How to Deal with Skeletons in your Closet

Posted on Nov 12, 2009 | 51 comments


This is part of my series with Advice on Raising Venture Capital.

skeletons closetI recently wrote a post on how to Deal with your Elephants in the Room during your VC meetings.  Elephants being big issues that the VC will be thinking whether you bring it to his/her attention or not. My advice with Elephants was that you need to take them head on in your first VC meeting because the VC is already thinking about the issue whether you bring it up or not.

But what about issues that might have a slightly negative connotation that the VC couldn’t know in advance?  Skeletons in the Closet are these types of issues.  They are issues, though, that your VC would certainly find out during due diligence or at a minimum you’d be ethically obliged to tell them.

Some examples:

  • A large company has told you that you need to change your brand name or they’ll sue you for trademark infringement (this is a real world, recent example)
  • A company has just filed suit against you for product patent infringement (obviously more serious)
  • Your CTO and leading technology visionary has just announced he’s quitting
  • You’re not happy with your existing investors
  • Your largest customer just cancelled its order
  • Large parts of your tech system are going to need to be rearchitected
  • You have a prior record as a felon (yes, this has happened)

These are all things that you know you’ll eventually need to tell your VC and ethically you must tell them before they fund you.  But when in the process should you tell them?

I’ve had this debate several times with VCs – sometimes they agree with me and sometimes they violently disagree.  In this particular case – I’m right.  Here’s my advice: Don’t reveal your “skeletons” in the first meeting but you need to tell your sponsoring partner before the full partner meeting.

Why shouldn’t you tell them up front?  Is it displaying a lack of ethics to avoid some of these facts?  I don’t think so.  I have often said that fund raising (like any sales process) can be related back to human instincts and therefore explained via dating analogies.  All prospective partners say that they don’t like to “play games” yet it is human instinct to do so.

Some VCs would tell you that you need to lead with all of your dirty laundry – but in reality this way they won’t fund you (whether they admit it to themselves or not).  So here’s my analogy:

snoringLet’s say you’re in your late 20’s and you’re in a bar trying to meet your prospective future partner.  You wouldn’t reveal the first night you meet girl / boy of your dreams that you snore like a bear, would you?  I guarantee the night would stop there.  It is important that he/she sees your positive attributes first.  She loves a man with a great sense of humor.  That smile!  He’s so kind to people.  He likes kids! Did you hear that he was an entrepreneur?

So eventually it will be known that you snore.  By then she has at least seen your good points for what they are rather than being biased by some smaller issue that she eventually would realize isn’t that big of a deal.  Or if it’s a big deal to her, she’ll abort just as a VC would.

BUT (and there’s always a but) … you need to reveal your snoring habits to your sponsoring partner before the full partner meeting.  Why?  Because that individual is your champion within the VC firm and is going to bat for you with his/her partners telling them how great you are.  You can’t send them into battle without the full details or you’ll lose a supporter.

It’s ok to not admit to snoring on the first meeting but it’s not okay to ask somebody to champion you without complete information.  If they back you in the full partner meeting and then later have to reveal your secrets to his/her partners you’ll not only lose the deal but you’ll lose a friend and contact (along with your reputation).

UPDATE: @BSierakowski wrote to me on Twitter and pointed out that I didn’t really deal with how to begin to reveal your Skeletons in the Closet.  This is a tough one because every VC process will go differently depending on how hot your deal is perceived to be, what the general market conditions are and whether that partner has other deals in his pipelines.

But let’s assume a standard pace.  Let’s say it takes you 3-4 weeks to get from your first meeting with a single partner to get to the full partner meeting.  Let’s assume that you have 2-3 one-on-one meetings with the partner and several phone calls.  My suggestion is that you get through the first 2-3 meetings and feel out whether the partner is comfortable at some point putting you in front of his/her partnership.  If the answer is “yes” then before the full partner meeting is scheduled I suggest the following process:

  • Call the partner to say you want to sit down to go through some final details before the full partner meeting is scheduled to be sure you’re all on the same page
  • Ask that this meeting be 1-on-1 (e.g. no principals, associates or analysts) because you have some sensitive stuff you’d like to go through before the partners’ meeting
  • ALWAYS have this discussion in person – even if it means jumping on a plane and flying 5 hours
  • Sit down and have a 1-on-1 discussion.  Lead with the information early in that meeting.  Make it clear that you wanted to reveal the information before asking that partner to sponsor you in front of his other partners
  • Make sure you walk the partner through the details of how and why you believe you’ll be able to overcome this issue
  • If the partner grills you on why you didn’t tell him sooner you can answer in two ways.  A) you can explain that you felt it was important that people judge your business for its positive attributes that you are passionate about and your commited to making sure your Elephant won’t harm the company – OR – B) tell them you read this post and followed my advice and you won’t let that happen again ;-)

  • http://reecepacheco.com reecepacheco

    It all goes back to relationships…

  • http://seekingventurecapital.com jasonspalace

    out of curiosity wondering about that felon, did they get a term sheet? it would be a shame if the next Jobs/Gates couldn't fund their vision for a mistake they once made (depending on the relevance of the mistake of course). shit happens!

