Trust But Verify: The Essential Paradox of Startup Due Diligence

The phrase "trust but verify" has a fascinating history, even predating its use in the world of startup investment. It actually originated as a Russian proverb, "доверяй, но проверяй" (doveryay, no proveryay), which translates literally to "trust, but verify." This proverb, rhyming in its original form, emphasizes the importance of caution even in trusting relationships.

Fast forward centuries, and the phrase gained international recognition in the 1980s when President Ronald Reagan used it repeatedly during nuclear disarmament discussions with the Soviet Union. Reagan, who learned the proverb from scholar Suzanne Massie, emphasized the need for extensive verification procedures to ensure compliance with arms control treaties.

While the context has shifted from Cold War politics to the fast-paced world of startups, the core principle remains the same: trust is essential, but verification is necessary.

In the fast-paced world of startups, where passion and innovation reign supreme, due diligence can feel counterintuitive. We're encouraged to trust the fire in a founder's eyes, to believe in the world-changing potential of their idea. But as an investor, I've come to believe in a seemingly paradoxical principle: trust but verify.

This isn't about micromanaging brilliant minds. It's about building unshakeable trust, the kind that allows you to confidently back a company through thick and thin. Because let's face it, I won't invest in a founder I can't trust completely.

So, how does due diligence become the tool that verifies, rather than undermines, this trust?

Transparency is King

Great founders understand that true trust thrives on transparency. Due diligence isn't an interrogation; it's an open conversation. Financial records, market research, and even past failures should be readily shared. This willingness to be open fosters a deeper connection and allows you to assess the team's problem-solving abilities firsthand.

Beyond the Numbers

Numbers are important, but they only tell part of the story. Due diligence is about diving into the team's DNA. How do they handle challenges? What's their decision-making process? Do their values align with yours? Talking to past colleagues, customers, and even competitors can offer invaluable insights into a team's character and capabilities.

The Power of Asking Why

Don't settle for surface-level explanations. Ask why behind everything: Why this market? Why this approach? Why this team? The "why" reveals a founder's vision, their understanding of the problem they're solving, and their unwavering belief in their solution.

Scope of Due Diligence

• Verifying Revenue: While I trust founders to be sincere, my fiduciary responsibility as an investor demands verification, especially regarding revenue. This might involve requesting bank statements to examine the actual transactions. Here, meticulous record-keeping is crucial. We need to see these transactions matched with corresponding invoices and payment receipts issued. It's important to remember, in accounting, revenue is only considered earned after the value for which the payment is made is fulfilled. For instance, in a trading business, this would involve verifying payments made to suppliers and delivery agents for the goods or services sold.

Verifying revenue is just one piece of the puzzle. Here are some other areas where a thoughtful due diligence process can build trust:

• Market Validation: Is there a real need for the product or service? How big is the market opportunity? Don't just rely on the founder's enthusiasm. Look for independent market research reports, customer surveys, and competitor analysis to assess the validity of the market need. Analyze trends, demographics, and potential disruptions that could impact the market size.
• Competition: Who are the other players in the space? What are their strengths and weaknesses? Conduct a competitive landscape analysis to understand the existing solutions, their market share, pricing strategies, and any potential gaps the startup's offering can fill. Talk to industry experts and potential customers to gauge the competitive landscape.
• Product/Service: How well-developed is the product or service? Does it have a clear competitive advantage? Evaluate the product's functionality, user experience, and stage of development. Assess the technology stack and development roadmap. Ensure the product offers a clear value proposition and has a defensible edge over the competition.
• Intellectual Property: Does the startup have the necessary patents, trademarks, or copyrights to protect its intellectual property? Verify the existence and strength of any intellectual property rights. This protects the startup's innovation and prevents competitors from copying their ideas.
• Legal and Regulatory: Are there any legal or regulatory hurdles that could impact the business? Identify any potential legal or regulatory issues that could impede the startup's operations. This could include data privacy regulations, industry-specific licenses, or potential legal challenges from competitors.
• Team Expertise: Does the team have the necessary skills and experience to execute on the plan? Assess the founders' and team members' backgrounds, skills, and relevant experience. Look for a well-rounded team with expertise in areas critical to the startup's success, such as product development, marketing, and sales.
• Go-to-Market Strategy: How will the startup reach its target customers? Evaluate the startup's go-to-market strategy, including their pricing model, sales and marketing channels, and customer acquisition plan. Analyze the effectiveness of their chosen channels and the overall feasibility of reaching their target audience.

Building for the Long Haul

Due diligence isn't just about the initial investment. It's about building a foundation for a long-lasting partnership. By verifying trust, you're ensuring you're aligned with a team you can support through inevitable hurdles.

The Paradoxical Payoff

Yes, due diligence is a process of verification. But conducted thoughtfully, it strengthens trust, not hinders it. It allows you to back a founder you believe in, not just because of their idea, but because of the team they're building.

So, the next time you find yourself drawn to a passionate entrepreneur, remember: trust is essential, but verification is the key to unlocking its full potential.