Unit 28 of 63
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More On Due Diligence

Upfront Venture partner Mark Suster is one of our favorite sources on Venture Capital.

In a recent post, he takes a very unconventional view and advises founders not to create a data room. 

Data rooms are the online folders containing all the startup information needed for VC firms to conduct their audits (also called due diligence.)

The post was written for Founders but it also provides useful advice to VCs who have a tendency to ask too many questions ahead of showing commitment. The two main takeaways are:

  1. The startup’s detailed information is very sensitive and should be shared only with parties that proved commitment to the deal;
  2. Term sheets are a good means for Founders to test that commitment.

As you can see in the chart above, in this chart the due diligence (DD) process is split into two steps.

Firstly, the high-level business diligence done by the VC team. Secondly, the more technical audits done by external auditors and lawyers – which generate costs. 

What due diligence items do you cover internally? Is asking too much information detriment to the deal dynamic?

💬 Let us know in the Comments section below.

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    • Correct. The problem is, there is an incompressible cost to audits and long form documentation, which is not driven by the size of the round but the sophistication of the company and the deal. So you often end up spending the same amount whether the company raises €100k or €1M (more or less). That’s also why angels generally invest at the bottom of that range (and often run no formal DD at all) while VCs tend to invest a few hundred K€/$ minimum. Some VCs have streamlined the process with templates and work with the same providers to lower that cost.

  • I once participated in a roadshow between a pre-IPO company and Sequoia, during which Sequoia’s investors asked very detailed questions about the clinical trial data of each of the company’s pharmaceutical products, so that the company’s executive team was a little angry. Some large investment institutions may be more stringent in due diligence, but I think for some less famous VC institutions, it may be difficult to balance due diligence and the willingness of the startup team to cooperate.

  • I experienced a case in CVC in which information and time completely changed the outcome of the transaction. Initially, the idea was to make a minority investment in the startup but as negotiations went on and the corporation gained access to more data (also more time to think about the deal), they ended deciding to acquire the startup entirely and help it bring the product to the market by leveraging internal resources. However, the case was in Healthcare & Life Sciences which I would argue is an industry where you have to share information with investors otherwise no one will “believe you” and no one will invest (i.e., success rate of getting FDA approval etc… is too low). Could that be the case in other industries as well?

  • Since the detailed information is very sensitive and confidentiality is important, I suppose that before starting the process of due diligence, the potential investors are supposed to sign a non-disclosure agreement to keep the confidentiality. The due diligence items include financial situation, shareholding structure, number of users/clients etc.

    • VCs very, very rarely sign NDAs, for reasons explained during class: they see too many startups that are competing with each other to restrict their capacity to invest in one vs another.

      • As NDAs are rare, what are the ways one can protect novel ideas during the DD process from the point of view of the startup founder? I suppose the startup can file for a patent for technological innovation, but many novel ideas aren’t exactly patent-material (e.g. a new business model, or the idea to target a specific client segment)

        • True, and even patents are not great protection if you don’t have enough cash to defend them in court. It all goes down to accepting a degree of risk, or being strong enough to convince Investors without revealing the secret sauce (à la Theranos, but VCs are not as amenable to these tactics).

  • Talking about NDAs, I have listened to a few podcasts from a number of VCs about NDA. The consensus seems to be that they do not entertain any NDA as part of their due diligence. I believe there may be cases where NDAs may be applicable such as details of patents filed or held for strategic advantage.
    There’s so much one can ask for before it becomes overwhelming. However, I like to verify the veracity of claims, data points or walk the details of financial projections. I am aware that financial projections are mere optimistic outlook, but I still like to see.

  • I have been a part of several financial due diligence processes. Generally, I have observed that sell-side DDs are more transparent in terms of data sharing. Buy-side DDs are trickier because the business under investigation is very hesitant to share data. In such cases, we need to be tactful with the kind of data we ask, and involves a lot reading between the lines to analyse the investment prospects.

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