The diligence never stops
Reading about the SEC's many fruitless investigations of Madoff over 16 years has me thinking of due diligence this morning. It's easy to criticize the SEC in hindsight for not finding anything. Obviously, Madoff was a master at covering his tracks, making any diligence process difficult. He also played off of reputation and trust to swindle his clients. This probably worked on the SEC as well. I'm guessing that they cut corners on the investigation because of who (they thought) Madoff was.
As an investor, I never stopped the due diligence process, even after making an investment. Pre-investment, I would try to do 360 degrees of diligence, talking to anyone I could find who knew the people, market, or technology involved in a prospective new investment. I would try to get them to meet first-hand with the company to get their direct impressions. I would also talk to previous employers and investors from the founders' companies. As is the case with anyone, no one gets 100% scores. You have to weigh issues and risks with the potential upside.
People learn from their mistakes, and I tend to be a forgiving guy (one of my weaknesses, some may say). I wasn't necessarily put off by a failure in a previous situation, but I wanted to learn as much about it as possible. It's startling to hear the different perspectives that multiple people can have on the same situation. On one company, I had one board member tell me that a key person was barely involved with the company while another said that this person was chiefly responsible for the company's success! How do you know who to believe?
If you talk to enough people, you can form your own opinion. If you weren't there yourself, you can be like an investigative reporter, digging up as many facts as possible and stitching the story together. You can listen to your own instincts and see how they line up with what you've heard from others. But, there are some things I'm not very forgiving on -- honesty and ethics. If someone lied once, they'll certainly do it again. That's an almost impossible habit to break.
I'm always amazed at the lack of diligence that some investors and entrepreneurs do. I've seen some investors back entrepreneurs from failed companies without talking to any of the previous investors. Maybe they wanted to keep the new deal to themselves, but is that worth the risk of missing out on the other investors' perspective? And, very few entrepreneurs perform diligence on VCs. Those investments are two-way partnerships. If you have a choice of investors, shouldn't you do your homework on them?
As I mentioned before, I don't stop this process after investing. If I am working with a CEO and I come across someone who knows them well, I'm going to ask a lot of questions. This has bothered some people who thought I was 'going behind their back'. But, I just want to continue to learn as much as possible about the people I am in business with. I always put a much greater emphasis on my first-hand interactions because they are only colored by my own judgment, not someone else's, too. However, if I can learn how to help a CEO be more effective by understanding a past situation they were in, it only helps all of us for me to take advantage of that.
Also, be very wary of someone who doesn't want their background to be an open book. I've encouraged people checking my references to call anyone. And, I don't feel I need to prep my references on what to say about me. I've got nothing to hide and am happy to discuss any situation I've been involved with, including those that haven't worked out. I'm guessing that Bernie Madoff didn't consider his fund to be an open book for the investigators. He certainly controlled the information that anyone could find out, much to everyone's dismay.