  • http://giffconstable.com giffc

    nice post Mark. You continue to show that you haven't forgotten the entrepreneur's perspective after having moved to the dark side of the force :)

  • http://www.dantiernan.com/blog/ dantinpa

    Here is a scary approach I have seen happen: recruit someone else to lead your company that does not have skeletons, don't tell them and let the investors find out at the same time as the new leader. The new leader and investors are both pissed, maybe burned, but at least someone new will be in place. I am NOT recommending this – just highlighting it for anyone that every might find themselves in this “leader” role – don't be surprised by the surprises!

  • http://reecepacheco.com reecepacheco

    It all goes back to relationships…

  • http://www.jasonspalace.com/ jasonspalace

    out of curiosity wondering about that felon, did they get a term sheet? it would be a shame if the next Jobs/Gates couldn't fund their vision for a mistake they once made (depending on the relevance of the mistake of course). shit happens!

  • http://venturehacks.com nivi

    In Predictably Irrational, Dan Ariely discusses experiments that back you up. If you tell people about your cons after they already like you, they don't care about your cons as much. Check out the beer/vinegar experiment in the book.

  • scottmerritt

    Hey Mark,

    Great follow through on the earlier promise to post this…I was anxiously awaiting your thoughts on the “skeletons”!

    As another followup, it would be interesting to hear either anecdotal scenarios or even just specific advice on some of the hypotheticals above.

    I think most people, like with snoring, or with other sensitive topics have good intentions (to disclose), but might put it off and not know where to start. From personal experience, I have tried to fully “resolve” any skeletons before pursuing funding, which seemed to unnecessarily delay things funding wise. Like most entrepreneurs, I was optimistic about how long it would take to deal with things, and time passed as I was cleaning out the closet…killing opportunity.

    Issues that seem particularly challenging include:
    -Trademark infringement (this happened to me before)
    -A company has just filed suit against you for product patent infringement (has not happened to me, but every entrepreneur has probably dealt with a competitor that claims to be filing all types of patents in the same space)
    -Your CTO and leading technology visionary has just announced he’s quitting
    (my CTO/non-visionary quit/was fired, which still was a challenge both in reality and investor perception)
    -You have a prior record as a felon (not relevant to me, but I'm certainly curious as to how this “speedbump” would not be a deal breaker)

    I of course dealt with each as best as I could (I got things in order BEFORE pursuing funding)…but the delay caused the market opportunity to shrink from a Twitter/FB size opportunity to a niche play :(

    Clearly, the the appropriate course was to move forward despite the skeletons, but that's certainly scary/uncharted territory for me, and likely many others!

  • http://bothsidesofthetable.com msuster

    He did not get a term sheet because he didn't disclose his skeleton. We found it out in the background checks. But he's got a great company and will do very well.

  • http://bothsidesofthetable.com msuster

    Thanks, Giff.

  • http://bothsidesofthetable.com msuster

    Wow, that sounds like an awful situation. I guess as an incoming CEO you always need to do due diligence like a VC would.

  • http://bothsidesofthetable.com msuster

    Thanks for the tip. I'll go check it out. Funny, though, because most VCs I've discussed this with say they'd rather know up front. But then again most people dating say they “don't like games.” Human nature trumps all.

  • http://giffconstable.com giffc

    nice post Mark. You continue to show that you haven't forgotten the entrepreneur's perspective after having moved to the dark side of the force :)

  • http://www.dantiernan.com/blog/ dantinpa

    Here is a scary approach I have seen happen: recruit someone else to lead your company that does not have skeletons, don't tell them and let the investors find out at the same time as the new leader. The new leader and investors are both pissed, maybe burned, but at least someone new will be in place. I am NOT recommending this – just highlighting it for anyone that every might find themselves in this “leader” role – don't be surprised by the surprises!

