference:
- Things That Can Go Wrong: It's important to realize that, for many customers, this might be the first time they've ever done a "customer" reference call for a vendor who's seeking financing. It can seem mysterious and ambiguous; at the very least, there's not a widespread understanding of the purpose of the call. Here are some examples:
- "I need to appear smart": Often, the customer employee will feel the need to appear smart to the VC. Probably, this is part standard human reaction to a situation in which it's easy to feel like you're being "tested" on your knowledge of the vendor, their product and the industry, exacerbated by some nebulous sense that the VC must be important (or else, why would the vendor have asked me to do the call?). In any event, I have seen this movie, and it usually involves the customer employee struggling to appear "even-handed" in their evaluation of the product, so as not to appear naively enthusiastic. Particularly when the personality of the customer employee is not naturally enthusiastic, this can (inadvertently) present the picture of a customer that isn't all that happy with the product. Not good on a VC due diligence call.
- "I Don't Want to Be Blamed if the Investment Doesn't Work Out": Because the VC is calling the customer as part of the process of deciding whether to invest in the vendor, customers can feel that the VC is looking to them to be an integral part of the investment decision -- in the extreme, it can feel like the VC is asking the customer whether or not the VC should make the investment (I've heard VCs actually ask customers a version of this question: "I know you're not in a position to know, and its clearly our call to make, but, just curious, would you make this investment?"). No surprise, this can make the customer very cautious about sounding too enthusiastic. It's vitally important that the customer not feel that, by giving a good, enthusiastic reference, he is, any way, "on the hook" for the VC's decision whether or not to invest.
How to Avoid the Problem(s):
- For these, and other reasons, the entrepreneur should prepare the customer for the reference call. This includes, among other things, alerting the customer to the areas which the VC wants to explore, so the customer can have ready answers. But, the most important part of preparing the customer is to explain the purpose of the call and what the VC wants to get out of the call. To reiterate, unlike personal references, which are sought and given frequently -- and with which most (relevant) folks are familiar -- customers may never have given a VC reference, and inadvertently harm the financing process through their misunderstanding.
- Here's an example: I've recently had a VC seek a customer reference call with on of my "Sherpa" company's customers. The call was with a mid-level employee of the customer who "owned" the relationship in the customer organization, so the logical person to whom the VC should have spoken. It was this person's first such call (we didn't know this at the time -- the person was senior enough that we, more or less, assumed they knew the drill -- which they didn't), and the company seeking financing didn't prepare the customer for the call at all. The call ended up being a disaster (but for the wrong reasons), with the VC ultimately backing out. The reasons were that the customer employee giving the reference found the VC aggressive, "probing", doubting, "looking for all the weaknesses", and a bunch of other stuff. The customer employee got flustered, gave bad or rambling (and defensive) answers to the questions. And, in "self-defense" started obliquely criticizing the vendor, just to (1) "appear smart", and (2) deflect the questions that were misperceived as attacks. Finally, the customer employee rang the alarm internally that the company seeking financing was near bankruptcy, based (wrongly) on the fact that they were fundraising, and the VC was so aggressive in their questioning.
The lesson: Always prep your customers before they do reference calls with VCs. This is not to induce them to prevaricate in any way, but, rather, to let them know, pre-emptively, that the VC will ask probing questions, might seem aggressive in some of the questions, may sound somewhat doubting about the company's prospects, may ask them whether, in their opinion, the VC should make the investment, and other similarly potentially confounding gambits. Importantly, that this is normal, and the purpose of the call is to probe to make sure customers like the product -- and that it is consistent for the employee to answer with (genuine) enthusiasm for the product while appearing "smart" about the industry. And, finally/finally, that the fact that the company is out fundraising is a good thing, normal in the progress of successful companies -- not a worrying sign of impending financial problems.