The 10X Capital Newsletter

The 10X Capital Podcast is a podcast where David Weisburd and Erik Torenberg interview the world’s top Venture Capitalists and their Limited Partners.

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Every week, we’re going to cover a topic that is widely acknowledged but often misunderstood in the venture industry.

The truth is, that much of how VC operates today is still opaque, and managers - especially emerging managers - have a hard time finding guidance that they can operationalize.

Our goal is to distill actionable advice that managers can use to raise venture capital in this market.

So without further ado, today’s topic: Reference checks 👇

How LPs conduct reference checks on a VC manager

Reference checks are a necessary diligence item for LPs when deciding whether to write a check to a VC manager. Reference checks are also the #1 most underreported reason for why an LP says no to a fund.   

No LP wants to tell a GP that they passed on him or her because they didn’t reference well, so it is goes unreported.

Reference checks are a form of auditing the manager’s track record that provides additional information and context to a manager’s financial track record.

Similarly to any diligence process, reference checks are a process that triangulates conversations with 10-15 parties who have worked with the manager in order to ascertain the credibility of that manager’s statements.

In venture capital, LPs are specifically looking to understand both the manager’s character and skills as it relates to generating alpha for the fund.

Having a good character is great, but it is not a sufficient enough reason to invest.

Character is a key component of diligence as it predicts how that emerging manager will behave over a multi-decade relationship with an LP.

Questions asked include:

• How did the manager act during difficult market cycles?’

• How did the manager treat his previous co-founders and investors?

As an LP, it’s impossible to fully vet a manager by simply listening to a manager and taking his or her statements at face value.

After all, venture capitalists are some of the greatest narrative dealers on the planet.

Outside of vetting a manager’s character, references also are a critical part of ascertaining a manager’s source of alpha:

• Does the manager have an edge as it relates to sourcing companies?

• Is the manager a good picker?

• How does the manager win in a highly competitive and saturated market?

Each LP will have their own set of follow-up questions to these three key questions, but LPs primarily want to know if the answer to all three questions above is a resounding “yes” AND if the manager can continue leveraging those skillsets at a high level through the length of the fund’s investment period. 

Each answer to these questions will be a check in either the positive or negative column for an LP. 

LPs do not always agree on whether the feedback from references is a positive or negative signal. In many industries, the top performers may come across as difficult to deal with, so the signal that these answers provide is not so white and black. 

Who do LPs reference check when diligencing a manager? 

As an emerging manager, you should expect LPs to conduct both on-list and off-list reference checks. 

On-list references are ones that you explicitly provide to prospective investors. I recommend having easy-to-share video files for your on-list references included in your data room. These references will satisfy any small check investors in your fund and help institutional investors check the box for on-list references.

The main diligence for LP’s begins with off-list references - which are references with individuals that LPs reach out to that were not provided by the manager.

Many LPs fall into the trap of conducting all of their off-list reference checks by calling other LPs within the manager’s network. Other LPs however are not sufficient enough to build a mosaic of information on a manager which requires a 360 view of a manager’s skills and character.

Founders are the most important party that LPs should reference.  This is because venture capital is an ACCESS class, meaning that the asset picks the investor (not the other way around).

Whether it was Google Series A where the company forced Sequoia and Kleiner to co-lead their Series A or Facebook Series A when Mark Zuckerberg presented to Sequoia in his pajamas and ultimately picked Accel to lead the Series A (a position that today would be worth $158 Billion dollars) venture capital is an asset class where the top companies have their pick of who they want to invest in their company.

LP reference checks when they re-up

Most LPs conduct a much less extensive reference process when re-upping with a manager.

This is for several reasons:

• Firstly, LPs are overburdened with a large number of managers and don’t have the capacity to re-conduct extensive reference checks.

• Secondly, LPs postulate that since they already performed checks on the manager previously not much has changed since their last diligence process. This may be true largely for character references, but this is not always the case for skill based references as markets change.

• Thirdly, it is oftentimes too early to re-diligence a manager by the second or third vintage.  

In absence of a new round of references, LPs will re-up when they feel that:

• The manager has done what they said they were going to do (minimal or no strategy creep).

• There have been no significant management team changes.

• Fund size has not dramatically increased.
  
  But this is a topic for a future newsletter - until then.. 🫡

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Next week, we’ll be discussing one of the most common questions I get from emerging managers. What makes an LP re-up (or not)?

Top posts of the week ✍️

Chart of the week 📈

Emerging manager tools 🔧

• Chris Harvey for fund counsel 

  • Reach out to Chris at [email protected].

• AngelList for fund administration

  • Get in touch by emailing the team at [email protected].