  • http://www.skysnolimit.info/ Adam

    Not to divulge relevant info upon which a vc decision is made can be grounds for fraud in a suit. I had that with Robin Leach, in a less serious than a vc non disclosure situation. He was found liable (guilty) of fraud for non disclosure of information regarding a contract for his being a spokesperson for my company. Unfortunately the jury erred and did not find him guilty or liable for punitive damages.. so all I got was the $175,000.00 that I had paid him. Cost me millions.

  • abirbhattacharyya

    Mark:

    Another good post!

    Can you address in a follow-up:
    1. A co-founder or key employee has sued or is contemplating suing for intellectual property infringement, stealing code, blah blah blah

    I have seen this happen a lot…

    Thanks,
    Abir

  • http://venturehacks.com nivi

    In Predictably Irrational, Dan Ariely discusses experiments that back you up. If you tell people about your cons after they already like you, they don't care about your cons as much. Check out the beer/vinegar experiment in the book.

  • scottmerritt

    Hey Mark,

    Great follow through on the earlier promise to post this…I was anxiously awaiting your thoughts on the “skeletons”!

    As another followup, it would be interesting to hear either anecdotal scenarios or even just specific advice on some of the hypotheticals above.

    I think most people, like with snoring, or with other sensitive topics have good intentions (to disclose), but might put it off and not know where to start. From personal experience, I have tried to fully “resolve” any skeletons before pursuing funding, which seemed to unnecessarily delay things funding wise. Like most entrepreneurs, I was optimistic about how long it would take to deal with things, and time passed as I was cleaning out the closet…killing opportunity.

    Issues that seem particularly challenging include:
    -Trademark infringement (this happened to me before)
    -A company has just filed suit against you for product patent infringement (has not happened to me, but every entrepreneur has probably dealt with a competitor that claims to be filing all types of patents in the same space)
    -Your CTO and leading technology visionary has just announced he’s quitting
    (my CTO/non-visionary quit/was fired, which still was a challenge both in reality and investor perception)
    -You have a prior record as a felon (not relevant to me, but I'm certainly curious as to how this “speedbump” would not be a deal breaker)

    I of course dealt with each as best as I could (I got things in order BEFORE pursuing funding)…but the delay caused the market opportunity to shrink from a Twitter/FB size opportunity to a niche play :(

    Clearly, the appropriate course was to move forward despite the skeletons, but that's certainly scary/uncharted territory for me, and likely many others!

  • http://bothsidesofthetable.com msuster

    He did not get a term sheet because he didn't disclose his skeleton. We found it out in the background checks. But he's got a great company and will do very well.

  • http://bothsidesofthetable.com msuster

    Thanks, Giff.

  • http://bothsidesofthetable.com msuster

    Wow, that sounds like an awful situation. I guess as an incoming CEO you always need to do due diligence like a VC would.

  • http://bothsidesofthetable.com msuster

    Thanks for the tip. I'll go check it out. Funny, though, because most VCs I've discussed this with say they'd rather know up front. But then again most people dating say they “don't like games.” Human nature trumps all.

  • http://bothsidesofthetable.com msuster

    Totally agree that it needs to be divulged. And far before the final investment decision. Sounds like your situation was no fun

  • http://bothsidesofthetable.com msuster

    I presume you're asking how to discuss with your VC rather than how to deal with the actual circumstance?

    Dealing with the circumstance obviously involves working with the best lawyer you can afford. But I would also suggest that you get an opinion from this lawyer that can be disclosed at the right time to the VC. Have great documentation siting why this won't be an issue.

    Don't be surprised if the VC asks for some non-standard legal provisions to protect themselves in the case where they decide to proceed.

  • http://bothsidesofthetable.com msuster

    You're right and I should have pointed that out in the post. If you can deal with your skeletons before fund raising even better. But if you're going through funding without resolution I'm assuming it wasn't a straightforward fix. Thanks for your input.

  • http://www.skysnolimit.info/ Adam

    Not to divulge relevant info upon which a vc decision is made can be grounds for fraud in a suit. I had that with Robin Leach, in a less serious than a vc non disclosure situation. He was found liable (guilty) of fraud for non disclosure of information regarding a contract for his being a spokesperson for my company. Unfortunately the jury erred and did not find him guilty or liable for punitive damages.. so all I got was the $175,000.00 that I had paid him. Cost me millions.

  • abirbhattacharyya

    Mark:

    Another good post!

    Can you address in a follow-up:
    1. A co-founder or key employee has sued or is contemplating suing for intellectual property infringement, stealing code, blah blah blah

    I have seen this happen a lot…

    Thanks,
    Abir

  • http://www.mobilgistix.com/ Johann Blake

    Whatever you do, don't forget to remove your GPS ankle bracelet before you come to your first meeting.

