From Zero to IPO: People Due Diligence at Every Startup Stage

Daneal Charney

March 9th, 2020Venture Capital

Every time an investment firm considers putting capital into a growing company, even in the earliest funding rounds, they should insist on some level of people due diligence. This due diligence should be led by a trusted HR executive or advisor in their network.

We are used to seeing people due diligence support potential exits scenarios, whether that is an IPO or acquisition. What is missed is the people due diligence that should happen prior to each funding round, with increasing rigor in later stage financing. Based on my 10 + years of experience of working in high-growth companies, the business will incur unwanted costs and stalled growth if they haven’t invested in people due diligence by series B or after the 75-person mark. This is the beginning of the teenager stage of organizational growth where the complexity of managing a larger team requires a new level of sophistication in people operations.

As an investor you are betting on a company hitting certain growth targets and milestones. This future business performance is dependent on the skill and will of the leaders and key employees in your invested business. People due diligence can ensure these key employees are identified, actively managed and retained through the investment period.

The Costs of Woefully Neglecting the People-Side of the Business

Avoiding people due diligence altogether can lead to a situation similar to an oil tanker trying to contain its spill. From personal experience, you may spend 6 – 12 months cleaning up this mess that could have been avoided though due diligence earlier out of the gate. I was brought into a business where I spent my first few months at a company reacting to daily resignations of mission-critical team members whilst trying to back-fill a host of roles. This was a company who had recently gone public but had woefully neglected the people-side of their business prior. High turnover and lean teams made it challenging for the business to deliver on what they had already promised to their customers and even put new customer accounts in jeopardy. In addition to the huge turnover costs, we were forced to adjust compensation packages (including base, bonus, stock option plans) that were woefully below marketplace. With a strong HR lead at the helm early on, many of these issues could have been avoided. It took more than a year to turn things around and even more to win employees trust back.

Go Further than Your Data Room!

Most articles on M&A due diligence focus solely on reviewing the people-relevant data set to identify irregularities and red flags. These may include but are not limited to: employment contracts, policies, disciplinary action, grievances, tribunal claims, leaves of absence and more.

While this is a good start to avoid costs and risks later, it doesn’t go far enough. People due diligence should focus on maximizing the individual capabilities of key people for the duration of the investment period. The future performance of a company is dependent on the current engagement/retention of key human assets. In other words, your goal is to maximize the lifetime value of key employees both in terms of output and tenure.

In order to do this, you need to review how individual employee competencies, motivation, and performance will be maintained through the investment period. In addition, employee’s attitude towards the impending funding rounds (or particularly in an exit scenario) needs to kept front and center.

A study done with 96 organizations that went through acquisitions between 1980 – 84 points to the significant correlation between post-acquisition performance and staff retention especially at the executive level.

Recently I read Craig Walker’s article on what he learned about keeping a team together after an acquisition (Craig Walker was the CEO of three start-ups, two of which were acquired by Yahoo and Google). What he shares is the need to understand the type of people you have in place, in particular that they have the skill and the will you need to drive future performance.

Similar to an acquisition, a new investment round aims to maintain business continuity to realize the benefits of a new capital injection. To reap the benefits, individual capabilities of key people are needed to drive towards the desired future state. How can you do this without an understanding of this capability and developing a strategy to retain these human assets in the future?

Best practice is to put in place a retention plan for all top employees that includes short-term growth opportunities, financial remuneration and a career plan that aligns with your organization’s vision. A company-wide succession program with contingency plans is also prudent.

Starting Point – Due Diligence Checklist

So where do you start in your human due diligence if you are approaching a new funding round? Y Combinator shares a due diligence checklist that references a basic people-relevant data set. Of course, you need to get beyond this by reviewing people-related data using three lenses – the individual employee, targeted employee groups (c‑suite, management, mission-critical employees, etc.) and employees as an aggregate. Key questions that should be answered include

1) Are you capitalizing on an individual/target group’s skills, knowledge, time, motivation in order to deliver your growth objectives? (business outcome – performance)

2) Are you enabling and incentivizing them to maximize their performance? (business outcome – performance)

3) Do key individual’s career trajectory and development plan align with the companies’ future goals and vision? (business outcome – retention)

4) Do you have a retention and succession plan that incentivizes key individuals to stay for the next 2 – 3 years? (business outcome – retention

Aggregate people-related metrics include indicators that are tied to output (revenue per employee, employee discretionary effort, etc.) and retention (turnover, average tenure, employee current/future commitment, etc.).

Summing it Up!

Investors should do human due diligence as a standard part of their overall review of any potential opportunity. Every stage of the business necessitates a higher level of human due diligence to ensure you mitigate future costs and drive your desired business performance. If you are counting on future individual, executive or team capabilities to drive future business performance, don’t assume this will happen without a retention strategy. A seasoned HR pro is a key partner of this journey.