Due Diligence — Fast vs Slow
How much time should VCs spend doing Due Diligence before issuing a Term Sheet?
While some VCs are capable of issuing a term sheet in 3 weeks, others may need a couple of months. What is the reason for this disparity and what are the implications of a fast versus a slow due diligence (DD) process?
While there is clear evidence that more time spent on Due Diligence correlates with better investment outcomes, increased competition in the VC industry is forcing investors to speed up their analysis if they do not want to miss on the best deals. This trend, by the way, has not changed at all during Covid as the best deals are still highly competitive.
As a firm we do not have a fixed amount of time that we want to spend doing Due Diligence but we do have processes that influence it. This leads to the question of
What is the optimal due diligence time given my investment stage and the competitive dynamics of the ecosystem?
In my view, the optimal due diligence time is the minimum necessary to generate conviction but the maximum allowed by your competitors and the timeline of the startup itself. So basically, there are two counteracting effects:
- Quality of the analysis: The quality of the analysis naturally increases with the process duration but eventually saturates, i.e. once most of the checks have been made, any additional check only provides a marginal improvement.
- Competitive dynamics: You should not be significantly slower than your competitors or you will experiment adverse selection at the bottom of your funnel 👉 the good opportunities will be gone by the time you are done with the analysis and you will be left with the rest.
Side note: I recently made an analysis of what VCs communicate to the entrepreneurs versus reality in terms of how much time they need to analyze an opportunity. While at Seed stage most VCs claim that they can do processes in 2–3 weeks, the reality is more like 3–4 weeks from first contact to term sheet. At series A, VCs claim 3–4 weeks while my data shows 5–6 weeks.
1. Quality of the analysis
In absence of competition, the more time a VC can spend analyzing the investment opportunities, the better the returns will be. This has been shown by a number of studies (see Wiltbank and Boeker and nesta.org).
On the other hand, the marginal improvement in the analysis gets smaller as the due diligence advances and at some point it becomes inefficient and tedious, particularly for founders. As an example, beyond a certain point increasing the due diligence time by 2x might only increase the quality of the analysis by 10%. Schematically, 👇
Also, there is a high degree of randomness in VC, particularly in early stage, which cannot be removed from the equation by any DD process. As a result, there is no significant value in adding more due diligence time to the process beyond a certain point because the background noise dwarfs any further accuracy improvement anyhow.
2. Competitive dynamics
In ecosystems or sectors with a certain level of competition among VCs, startups are usually able to structure a competitive process with two or more bidders. In this situation, if one VC is significantly slower than the rest he/she may miss the chance to invest in the company.
If a VC firm has internal processes that generate longer DD times than its peers on a consistent basis, the firm will face adverse selection at the bottom of the funnel because by the time the analysis is finished, the good startups will be gone and only the rest will be left.
3. Optimal due diligence time and how to improve it
Based on the two counteracting effects described above there seems to be an optimum of the time spent by a VC doing due diligence depending on the level of competition in the market.
In other words, if a VC spends too little time on DD he/she might be faster than the competition but the decisions will be more prone to errors. On the other hand, if a VC spends too much time on DD the accuracy of the decision can be very good but by the time the decision is made the opportunity may be already gone.
Traditionally, VCs have solved the DD time problem by getting to know the startups in advance and keeping a watchlist of promising companies. However, now everyone is doing it and the efficiency of this method has come down.
Here are some more things that can be done to have a competitive DD process while keeping high quality standards:
- Specialize: By focusing on a specific sector, business model or market, specialized VCs can come to a high degree of conviction much faster than a generalist. Moreover, as shown by nesta.org investors with a high degree of industry expertise perfom better than the average.
- Technology: Technology can be of great help to improve the efficiency and quality of the VC operations. A number of VCs have developed proprietary technology platforms to become smarter and more efficient. Although the approaches and technologies vary a lot the goals are similar: a) Identify promising opportunities earlier and b) Filter through the noise faster.
- Process, Tools and Training: Having a well-oiled-machine is critical to analyzing large volumes of companies with high accuracy and in a timely manner. In order to accomplish that, the analysis process has to be carefully designed to work in harmony with the technology stack. The investment teams should then be well trained to execute the process in the markets they operate. In our case, by redesigning our analysis process and increasing the frequency of internal touch points we have been able to cut our due diligence time by half while improving the quality of our analysis.
If you can think of new/other approaches to improve VC operations feel free to publish your comments here or DM me at my twitter account @guillemsague
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About myself: I’m VC @ Nauta Capital focusing on Enterprise Software