  • http://arnoldwaldstein.com awaldstein

    Mark, an important discussion.

    I disagree on this one. Not that there are some things better left unsaid but that you need more specific and less general rules to address them. In fact, I think you need not a rule but some guidance on most of these to help parse them out.

    -Felon status. Not relevant unless egregious. I agree.
    -Infrastructure rebuild. That a tipping point for a raise and opens up positive discussion on moving to open source, more scale and so on.
    -Loosing the URL for your tradebrand that drives SEO or partner linked traffic. OUCH! There are strategies to overcome that show some chutzpah but can't imagine not talking about.

    So, I agree. Be smart. Be strategic because, duh, you are selling yourself. But don't be stupid and have to tell someone later and then they will say, “why didn't I know sooner, what else didn't you tell”.

    I like to look at it under the old hack of “Can you turn that bug into a feature” or 'Can you turn that problem into an opportunity?” Of course there are lots of corner cases and many shades of grey.

    Its the kind of thing my clients talk to me about and I address each one individually.

    Thanks for raising this. At its essence its about being smart enough to think these through one by one.

  • http://bothsidesofthetable.com msuster

    Totally agree that it needs to be divulged. And far before the final investment decision. Sounds like your situation was no fun

  • http://bothsidesofthetable.com msuster

    I presume you're asking how to discuss with your VC rather than how to deal with the actual circumstance?

    Dealing with the circumstance obviously involves working with the best lawyer you can afford. But I would also suggest that you get an opinion from this lawyer that can be disclosed at the right time to the VC. Have great documentation siting why this won't be an issue.

    Don't be surprised if the VC asks for some non-standard legal provisions to protect themselves in the case where they decide to proceed.

  • http://bothsidesofthetable.com msuster

    You're right and I should have pointed that out in the post. If you can deal with your skeletons before fund raising even better. But if you're going through funding without resolution I'm assuming it wasn't a straightforward fix. Thanks for your input.

  • tomblondi

    Another good one, Mark.

    Many times it is hard for an inexperienced entrepreneur to know what an Elephant or Skeleton actually is to a VC, isn't it? Like an in-law who invested in the FFF round with that pesky little clause about anti- dilution in perpetuity. Is that a big skeleton or a small one? Not sure how they know to fix that before they go big game hunting. Is the size of the elephant or skelelton critcal?

  • http://bothsidesofthetable.com msuster

    Yeah, it's true that this issue is always case specific and in a blog it's hard to be able to cover each case so you try to abstract as a rule. And as a rule I think these “skeletons” are best covered early (e.g. pre-partner meeting) but not at the first meeting.

    FWIW, the felony was egregious.

  • http://bothsidesofthetable.com msuster

    Well, in your case it is actually not out of the ordinary for FFF round to have anti-dilution. But usually when you're in the VC round they don't want to pony up their large $$$ to keep pace with the investment. And usually when the CEO talks to them they step back from anti-dilution.

    Regarding how to know whether it's an elephant or a skeleton … I think each team needs to sit down and say, “what would I reasonably be thinking if I were on the other side of the table.”

    Example: 4 of you worked together at a previous company and only 3 of you are together at this company. The missing person is the former CEO. Do you think the VC meeting you will be wondering where the CEO from your last company is and why he didn't join? Elephant.

  • http://arnoldwaldstein.com awaldstein

    Got it.
    From my perspective Mark, if you are spurring me to spend my time engaging with you and the topic on your blog, and my comments add depth to the discussion, then this is a win win.
    Thnx.

  • http://www.mobilgistix.com/ Johann Blake

    Whatever you do, don't forget to remove your GPS ankle bracelet before you come to your first meeting.

  • http://arnoldwaldstein.com awaldstein

    Mark, an important discussion.

    I disagree on this one. Not that there are some things better left unsaid but that you need more specific and less general rules to address them. In fact, I think you need not a rule but some guidance on most of these to help parse them out.

    -Felon status. Not relevant unless egregious. I agree.
    -Infrastructure rebuild. That a tipping point for a raise and opens up positive discussion on moving to open source, more scale and so on.
    -Loosing the URL for your tradebrand that drives SEO or partner linked traffic. OUCH! There are strategies to overcome that show some chutzpah but can't imagine not talking about.

    So, I agree. Be smart. Be strategic because, duh, you are selling yourself. But don't be stupid and have to tell someone later and then they will say, “why didn't I know sooner, what else didn't you tell”.

