Due Diligence: The King of Validation
Did you know that approximately 75% of startups backed by Venture Capital funds do not generate returns on capital for investors in the United States? (Shikhar Ghosh in Harvard Business Review). Also, did you know that startups that are not backed by Venture Capital funds are more likely to fail? Have you ever wondered how an investor can minimize the risk of a startup’s failure?
A good due diligence is the most efficient mechanism to validate an investment and minimize the potential risk of failure. Due diligence is part of the investment process of any transaction, including Venture Capital, Private Equity, M&A, among others.
Let’s remember the case of Elizabeth Holmes, who was student in a top U.S. university in California and founder of Theranos. She promoted the “fake it till you make it” culture, and raised over USD$700 million from Venture Capital funds and private investors reaching a USD$10 billion valuation. It was later shown that Theranos was operating under false assumptions and that the product that had convinced the investors was not yet functional. Therefore, the importance of carrying out a detailed due diligence process by Venture Capital funds, where the main considerations are the following:
1. The Team
In the early stages of a startup the team is the most important element. As the startup progresses, the team’s capabilities change and the focus on results increases. Usually investors want to understand the background, experience, character and motivations of the entrepreneurs, which is achieved through one-on-one conversations and referral calls with third parties. They also try to talk with relevant team members who at some point left the project and with those investors who decided not to invest in the opportunity to know the other side of the story.
The opportunity, the business model, the competitive landscape and the potential market size are key elements in this due diligence phase. It is not enough just to know what the entrepreneur is sharing about the business, it is important to conduct an independent unbiased research, expanding it even to other geographies. In addition, it should be taken into consideration the user experience (UX) and the user interface (UI), so the conversation with customers and with suppliers is fundamental. Even better, if you can become a client of the startups you are evaluating, or if you, as a corporate investor, can run a proof of concept or a pilot.
It begins with a demo from the startup, then goes deeper into the technological core, including the infrastructure, architecture, coding and development. In addition, you must understand what third party applications or services the company uses to develop its business. It is important that all core activities are developed in-house (insourced) and not outsourced. In particular, the technological capacity must be robust and not easily replicable.
It evaluates the startup unit economics and the aggregated financials. All ventures should be able to calculate their unit economics, and these must be positive at some point in time. In addition, evaluating the financial model validates that the assumptions of the business model are in line with reality. If possible, review the audited financial statements to understand the company’s financial history. All this information will be the basis for you to build an estimated valuation and compare it against the entrepreneurs’ expectations.
As an entrepreneur, from the beginning you must define the corporate governance of the company and put in order all legal documents, since it is a fundamental part of the due diligence process of any institutional investor. The main elements to be reviewed are the Articles of Incorporation, the Shareholders Agreement, Shareholders Meetings, Powers of Attorney, etc. It also validates intellectual property, including trademarks, patents and licenses, including brands and software development.
Couple of important elements for institutional investors are the corporate structure and legal jurisdiction of the company and its subsidiaries. As an entrepreneur, invest in a good tax advisor to help you make the best decisions in this area along the way.
Due diligence encompasses multiple elements. Investors should do their job, remember the fiduciary duty they have with Limited Partners. Consider the case of Yogome, an educational video game application based in Latam that raised more than USD$36 million from institutional investors and closed its doors when it was discovered that the traction they were showing to their investors was false. Fear of being missing out (FOMO), reliance on the due diligence of other investors, and lack of sound corporate governance have allowed these frauds.
Some additional recommendations are:
1. Typically due diligence is adjusted depending on the type and round of capital raised.
2. Its depth will depend on the investor type, some funds such as Softbank carry out much more rigorous due diligence processes.
3. Regardless of the round, startups need legal and tax documents and advisory.
4. Promote a constructive dialogue between lawyers and investors. Do not imagine things, first try to understand the logic of the investor’s request for information or the entrepreneur’s position.
5. Respect investors and their processes.
6. Align expectations from the beginning to make it an efficient process.
As an investor, don’t get carried away by what other investors do or don’t do. Establish your due diligence process and follow it closely, don’t look for “shortcuts”. As an entrepreneur do not feel overwhelmed, it is part of the process, enjoy it. A due diligence will help you to know yourself and your team, and to know if your business meets the expectations you had at the beginning, or not.
“Don’t look for shortcuts to success. Work harder than anyone else and never give up” — Anonymous
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund.
Ana Maury Aguilar. Investment analyst at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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