Authentic Due Diligence: An Impact Investor’s Approach to Evaluating Investments
In venture capital and private equity, “due diligence” is the research that investors do on a company before they invest money in it. There are a lot of different opinions on how to perform due diligence. Some of my ideas are a little bit different and may be of particular interest to investors who are committed to having a positive social impact.
Seven years ago, my colleagues and I were talking to a fast-growing education start-up that was raising a big A round. We were a little late to the party because we were putting together our first fund. Because we were late to the party, we asked the company if any of the other investors would be willing to share some of their due diligence, and particularly their notes on their conversations with the company’s customers. It turned out that none of the other investors talking to the company had called any of the customers. When we made some customer calls of our own, we found a few issues that led us to decide not to invest. Nonetheless, other firms liked the traction and the management enough to invest millions of dollars.
Many venture capitalists believe that they recognize excellence when they see it within five minutes of meeting an entrepreneur. And I know the feeling they are talking about: the incandescent charisma, the intimacy, the unforgettable anecdote, the compelling mission, and of course the acute fear of being the idiot who gets left behind. You leave the meeting energized and alert. Even a brief conversation with the entrepreneur helps you to be a better version of yourself. But this initial impression can be dangerous. Good due diligence can uncover many unpleasant surprises, like a CEO with a drug problem or angry, disappointed customers.
It is worth noting that the odd-sounding phrase “due diligence” is an obligation of a fiduciary: it describes one of the obligations venture capitalists have to their limited partners (the investors in their fund). Due diligence is not an optional, ornamental extra. Even when a deal is hot and fast-moving, a venture capitalist still needs to perform due diligence.
When we venture capitalists are mindful of our obligation to perform due diligence, we sometimes treat it in a perfunctory manner, performing what is due and no more. We make sure to document our work so that no one can accuse us of being negligent, but we do not always bring the full weight of our curiosity and imagination to bear on the task.
On the other hand, I have seen private equity firms perform due diligence in a way that brought a company to its knees and became almost a full-time job for many members of the management team for six or eight weeks. Private equity firms often hire multiple teams of outsiders: technology consultants, lawyers, forensic accountants, specialists in detailed investigation of the background of managers, and market researchers, among others. Some of these investigators are compensated on an hourly basis, so they have an incentive to be exceedingly and perhaps excessively thorough. This kind of thoroughness is more or less obligatory for private equity firms, semi-obligatory for growth equity firms, and out of the question for venture firms. Good venture capital firms will steer a middle path between the perfunctory and the crushingly excessive.
There are, however, some painless hacks that can give a venture capitalist a much deeper insight into a start-up while helping the entrepreneur at the same time.
First, I find it helpful to think of due diligence as a consulting engagement, with the goal of producing some insights that are useful to the entrepreneur. If a venture capitalist approaches the research with this goal in mind, it is not hard to find information that wouldn’t ordinarily be accessible to the entrepreneur. Customers and partners will often tell a venture capitalist things they wouldn’t tell the company directly. And venture capitalists can on occasion have a very frank dialogue with an entrepreneur’s competitors. Sometimes when you ask a competitor about a company you are diligencing, you get a passionate, entertaining, and informative 45-minute rant.
Second, one can help the company make valuable connections to customers and partners. There are multiple benefits to introducing an entrepreneur to a potential customer or partner from your own network. For a firm like mine that focuses on a single sector, this is a particularly painless and obvious process. If one does this well, both the entrepreneur and the other party will be grateful for the introduction. Afterward, the venture capitalist will be able to get a candid assessment from a person whose judgement she trusts.
Third, one can talk to some of the more junior employees at the start-up. Junior employees are not typically involved in a venture due diligence process, but they are curious and open to a bit of career advice, and they can generally spare fifteen minutes. Talking to junior people reveals the actual values and priorities of the CEO, which may be different than the values she or he enunciates to an investor. This is not a game of gotcha but rather a way of seeing whether the investor and the company are truly compatible. It is important for the investor to understand the secret inner architecture of the company: the shared values and habits and beliefs. Another way to illuminate the load-bearing structures of this secret architecture is to simply hang out in the offices of the company one is diligencing. One can learn a lot about a corporate culture as a quiet ethnographic observer sitting on a couch in the corner or shadowing a key executive through a few meetings. One of the things I personally look for is joy.
Fourth, entrepreneurs can (only with permission!) record and share their interactions with customers. One company I admire accelerated our due diligence in a meaningful way by recording and then transcribing a presentation by one of their customers to his peers at a conference. The customer’s peers probed the nuances of the use case for the product in a much deeper way than we could have. The same company subsequently began recording its initial training sessions with new customers. These transcripts provide a lot more texture than most due diligence artifacts. These transcripts are also quite useful to start-ups for onboarding new employees and improving customer satisfaction.
A lot of venture capital due diligence activities often feel artificial and awkward. The due diligence activities described above, on the other hand, are authentic: they deepen the relationship between entrepreneur and investor. They are so useful that the venture capitalist and the entrepreneur might choose to continue doing them even after the investment decision. Investors should think of every aspect of the investment process as a moral act, one that nourishes the world or poisons it. An investment partnership is not a machine: it is an organism in a larger ecology.