    I like to look at it under the old hack of “Can you turn that bug into a feature” or 'Can you turn that problem into an opportunity?” Of course there are lots of corner cases and many shades of grey.

    Its the kind of thing my clients talk to me about and I address each one individually.

    Thanks for raising this. At its essence its about being smart enough to think these through one by one.

  • tomblondi

    Another good one, Mark.

    Many times it is hard for an inexperienced entrepreneur to know what an Elephant or Skeleton actually is to a VC, isn't it? Like an in-law who invested in the FFF round with that pesky little clause about anti- dilution in perpetuity. Is that a big skeleton or a small one? Not sure how they know to fix that before they go big game hunting. Is the size of the elephant or skeleton critical?

  • http://bothsidesofthetable.com msuster

    Yeah, it's true that this issue is always case specific and in a blog it's hard to be able to cover each case so you try to abstract as a rule. And as a rule I think these “skeletons” are best covered early (e.g. pre-partner meeting) but not at the first meeting.

    FWIW, the felony was egregious.

  • http://bothsidesofthetable.com msuster

    Well, in your case it is actually not out of the ordinary for FFF round to have anti-dilution. But usually when you're in the VC round they don't want to pony up their large $$$ to keep pace with the investment. And usually when the CEO talks to them they step back from anti-dilution.

    Regarding how to know whether it's an elephant or a skeleton … I think each team needs to sit down and say, “what would I reasonably be thinking if I were on the other side of the table.”

    Example: 4 of you worked together at a previous company and only 3 of you are together at this company. The missing person is the former CEO. Do you think the VC meeting you will be wondering where the CEO from your last company is and why he didn't join? Elephant.

  • http://arnoldwaldstein.com awaldstein

    Got it.
    From my perspective Mark, if you are spurring me to spend my time engaging with you and the topic on your blog, and my comments add depth to the discussion, then this is a win win.
    Thnx.

  • http://twitter.com/mpstaton mpstaton

    This is a pretty good tactic. Intuitive, but just because it's common sense doesn't mean everyone would do it. I think I accidentally did this. I also just left a few minor things in the schedule of exceptions….

  • http://twitter.com/mpstaton mpstaton

    This is a pretty good tactic. Intuitive, but just because it's common sense doesn't mean everyone would do it. I think I accidentally did this. I also just left a few minor things in the schedule of exceptions….

  • abirbhattacharyya

    Thanks Mark , keep up the good work on this blog. Finally Brad & Fred have real competition. You guys are tied for #1.

    Best,
    Abir

  • abirbhattacharyya

    Thanks Mark , keep up the good work on this blog. Finally Brad & Fred have real competition. You guys are tied for #1.

    Best,
    Abir

  • Guy

    Elephants are better than skeletons, no doubt about that…
    However, the fact of the matter is that VCs need very little to say no. Any reason would do – and they'll just move on to the next deal. There's nothing to be mad about here, its perfectly natural – think of yourself going into a shop to buy T-shit for $10 – even if the shirt is absolutely stunning, if it has one small defect or stain you won't buy it. Now think about a mulio-million dollar deal…
    Your company needs to be absolutely amazing, or that you need to be absolutely amazing in soliciting capital for a deal to close. Amazing will triumph skeletons to a degree, but very good will not.

  • Guy

    Elephants are better than skeletons, no doubt about that…
    However, the fact of the matter is that VCs need very little to say no. Any reason would do – and they'll just move on to the next deal. There's nothing to be mad about here, its perfectly natural – think of yourself going into a shop to buy T-shit for $10 – even if the shirt is absolutely stunning, if it has one small defect or stain you won't buy it. Now think about a mulio-million dollar deal…
    Your company needs to be absolutely amazing, or that you need to be absolutely amazing in soliciting capital for a deal to close. Amazing will triumph skeletons to a degree, but very good will not.

  • http://OpenSwipe.com Casey Allen

    “It is important that he/she sees your positive attributes first…Did you hear that he was an entrepreneur?”

    Nice. Love it.

    Truthfully, I avoid the e-word like the plague because chicks assume that I'm independently wealthy. Little do they know. I'd actually pay extra to be able to filter out “daughter of an entrepreneur” on Match.com.

  • http://OpenSwipe.com Casey Allen

    “It is important that he/she sees your positive attributes first…Did you hear that he was an entrepreneur?”

    Nice. Love it.

    Truthfully, I avoid the e-word like the plague because chicks assume that I'm independently wealthy. Little do they know. I'd actually pay extra to be able to filter out “daughter of an entrepreneur” on Match.com.