He Knows How to Be Diligent About Due Diligence

Whether you're sizing up an investment or a new hire, it's not enough to study the financials and the references. As due-diligence expert Barry Rhein will tell you, you've got to read between the lines.

Deciding whether to green-light a deal can feel like an exercise in paranoia: What's behind that résumé? Does this company have what it takes? Are these people trustworthy? Have you done your homework, and ferreted out any secrets that might make you wish later that you'd just said no? The odds are, you haven't, says Barry Rhein, a due-diligence consultant who teaches venture capitalists how to size up their next deal. According to Rhein, most people don't ask the right questions, let alone wind up with enough good information to make the final call.

"Most people don't lie intentionally," says Rhein, 40, "but unless you really probe, you're not asking them to go beyond the pat answers they have rehearsed. That means you'll always get the positive data, but you're not getting the full story."

Rhein has good reason to take due diligence seriously. As a reserve officer in the San Jose police force, he helps design risk-assessment exercises for narcotics squads. Not that the average VC needs to know when to go for the tear gas. But similar rules of engagement apply. And rule number one is this: Doing your homework is about asking smarter questions and listening harder.

"Barry teaches how to ask questions and listen in a methodical way," says Steve Baloff, 45, a general partner with Advanced Technology Ventures Capital in Palo Alto. "He's trained our analysts to go through that process, and, as a result, we get deeper data. It's not like we've found any smoking guns, but we have much better information with which to make a call."

Here's Rhein's advice on how you can do a better job of giving diligence its due.

How you ask matters as much as what you ask. Skip the yes-or-no questions. One startup that Rhein evaluated for a VC (after the VC had agreed to fund it) had a software product with 200 beta users, all of whom the company expected to convert to real customers. The VC's interview with the startup team asked the obvious: Had they surveyed their users? Yes. And the users liked the software? Yup. Great. But Rhein's follow-up with the software company cut to the quick: What did you ask the users about your software? Not enough, it turns out. The beta users said they liked the software okay, but not enough that they'd be willing to pay a premium price for it. (Ultimately, only 10 of them did.)

"You have to be incredibly curious and want to know why and how, not just whether or not," Rhein says. "Every answer they give you should lead you to another open-ended question: How did you do that? How did you respond to that? What else?"

Find out what they really mean. "People tend to rely heavily on assumptions to communicate. The problem with that is that you can't be sure if someone else's assumptions about, say, what a 'driven, hard worker' is are the same as yours -- unless you ask them to explain," Rhein says.

Don't tip your hand. One of the most common mistakes that interviewers make when checking references for a prospective hire or a startup entrepreneur, Rhein says, is giving away the "right" answers in the process of asking the questions themselves.

It's a mistake that goes something like this: "We're looking for a manager who's a great team motivator and has a history of increasing sales growth in new territory, someone who's comfortable being a pioneer. Is Johnny Doe our man?"

Rhein says that anyone who is curious and tenacious can learn to be better at doing due diligence. But most people don't want to take the time. "Doing an interview well is not a 20-minutes-on-the-phone-and-I'm-done exercise," he says. "I often hear from venture capitalists, 'I don't have time to do this.' My response is that if you don't have the time to do the due diligence well, you certainly don't have time to fix a deal gone sour. The best way to save time is to make time to ensure it's a good deal."

Contact Barry Rhein by email (barry@rheins.com).

Sidebar: What's Your Secret?

Giving due diligence its due is mostly about practice and persistence, says consultant Barry Rhein, who schools Silicon Valley venture capitalists in the fine art of asking the tough questions. But there are a few specific strategies and tactics that you can use to improve your skills significantly.

Tape and transcribe your interviews. The best way to get better at asking questions is to review your own work. Practice really does make perfect. "It's much easier to see the questions that you missed or the inconsistencies that you didn't follow up on when you look at a transcript than it is to recognize them during the conversation," Rhein says. "And always ask the person you're interviewing for permission to call him or her later, in case you need more information."

Ask the magic question. "Ask open-ended questions. One of my favorites is, What else? It assumes that there's more to tell, and it's unspecific enough that people really have to think before they respond."

Look for the uncommon. "I'm always looking for people who don't do what everyone else does. For instance, everyone in Silicon Valley sends email thank-yous after their interviews. It's basically a given. These days, what I really notice is when someone takes the time to send a handwritten note. It's a good indication that they're not functioning on autopilot."

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