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What Do VCs Do?

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  1. INTRODUCTION

    How This Module Works
  2. How Much Do You Know About The VC Job?
  3. The Six Tasks of VCs
  4. The VC Cycle
  5. Quiz 1
    1 Quiz
  6. GENERATING DEAL FLOW
    What Is The Best Way To Generate Deal Flow?
  7. Generating VC Deal Flow
  8. Building A VC Referral Network
  9. Networking 101
  10. The Importance of Branding
  11. The Startup Ecosystem
  12. Service Professionals
  13. Warm Introductions
  14. Co-Investing
  15. Cold-Calling Startup Founders
  16. Making Angel Investments
  17. The Deal Flow Funnel
  18. Analyzing Pitch Decks
  19. Time Management Tips For VCs
  20. The Anti-Portfolio
  21. Quiz 2
    1 Quiz
  22. EVALUATING COMPANIES
    What Are The Critical Characteristics VCs Look For In Startups?
  23. Analyzing Startups For Venture Capital
  24. VC Firms' Investment Strategies
  25. What Is (Really) Scalability?
  26. The Product/Market Fit
  27. The Hard Truth About Network Effects
  28. The Idea Maze
  29. More On Due Diligence
  30. Breaking The Mental Model
  31. Being Primed For The Problem And The Idea
  32. Making The Investment Decision
  33. Quiz 3
    1 Quiz
  34. Case Study: Write The Investment Memo
  35. How Much Do You Know About Term Sheets?
  36. NEGOTIATING TERM SHEETS
    Negotiating Term Sheets
  37. Our Term Sheet Courses
  38. Quiz 4
    1 Quiz
  39. Portfolio Monitoring Survey
  40. PORTFOLIO MONITORING
    Adding Value
  41. What Kind of Value Do VCs Add?
  42. What Is The Background Of Top VCs WorldWide?
  43. Jack Welch's HR Practices
  44. The Reporting Pack
  45. How Much Time Should You Spend With Portfolio Companies?
  46. Quiz 5
    1 Quiz
  47. How Much Do You Know About Exits?
  48. LIQUIDATING INVESTMENTS
    Selling Startups
  49. Testing Founders' Exit Strategy
  50. The Most Common Exit For Startups
  51. Taking Money Off The Table
  52. About Startup IPOs
  53. How Long Does It Take to Exit?
  54. When Raising Too Much Money Makes Exits Difficult
  55. Helping Founders Exit: The M&A Cheat Sheet
  56. Quiz 6
  57. How Much Do You Know About VC Funds?
  58. RAISING VC FUNDS
    Raising VC Funds
  59. Investment Strategy: Which Round To Target?
  60. When VCs Pitch Investors
  61. How Do VCs Make Money?
  62. Case Study: Acrobator Ventures

Participants 401

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What Do VCs Do? More On Due Diligence
Unit 29 of 62
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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.

👀 Sources & Additional Material

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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.

  • I wonder whether different VCs have different DD ‘strategies’ and, if so, how it impacts their investments and returns. Has there been any analysis for VCs on how DD impacts investment returns?

  • One aspect of due diligence that is often neglected and (at least to what I’ve heard) has not fully arrived in the VC world yet is ESG due diligence. In an article called “Venture capital investors must take ESG due diligence seriously – our new DDQ can help” by the UN Principles for Responsible Investment Blog, the issue is raised the ESG is rarely included in DD processes, which is especially crucial, because a lot of the most socially and environmentally impactful companies in the next few years will be VC-backed. To help with this, they have developed a DD questionnaire which is heavily focused on ESG topics and includes a detailed list of questions to investigate the startup on. I thought that this might be very helpful for everybody starting out in the VC space because resouces like this will be of great value for the future.

  • Dear All,

    I have found a very interesting article that examines the benefits of due diligence in VCs. It shows that informal meeting with the portfolio companies have no value add, but that the formal DD process adds value. It seems that the DD adds value not only for the company being the DD target but also for the other companies the VC has not invested, showing some positive externalities VCs have on the start-ups and innovation in general.

    More to be seen here: https://juanitagonzalez-uribe.net/wp-content/uploads/2021/11/DueDiligence_share_18112021.pdf

    However, the public opinion, or more precisely the view of those working in finance sector but not in VC seems to be that the VCs are not doing enough of the DD. This could be summarized by the following twitter ‘comical’ post: https://twitter.com/Cokedupoptions/status/1640035243993321473?s=20

    So the question is, can VCs do more to speed up the innovation, or more broadly, the economic growth?

    Anyone has ideas?

    Pavle

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