In the dynamic landscape of venture capital, due diligence has resurfaced as a crucial practice. The investment frenzy of 2021, driven by crossover hedge funds and rapid deal-making, saw deals closing in mere hours and led to inflated valuations and superficial vetting processes.
However, the volatile market conditions over the past two years have highlighted the necessity of returning to more prudent and comprehensive due diligence practices. This article delves into the evolution, significance, and strategic nuances of due diligence, particularly within the realm of corporate venture capital (CVC).
The Evolution of Due Diligence
Traditionally, due diligence in venture capital involved meticulous, time-consuming evaluations. Historical data indicates that a typical deal once took over 80 days to complete, with VCs dedicating more than 100 hours to due diligence per deal, including extensive reference checks and thorough assessments. This began to change with the advent of massive investment funds, which contributed to valuation bubbles and accelerated investment cycles.
The COVID-19 pandemic further disrupted the venture capital environment. The Federal Reserve’s zero interest-rate period (ZIRP) in response to the pandemic led to an influx of cheap capital, making 2021 a record-setting year for venture capital. The fear of missing out (FOMO) drove VCs to prioritize speed over thoroughness, often at the expense of due diligence. This period saw the rise of funds that closed deals at unprecedented speeds, sometimes reaching term sheets within a day.
The fallout from neglected due diligence became apparent in subsequent years. High-profile failures and scandals, such as the collapse of tech companies due to fraudulent activities, underscored the critical risks associated with insufficient vetting. Established investors faced substantial financial losses and public scrutiny, reinforcing the importance of rigorous due diligence, even amidst market exuberance.
Key Components of Due Diligence : Comprehensive Evaluation Framework
Effective due diligence is a multifaceted process that involves thorough evaluation of an investment opportunity. This includes vetting founders, analyzing financials, assessing market potential, and scrutinizing the startup’s governance structure. The process encompasses both pre-term sheet and post-term sheet diligence, with the former determining basic terms and valuation, and the latter confirming the investor’s assumptions.
While speed is crucial in startup investing, maintaining rigor in due diligence is essential. The “art” of due diligence lies in identifying and focusing on the key issues that could impact the investment’s success. This may involve validating market traction for one startup or assessing governance risks for another. Comprehensive reference calls and industry analysis are vital for substantiating the information provided by the startup.
Tailoring Diligence to Investment Stages
The nature of due diligence varies with the investment stage. Early-stage startups, which may be pre-revenue or pre-product, require a heavier focus on the founders and market potential. Later-stage investments, on the other hand, involve more detailed financial analysis, technical due diligence, and examination of the startup’s intellectual property portfolio and corporate documents. The use of alternative data and advanced analytics, such as machine learning and AI, is increasingly common to enhance the diligence process.
Collaborative Process and Mutual Commitment
Due diligence should be a collaborative process that validates the commitment between investors and startups. For founders, this scrutiny is an opportunity to refine their business and address strategic issues. Smart investors recognize the value of a positive diligence experience and actively support founders throughout the process.
Minimizing Disruption and Enhancing Efficiency
Investors must be mindful of the time-intensive nature of due diligence for startups and provide support to minimize disruption. This includes discussing data requests with founders, showing flexibility on less critical items, and facilitating introductions to specialist contractors and vendors. A cooperative approach can help build a stronger relationship and increase the chances of a successful investment.
Transparent Communication and Managing Expectations
Clear and transparent communication is crucial during due diligence. Investors should manage founders’ expectations and provide clear signals regarding the likelihood of investment. A straightforward approach can prevent prolonged uncertainty and maintain a positive relationship, even if the decision is ultimately a “no.” Investors should also handle sensitive data requests with care to protect the startup’s interests.
Distinctive Approaches in Corporate Venture Capital (CVC) Diligence
Corporate venture capital (CVC) firms, with their single corporate parent as the limited partner, have unique diligence processes. CVCs often have strategic motivations that extend beyond financial returns, focusing on areas of overlap between the startup and the corporate parent. This includes evaluating product complementarity, potential for R&D collaboration, and opportunities for technology licensing or future acquisition.
Cultural Fit and Strategic Integration
CVCs place significant emphasis on strategic alignment and cultural fit between the startup and the corporate parent. Cultural compatibility is crucial, as misalignment can lead to failed integrations and unsuccessful investments. CVCs may also incorporate broader purpose-driven criteria into their diligence process, assessing the startup’s potential impact and the founders’ commitment to related key performance indicators (KPIs).
Leveraging Industry Knowledge for Agility
Contrary to the assumption that CVCs are slower than traditional VCs, some CVCs leverage their industry knowledge and context to make swift investment decisions. Some Ventures can move from a first meeting to confirming an investment within just ten days, demonstrating that CVCs can be agile and efficient in their diligence processes.
Navigating the Challenges of Hype Cycles
Hype cycles, driven by the emergence of promising new technologies, often lead to inflated valuations and FOMO-driven investments. However, maintaining rigorous due diligence is critical even during these periods. The rapid rise and fall of certain tech sectors serve as cautionary tales, where investors overlooked fundamental issues, leading to significant financial losses.
Amidst hype cycles, comprehensive due diligence can uncover potential flaws in a technology or business model that are overlooked in the rush to invest. Investors must resist the urge to cut corners and instead focus on validating the long-term viability and profitability of the investment. This approach helps mitigate risks and ensures that investments are based on solid fundamentals rather than market euphoria.
Crafting a High-Conviction Investment Thesis
The culmination of the due diligence process is a high-conviction investment thesis. This document should outline the key reasons to invest, the associated risks, deal terms, and expected returns. Starting from first principles, the thesis should present an informed perspective on why the opportunity is likely to generate outsized returns, supported by the insights gained from due diligence.
Leveraging Deep Explorations for Strategic Insights
Some investors regularly conducts “Deep Explorations,” intensive research efforts to build market insights, develop competitive landscapes, and understand technology arcs. These explorations inform the investment thesis by providing a comprehensive understanding of the industry and identifying the strategic relevance of potential investments. This rigorous approach helps making well-informed, high-quality investment decisions.
Conclusion
Due diligence is the cornerstone of successful venture investing. The return to rigorous due diligence practices reflects a broader recognition of the importance of high-quality decision-making in the context of risk. While the venture capital landscape will continue to evolve, the fundamentals of thorough evaluation, strategic alignment, and informed judgment will remain essential. As investors rebuild their diligence capabilities, they are better equipped to navigate the complexities of venture investing and achieve outsized returns in a dynamic market environment
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About The Author
Janus Andersen
Advice on Strategy | Innovation | Transformation | Leadership Helping growth strategies and M&A transactions for 20 years