Chapter #8: Completing the Due Diligence Process — Part 1 of 2
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, meeting dynamics in Chapter #6, due diligence process factors in Chapter #7, in Chapter #8 I’ll discuss several of the risk factors that VCs aim to manage via the due diligence process and how you can address their concerns in an efficient manner.
Rather than seeing due diligence as an arbitrary process to get out of the way, see it as a set of applied methodologies used to challenge the assumptions of your company’s thesis. If anything, going through due diligence processes make your company more resilient by shining the flashlight on risks that you may have failed to identify yourself, which you can then take steps to manage. In terms of time allocation, a VC may dedicate 5–10% of their monthly time budget to a given investment. However, you will dedicate 80–100% of your time to your venture. Since you therefore have a much greater risk exposure, if the VC sees that you haven’t defined, mapped, analyzed, and managed the generic and specific risks facing your business, this creates a bad signal.
To make this less abstract, let’s say a VC finds a direct competitor you never mentioned. The fact that you’re willing to dedicate your life to building a business but failed to identify direct competition suggests negligence. Bottom line, due diligence is something you should have already completed for yourself before you approach investors — otherwise you might be wasting the next two years of your life working on a business that has no chance of succeeding. With this understanding, let’s now work through the key risk factors and how to think about them.
At the seed stage, VCs care disproportionately about the people involved relative to other factors. At lool we focus on track record, domain expertise, chemistry, body language, strategic thinking, motivation, agility, speed, character, competence, verbal and written communication, and confidence, among other characteristics. Each VC will have its own hybrid algorithm for evaluating the people involved which meshes together intuition and data.
People data is collected and analyzed from your interactions with the VC, reference checks, your interactions with the people the VC introduces you to, and sometimes personality / psychological assessments. Usually the VC will ask you for personal references on all of the founders. Make sure to get the buy-in of your personal references at least a week before you start meeting with VCs and educate them about your venture. Furthermore, make sure to choose relevant references. Someone who you worked for or with for less than a year does not typically have enough data on you to give credible answers. Someone who you worked with or for ten years ago does not have enough relevant data on you to give credible answers. Pick your references wisely, as they can have a significant impact on the VC’s perception.
In addition, you may be asked to spend time with other people in the VC network — such as HR consultants, industrial psychologists, portfolio companies, potential customers, and others. Some VCs also use personality / psychological assessments to further validate the data they are collecting from the process. As mentioned in earlier chapters — you will not click with everyone you interact with, so your best bet is to stay authentic and find the VC(s) with which you have the best chemistry.
You may ask yourself why do VCs care so much about “people”? First, early-stage investing is like committing to a 5–10-year marriage. Would you want to marry someone for 5–10 years if you had bad chemistry and trust issues? Second, people ultimately make the decisions that drive a business forward. If a VC senses a lack of competence or credibility when it comes to intelligent decision making, it doesn’t matter how innovative the business idea is, it is unlikely to succeed. Third, people represent the creative force bringing ideas into reality. Without confidence in your ability to execute on your promise, the idea will stay an idea, and financial returns will not manifest. Lastly, your business’ success depends on your ability to sell a vision to employees, customers, partners, and other key stakeholders. If your team can’t sell to the VC, how will you sell successfully to others?
VCs typically want to understand the following market characteristics before making an investment decision in a B2B, B2G, or B2D context. I break down the market into four sections for clarity.
