How important is Due Diligence when sourcing a Venture Capital fund?
How important is Due Diligence when sourcing a Venture Capital fund?
Venture capital investment process is a multi-stage process that involves identifying, evaluating, and investing in startups. The different steps in the process are:
- Sourcing
- Due Diligence
- Term Sheet
- Investment and Documentation
- Post-Investment
- Follow-on Rounds and Exits
Due Diligence is one of most important step
Why? It is because (it appears) that this is the most crucial step which can have a significant impact (make or break) on the outcome of the entire investment. This is where “outliers-of-outliers” are discovered -- driven by data, patterns, experience, expertise, and probably gut. VC gurus has highlighted the importance of it (from 4x to 1000x) and therefore this becomes more pertinent step.
Moreover, the extent of the due diligence process highlights the diligent & meticulous nature of venture capital investments, where thorough scrutiny is applied to ensure that investments are well-vetted, and at the same time has the potential to cause delays for startups who are in need of quick funding. Therefore, as a fund manager I find it not only interesting but want to learn how to master it and find those 0.01%, fast with 100% chances of success!
Due diligence is a critical step in the venture capital investment process. It involves conducting thorough research and analysis of the startup to assess its investment potential. The due diligence process typically covers the following areas:
Management team
to assess the experience, expertise, and track record of the startup's founding team
Business model
to evaluate the startup's business model, including its target market, product or service, and competitive landscape
Financial projections
to check the startup's financial projections & its financial viability
Market potential
to assess the market potential for the startup's product or service
Intellectual property
to review the startup's intellectual property portfolio to identify any potential (positive or negative) risks
And more
It may also include other data points such as: industry, funding stage, customer satisfaction score (CSAT), net promoter score (NPS), revenue growth rate, profit margin, number of employees, number of patents, amount of funding raised, and current valuation (etc).
Due Diligence Best Practices
Here are some best practices for venture capital due diligence:
Be comprehensive & thorough
Should be comprehensive and cover all aspects of the startup's business, and involve a deep dive into the startup's business.
Be objective
The due diligence process should be objective and avoid personal biases, which can have unforeseen and unintentional impact.
Be timely & collaborative
Should be completed in a timely manner to avoid delaying the investment decision, by collaborating with internal + external stakeholders, and involve the startup's founding team whenever necessary.
“Hard” due diligence is about the numbers, and “soft” DD focuses on people: employees, customers, partners
VC due diligence is the process of evaluating a startup's potential before investing in it. This process involves gathering as well as analyzing information using various data points such as: financials, legal, market, product, business model, and founder or management team. DD helps minimize risks and maximize returns.
It can also benefits startups by uncovering their weak spots and help them prepare for future deals.
There are 3 core stages:
- screening,
- business due diligence,
- and legal review
– and each state requires different type of info and analysis to assess the viability of the deal.
Challenges in Venture Capital Due Diligence and Key Focus Areas for Investors
Venture capital due diligence has its own challenges, such as lack of historical data, comparable competition, proven demand, PMF, and etc info gaps that make valuing a startup difficult. A few key items that investors should examine are:
- financials,
- legal status,
- assets,
- liabilities,
- and human resources
A well-scoped due diligence review, prospective investors or acquirers will benefit significantly, becoming more informed about their proposed target, thus increasing trust in the fund manager. It can help deliver a stronger deal, enabling active dialogue, find the right fit/value to their “thesis”.
Follow a due diligence process when evaluating potential investment targets, including:
- Initial screening,
- market research,
- financial analysis,
- legal review,
- tech assessment and customer validation,
- product market fit,
- management evaluation and reputation check.
Summarize findings in a due diligence report and make a recommendation to the Investment Committee on whether to invest or not.
Reverse due diligence is also a thing
This is where startup founders may check VC's background and reputation towards bigger success goals.
An in-depth investigation or audit of a potential investment or product to confirm all facts, such as reviewing all financial records, market potential, and anything else deemed material. May consult with industry experts and conduct market research to assess the market demand and potential adoption of a startup’s innovative medical device.
The most surprising thing for me when Adeo Ressi mentioned that the number of Unicorns in a city is directly proportional to the number of VCs in that city. That blew me away, simply because there is a general perception that Unicorns are those which have the greatest ideas.
No doubt. But it also means that there are other equally great ideas (if not greater) which are going unnoticed. If we extrapolate this observation, then there are hundreds and thousands of cities (read: ideas) which are deprived of these “VC-funding privileges'', which means the industry is sitting on a gold mine.
Concentration Conundrum, Intense Competition, and the Prolonged Journey from Sourcing to Return
By increasing the number of VC firms, we increase the 1) number of great ideas (Teslas, Googles, etc) 2) and increase the depth of the sourcing list, which increases my (as a fund manager) chances of finding “quality-outliers”. It would be interesting to find out why VCs tend to be concentrated in certain cities? Is it because of strong startup ecosystems, great talent, etc. Or, most investors (organically) live in those cities and therefore end up investing in “local” startups.
Besides that, given the age of the industry I find it surprising that the process is cut-throat competitive. According to online research only ~1% of startups actually receive funding. This means the vast majority is not able to raise venture capital funding. And I understand this is because every single one of them (the VCs) is looking for those “quality-outliers”, those 1%, extremely rare -- that VCs believe have the potential to generate high returns.
Another thing about the venture capital investment process is how long it can take as a process to fund the investment, and for investment to generate return (up to 10 years). From the initial sourcing of a potential investment opportunity to the closing of the investment, it can take several months or even longer. This is because the due diligence process is very thorough and involves multiple steps. In fact, CB insights claim the unicorn birth rate is at its lowest level in 6 years.
I understand VC space is not easy, and the investment process is complex and demanding.
Sources:
-https://www.cbinsights.com/research/report/venture-trends-q1-2023/
-https://news.crunchbase.com/venture/fastest-growing-states-venture-capital-investment/ https://www.forbes.com/sites/hollyeve/2020/07/06/venture-capital-is-not-the-funding-reality-of-most-startups-heres-what-is/
-https://www.cbinsights.com/research/report/venture-trends-q1-2023/