No Fear of Truth: VC Due Diligence
“The expectations of life depend upon diligence; the mechanic that would perfect his work must first sharpen his tools.”- Confucius
“Fake it till’ you make it” was the guiding motto in the creation of Theranos, a company founded in 2003 by Elizabeth Holmes, who left Stanford to start it, grew to a valuation of $19bn. Investors were complacent, with little discipline, they were carried away by the fame and name of well-known advisors involved in the initiative.
This is a case of fraud, but above all of lack of rigor in the Due-Diligence process that led investors to lose their money and today the legal battle is still open and has been in court for a month.
With the clear objective that stories like this one are not repeated, the Due-Diligence process must be taken seriously. Beyond enthusiastically seeking that the startup complies with the investment opportunity points, all those that represent a challenge or risk to be overcome by the founders must be recognized.
When raising capital, the entrepreneur will receive one or several “Term Sheets” from the interested parties. Once the terms and conditions have been agreed upon, the formal due diligence process is triggered by the lead investors. This process may start informally when the investor has its first meetings with the entrepreneur, but it should always culminate in a formal process of reviewing all available data.
Although some entrepreneurs downplay its importance, the Due Diligence process is highly relevant because:
- It tests the hypothesis an investor has about the startup. Every investor has an investment thesis, so they have talked to multiple startups and have in-depth knowledge of the industry sector. Therefore, by having conversations and soliciting information from startups, he processes and validates his investment thesis.
- It allows the investor to validate all the information provided. The entrepreneur’s word is subjective, so the investor has to validate the substance. The entrepreneur by nature is an optimist and an excellent salesperson; when talking to investors he focuses on highlighting the goodness and strengths of his business. The investor, as a buyer, has the obligation to validate all the information provided by the entrepreneur to ensure that there really is a product and a business model.
- Validate and control potential risks of the business. At the time of making an investment, the investor must consider the main risks of the business and its operation in order to seek mitigants, have a realistic expectation of the true potential of the business and the time to achieve it.
In addition, the Due-Diligence process considers the following review elements:
- Business Strategy:
This is the basic element of any transaction where investors review in depth the strategy, business model, traction and financial performance, among others. The review of the investor deck, the financial model and conversations with entrepreneurs and ecosystem participants allow for first-hand information to make an investment decision.
We seek to validate the operational strength of the company beyond the robustness of the business model. This element speaks of the potential execution and scalability of the startup. Sometimes entrepreneurs are very good at imagining and designing their business model, but their ability to execute is quite poor.
- Human Capital:
The fundamental element of any startup is the people, so investors must validate the professional capacity, morale, technical competencies and cohesion of the team. In addition to conversations with the entrepreneurs, having references from the market such as other investors, customers, ex-employees is fundamental.
Technology is a differentiating factor among startups. Therefore, it is important to have a good understanding of the technological “core” and scalability for the startup to really be successful.
This is one of the most relevant sections of the Due Diligence where we seek to validate the legal existence of the company, that it is properly constituted, and that it complies with all the regulations applicable to the jurisdiction where it operates.
It seeks to understand the risk and fiscal and tax implications that the investor could have in carrying out the investment, especially if the startup is domiciled in tax havens or in countries with lax regulation.
The process of analysis of these elements may change depending on the strategy that each investor has. For example, there are very sophisticated investors with a complex investment policy, such as the IFC, for which their Due Diligence processes are rigorous, extensive, covering each of the previously mentioned elements, including issues such as “ESG”. In contrast, there are less rigorous investors who appreciate speed and perform expedited due diligence such as Tiger, which can take a single call as the entire process or just a few days to make its final investment decision.
Due to the difference in the type of investors, the Due Diligence process can vary drastically from one to another. However, typically it can take anywhere from a couple of weeks to a couple of months. Usually the process is conducted internally by the VC funds; sometimes legal and tax due diligence can be conducted by an outside firm.
In seed investment stages, the Due-Diligence is usually more relaxed and as the startup grows and raises more capital, it tends to become more rigorous. Therefore, it is important that the entrepreneur prepares himself to take on this challenge by building a Data Room from the beginning for extensive review by the investors. He should also reserve some time in his agenda during the process of raising capital, and be accompanied by a multidisciplinary team that can support him in the transaction.
The “Due-Diligence” is usually a slow, time-consuming and repetitive process. The entrepreneur must be psychologically prepared to cope with it and complete it successfully; he is the key for the process to be carried out in an adequate manner. In addition, as the startup grows, it will continue to raise capital and will have to carry out multiple Due-Diligence processes.
“Patience and Diligence, like faith, remove mountains.” — William Penn
Hector Shibata Salazar, adjunct Professor at EGADE Business School and Director of Investments and Portfolio at AC Ventures Fund
Ana Maury Aguilar, VC Investor at AC Ventures
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
Stay updated about Venture Capital, innovation, entrepreneurship and more! Sign up for AC Venture’s monthly Newsletter.
Follow us on LinkedIn: ACV_VC
Follow us on Twitter: acv_vc
Follow us on Spotify: ACV_VC