- The problem you’re solving
- The underlying causes of problem
- The type of individuals and organizations are experiencing the problem
- The # of individuals and organizations experiencing the problem
- The # of individuals and organizations that could experience the problem
- The segment of individuals and organizations for which the problem is most painful
- The segment of individuals and organizations which are willing to pay the most to solve the problem
- Trends that could make this problem more or less painful in the short-term and long-term
- Trends that could make this problem more or less common in the short-term and long-term
The competition (existing solutions)
- The way individuals and organizations address the problem with internal and external solutions
- Advantages and disadvantages of internal & external solutions
- Characteristics of the external solution providers such as: Date founded, $ raised, investor profile, management team profile, # of ees, revenue, growth/penetration rate, pricing, business model, value proposition, messaging, IP, customer sentiment, company vision
- Breakdown of external solution providers into incumbent vs. new entrant
- SWOT & Five Forces Analysis
The opportunity size
Not going to recreate the wheel here as Alon Amar does a fantastic job of outlining this exercise and Matt Heiman does a great job of showing why it may not matter. The important thing to realize is that the size of the opportunity is less about the output and more about the process. In general, the top-down approach to market sizing is seen as lazy and the bottom-up approach is more thoughtful exercise in segmenting your market, thus illustrating a stronger work ethic — which can improve your “people” score. If you come to a VC and say “The market for Cloud Infrastructure is worth $150b and so if we capture 1% we’ll be a unicorn ” vs. “We’ve identified 1000 SMEs that have a specific pain, we spoke to 50 and the range they’d be willing to pay for a solution is $50–100k/year, so our initial revenue opportunity is between $50m-$100m, but according to Gartner, there will be another 4000 SMEs that will need a similar solution over the next 5 years, increasing our addressable opportunity by 5x.” You can see the difference.
Another consideration is the potential for rapid market growth. As Peter Thiel points out in Zero to One, becoming dominant in a small market that’s about to explode usually produces better results than entering a mature, slow growing, inefficient market. It’s the difference between Uber and Gett.
Finally, you should consider areas where business model innovation unlocks value and revenue streams that do not fit in the existing market structure. Airbnb is a great example — no market research reports were covering the multi-billion platform opportunity to monetize existing home ownership via short-term rentals. Investors relying on this approach to market sizing missed one of the biggest venture outcomes in history.
As discussed in Chapter 4, VCs ultimately care about returns. Returns are typically generated by either selling the company to a larger company (M&A), or by raising additional growth capital from the public markets (IPO), thereby allowing your existing investors to sell their shares to others via the NASDAQ, NYSE, or hopefully at some point the LTSE. But how does the acquisition or IPO price get calculated? Rather than simply outsource this task to an investment banker, you should strive to understand the basics so you can have an intelligent discussion with your potential investors about the various exit scenarios for your company.
M&A & IPO pricing relies on a variety of components including talent, revenues, growth, total addressable market, business model, business model efficiency, market leadership, product offering, comparable transactions, industry multiples, industry dynamics, and industry competition. Most of the elements look eerily similar to what VCs evaluate during the due diligence process. This should come as no surprise since they make a living from estimating the likelihood that you will get acquired for a significant amount.
To bring this down to earth a bit let’s look at the automotive industry. Several years ago GM acquired Cruise Automation for $1b. The company had no revenue, just an enabling technology for autonomous vehicles and a highly intelligent and capable team. Not too long thereafter, Argus Cyber Security was acquired by Continental for $430m, also a pre-revenue enabling technology for autonomous vehicles supported by a highly intelligent and capable team. In a highly competitive trillion dollar automotive industry with 10+ players generating $100b in revenue, acquirers can afford to pay $500m-$1b for gamechanging technology.
Taken to another extreme, companies like Ironsource, Taboola, and Outbrain each generate close to $1b in revenue and barely surpass $1b valuations. How come a company with $1b in revenue is worth the same as a pre-revenue company? Put simply, demand for autonomous technology amongst manufacturers at the time of the Cruise acquisition was far greater than today’s demand for $1b of advertising revenue, relative to the available supply. Another way to think about this: perhaps with Cruise’s technology GM could improve its profitability by 10%, which would translate to $10b in new net income, a 10x return. On the other hand, what if Taboola’s $1b in revenue translates to $50m in net income? For a potential acquirer like Facebook, Google, or Verizon, an additional $50m in net income on top of $20-$30b barely moves the needle.
These examples are meant to merely demonstrate that M&A & IPO pricing depends on a variety of factors, most of which you should research before you enter due diligence and negotiation. Ultimately if you are in an industry where exit/valuation multiples are accelerating relative to other industries, you have a better chance of passing through Market due diligence.
While I wish I could fit all of the due diligence risk factors into a single post, I’ve decided to break it into two to give you some space and time to digest. Next week in Chapter #9, I’ll discuss the remaining key risk factors including technology, product, monetization, go-to-market strategy, your financial/hiring plan, company history, and cap table.