Chapter #7: Optimizing the Due Diligence Process
Raising your Seed Round — a Playbook for Israeli Entrepreneurs
After discussing how much to raise in Chapter #1, the various sources of funding in Chapter #2, VC organizational structure in Chapter #3, securing face-to-face Partner meetings in Chapter #4, guidance on how to prepare for these meetings in Chapter #5, and meeting dynamics in Chapter #6, Chapter #7 focuses on the factors that influence the due diligence process and how you can use them to your advantage. Please note that the process I’m referring to is different than legal due diligence which will likely occur after you’ve signed a term sheet (we’re getting there, don’t worry).
For founders, the point of the due diligence process is to get to an investment decision. Your job is to understand each VC’s process and manage it efficiently. Otherwise you’re wasting precious time that could be used to build your business.
You can think of a VC as a neural network, taking in data, iterating, and readjusting risk factor weights with an output of Yes or No. Your job is to “score” as high as possible on each risk factor, so that the VC says yes at the end of the process. And in the coming chapters I will dive deep into each risk factor and discuss what you can do to improve your scores. To set the stage, however, I want to give you a deeper understanding of the process factors that determine the speed of decision making. You could theoretically score 10/10 on all risk factors and get a term sheet, but if the process takes 6 months, you just wasted a lot of time, and time is money. Optimizing risk factors increases your chances of getting a term sheet but optimizing process factors significantly reduces the time it takes to get one.
If a two Partner, one Associate VC is diligencing four companies in parallel, the bandwidth available to evaluate your company is capped and what would normally take 1–2 weeks to complete might take 4–5 weeks. If the Chaggim just kicked off, get ready for an inefficient process. You want to get a finger on the pulse of the fund’s bandwidth as soon as possible in order to align expectations and timelines.
At the same time, you can influence this factor. If you come to a VC with a term sheet from a competing VC, they have an incentive to allocate more attention to you which will lead to a faster decision (not always a better decision). If you come to a lead VC with strong US micro-VCs who are looking for an Israeli lead, you’ve created another positive incentive to speed up the process. Since you can rarely predict when a VC will be overloaded vs. underloaded with other opportunities, your should create a situation where the VC will prioritize your company over the competition.
As Daniel Kahneman notes in Thinking Fast and Slow, “Intuition is pattern recognition”. Some VCs have accumulated a critical mass of experience that allow them to pattern match in an extremely efficient manner. In other words, they can subconsciously “sense” success or failure, because they’ve seen enough successes and failures in their careers from which they can derive a prediction about your likelihood to succeed. Intuition strength is highly correlated with bandwidth allocation. In other words, if a VC has strong positive intuition about you and your company, he/she will want to prioritize your company and accelerate the process. A strong negative intuition will most likely lead to a rejection. Unfortunately since each VC has a unique set of previous experiences, there’s no systematic way to consciously influence this factor — you need to be your best self and hope that you fall on the right side of the intuition line. That being said, VCs with strong intuition are likely to have a reputation for moving fast which can influence how you build and prioritize your list of leads.
Good or even great personal chemistry can accelerate a due diligence process faster than any other process factor. At the extreme it resembles falling in love — the VC really enjoys spending time with you and tends to overlook your flaws and shortcomings… until one day the VC looks in the mirror and asks, “What have I done!?” But by that point the money’s already in the bank ;) Since VCs are humans (for now) with emotions (some more than others), shared hobbies, stories about your kids, military service, philosophical debates, and laughter can go far. These aspects of personal chemistry can have surprising influence on the decision making process — because many entrepreneurs treat VCs like bankers (debt) instead of partners (equity). If you understand and develop personal chemistry, your process will be smoother and faster.
In general, the more a VC knows about your market, the less time they will need to make a decision. For example, if you have a cyber start-up, a specialist cyber fund will understand your market, business model, go-to-market strategy, value proposition, differentiation, future fundability, and exit potential 5–10x faster than a generalist VC fund who lacks cyber knowledge. Generalists will need to “get up to speed” in cyber by interviewing you, third-party sources, and conducting online research. Because this will take time and resources, creating a targeted list (chapter 4) improves your chances of an efficient process.
Since each VC has different knowledge and a different approach to analyzing risk, they may require different data. Try to define upfront exactly what data the VC needs to process in order to reach a decision. Keep in mind that this data set can evolve over time as the VC learns more; he/she may recognize new risks that require additional data/analysis to mitigate. In the best case scenario, you’ve already prepared a data room that satisfies the VCs needs. In the more typical case, you’ll provide data and the VC will supplement this data through their own research and network. In general, the quicker the data flows from you to the VC, the quicker the VC can reach a decision. Your job is to prepare, organize, and analyze the data in advance, stay on top of all data requests, and respond as you see fit.
Sometimes VCs will ask for a lot of data up front, not get back to you for a while, and then pass. It’s hard to know exactly what’s happening in the VC black box, but I’ve heard stories of VCs that ask for data and then share it with their portfolio, other VCs, and in the worst case with a competitor. In my view some of this is grey behavior and some is blatantly unethical. The best way to hedge against this behavior is not an NDA (which will likely kill the process entirely), but by using a password protected data room which allows you to monitor the actions of the VC. It still blows my mind that less than 10% of Israeli entrepreneurs use Docsend. There is always a risk of data leakage, but sending the data over email maximizes the risk, rather than minimizing it. For any sensitive data, you can add a confidentiality footnote to send a subconscious reminder to the VC.
Since due diligence is fund specific, transparency is the degree to which a VC honestly communicates where you are in their process, the areas in which they lack sufficient data to make a decision, and clear guidance on the steps that remain. With low transparency you have slim chances of a quick decision and limited ability to manage the process. With high transparency, you basically have an ongoing list of actions the VC is taking to further investigate your company, alongside ongoing updates regarding the status of their evaluation. When possible, develop a relationship and communication channel with a non-Partner who can give you better insight into Partner sentiment and process location.
To summarize, before you begin to share materials, schedule follow-up meetings, introduce the VCs to your network, and get introduced to theirs, honestly appraise your options. Are there certain funds with a reputation for being more efficient? Are some funds more educated on your business? Do you feel a personal connection with one VC more than another? Once you feel comfortable with the process factors outlined above, it’s time to continue to Chapter #8 where I discuss how to optimize the risk factors that the due diligence process seeks to measure.