Dig for Diligence
A primer on the venture capital due diligence process
One of my favorite movies is Raiders of the Lost Ark. A pivotal plot element in the movie reveals that the Nazis have thousands of men looking for the ark, but digging in the wrong spot. Indiana Jones and his two friends, armed with additional information, find the right spot and uncover the ark (only to have it taken from them, so that we get an additional 45 minutes of a great movie).
One of the keys to being a good venture capital investor is knowing where and how to dig for information. Diligence best practices are crucial to making good investment decisions.
What is Due Diligence?
Due diligence is the process of digging into a potential investment to learn key details about a company before investing. In the process of meeting with a company, the entrepreneur makes certain representations. Diligence allows a potential investor to determine whether those representations are accurate. The process allows VCs to assess a company’s risks before finalizing an investment decision. During diligence, we attempt to understand the four main types of risk that could derail an investment: market, people, technology, and financing.
Due diligence is sometimes dreaded by entrepreneurs; but if done well, diligence can be beneficial to the startup. Through thoughtful due diligence, a VC will learn the “ins and outs” of a business, and ultimately uncover patterns of success or failure. Good VCs know that sharing both positive and constructive feedback during the diligence process is a way to build trust in their long-term relationships with entrepreneurs.
Here is how Touchdown Ventures approaches due diligence:
First Start Digging: Preliminary Due Diligence
After meeting a company several times, we have formed a thesis for why the investment could be successful, and we have also begun assessing potential risks. This begins a process called preliminary diligence, where we probe into the opportunity with minimal help required from the entrepreneur.
From our initial meetings with the company, we have begun to understand the history of the business, the management team’s backgrounds, key metrics, competitive landscape, customer pipeline, and so on. During preliminary diligence, we start to perform references, including with industry experts, and assess the potential for competitive advantage by understanding what other entrants are attacking the same customer problem.
The goal is to be as objective (and therefore skeptical) as possible and identify potential “yellow flags” that might invalidate our investment thesis. Even the best companies will have potential problems. If we find “red flags,” we typically stop the process and decline the investment. Once we have completed this process and further socialized the investment opportunity internally, we determine whether to move it into full diligence. If we decide to continue, those identified yellow flags become the key focus of our full due diligence. Where preliminary diligence might require 20 hours of work, full due diligence could potentially demand upwards of 200 hours of work from a team of venture capital and legal professionals.
Then Dig Deeper: Full Due Diligence
Entrepreneurs may have experienced or heard about VCs asking for a laundry list of materials to perform full due diligence, but it’s helpful to understand that the primary goals are to validate your story, and pick apart those yellow flags to make sure we are making conscious decisions about the risks we are taking. This also helps us price the investment properly.
Experienced VCs also know entrepreneurs tend to paint the picture that their company is the strongest competitor in the market and has the best product. To remain disciplined, VCs must develop their own market knowledge and network of industry thought-leaders to pull together an objective and sophisticated view of the company’s strengths, weaknesses, opportunities, and threats. Therefore, the full diligence process is far more involved and requires meaningful input from the entrepreneur.
As described above, venture capital diligence focuses on understanding the four main types of risk that would adversely affect an investment. In full due diligence, we dig even deeper into these same issues:
1. Market Risk: We usually speak with three or more customers or potential customers, depending on the stage of the business. These could be customers that the company has shared or references that we know well (“off list” references). Our questions attempt to validate whether the product of service solves a real need, and whether the customer has committed budget to address the problem.
2. People Risk: We also speak to multiple management team references to understand personal and professional strengths and weaknesses. Good “back channel” references can include former employees of the company or people who have worked with the senior management team in their previous companies. We also want to know how the board of directors supports and advises the company. Sophisticated and dedicated Board members often play a key role in a company’s success.
3. Technology Risk: We frequently work with technical experts, who might be corporate executives or a portfolio company CEO or CTO, to validate the startup’s technology, intellectual property, product roadmap, and platform scalability.
4. Financing Risk: We build our own financial projections based on the company’s model, with sensitivities to understand downside cases for the company’s financial outlook, and in particular cash requirements that determine the timing of future financings.
What happens when due diligence goes wrong?
It’s easy to miss risks when due diligence is sloppy or simply not done. We have seen technology architectures which cannot scale due to flawed designs, founders with “skeletons in their closets,” undisclosed or pending lawsuits, and products with fatal market acceptance issues. It’s far better to surface and understand these kinds of issues prior to making an investment.
Venture capital due diligence helps identify weaknesses in a company and understand the entrepreneur’s plan to address them. It can be a tedious process, taking weeks or even months when performed thoroughly. And even when done right, venture capital remains the most risky investment class around, so there will always be “unknown unknowns.” It’s not possible to forecast everything that might go wrong prior to making an investment, but diligence helps make the decision conscious, and not a gamble.
Other Best Practices
Here are some other best practices that we have found can make the process entrepreneur friendly and yield good results. Consistent and honest communication is the foundation for building trust and for developing a good reputation in the venture capital and startup community.
These frameworks can help VCs understand and manage the risks associated with each potential investment.
While the downside of making a bad decision isn’t quite so bad as having your face melt, like in Raiders of the Lost Ark, investors can lose a lot of money by being sloppy or negligent during due diligence. If you are interested in learning more about why it’s so important to follow a trusted due diligence process, read Why Due Diligence is Important written by my colleague, Scott Lenet. He shares his insights from a narrowly avoided horror story.
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Greg Bergamesco is a Principal of Touchdown Ventures, a Registered Investment Adviser that provides “Venture Capital as a Service” to help corporations launch and manage their investment programs. Touchdown’s Philadelphia-based Director Eric Budin contributed to this article.
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