Why Due Diligence is Important
Or, how venture capital can go horribly wrong if you don’t do your homework
In 2003, my DFJ Frontier co-founder sourced an extremely compelling technology startup. This investment opportunity seemed amazing, and we were both excited.
The entrepreneur was one of the most charismatic salesmen we had ever met. When it came to vision, energy, and conviction, he had completely convinced us. We believed he would move mountains to achieve his vision.
We immediately began our due diligence process, which included all the normal requirements:
- verifying that the company owned its intellectual property
- reviewing material contracts
- talking to channel partners and prospective customers
- checking management references
Our goal was to assess the main risks of the startup: market risk, technology risk, financing risk, and people risk.
Diligence is useful in deciding how to manage an investor’s relationship with an entrepreneur, how to price the deal, and probably most importantly, whether to make the investment.
Because the company was new, we called board members from the CEO’s prior startup. Some of the references were provided by the CEO and some were “back channel” references who were friends of ours.
We were shocked by what we heard.
The references nearly universally told us that they didn’t trust the CEO. That he was great at pitching, and was truly visionary, but was also frequently guilty of hiding the truth. Bad references are fairly unusual in venture capital. Usually, when someone doesn’t have anything nice to say, nothing is said it all. So this was an especially discouraging sign.
We tried to convince ourselves that maybe the CEO had learned from his prior experience. But ultimately, we decided that we were engaging in wishful thinking, that we wouldn’t be able to look our Limited Partners in the eye if something went wrong, and that we had to pass on the deal.
Afew years later, we learned that a Fortune 500 corporation had acquired the startup. The initial acquisition price was announced in the nine figures range, but the deal included an earn-out for up to $1 billion.
I instantly felt my heart in my throat, because I had been so wrong. Instead of protecting our investors and our firm, our “uptight” diligence process and discipline had cost us the opportunity to make a substantial return.
My partner called me as soon as he saw the press release. He was justifiably upset. We couldn’t help ourselves, and we calculated the return we could have provided to our limited partners if the company made that billion-dollar earn out, and our stomachs began to turn. In addition to letting down our investors, we had personally walked away from life-changing money.
Even though we had made the decision together, I felt like I was responsible for the mistake, and I apologized for “making us pass on the deal” — and then I rationalized that we stuck to our process and had made the best decision we could on behalf of our investors, based on the information we had. But I really felt guilty about this decision for years to come. And so I learned that a lengthy career in venture capital rarely comes without a few regrets.
Another five years later, I was talking with a friend from the corporate venture capital arm of that Fortune 500 acquirer, and randomly the name of that startup came up. My friend became a little animated, raised his voice a bit, and started speaking faster. “You were lucky!” It turns out the company had been a fraud. The acquirer had pulled the plug on the business, and the acquisition itself was a failure. Of course, the earn-out had not been achieved.
But what my friend said next will stick with me for as long as I am active in venture capital. He said:
“None of the venture capitalists who were in that deal and sold us that startup will ever work with our company in any way again, ever, in their entire careers.”
I will admit that I felt a little vindication, but more than anything I felt relief that the due diligence process we had trusted hadn’t let us down. Venture capital is a long-term game, and our reputations are our most important assets. The startup we “missed” was playing a short term game, trying to make a quick buck, and had squandered the reputation of everyone involved. We had really dodged a bullet by relying on the discipline of due diligence.
What I took away from this decade-long, was a reminder that due diligence is an investor’s best opportunity to understand the key risks of a deal before signing up for a long-term relationship, and another reminder that references are the most essential part of due diligence.
This article originally appeared in ThinkGrowth.
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