What's the Deal with Due Diligence?

The dealio with due dily

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And now on to this week’s post…

What’s the deal with due diligence?

Every week, I receive dozens of question in my annoyingly large number of mailboxes. Inevitably, a few focus on some aspect of investor diligence / due diligence.

Here’s what I’ve seen.

Founders I interact with (especially earlier-stage) often have a high-level understanding of what diligence entails, but don’t REALLY understand what it is, why investors are doing it, and what they're looking for.

Many founders just go through the motions. They blindly Google “what to include in a data room” and try to check off the boxes like “include your financial model” and “provide at least 5 references” without grasping the fundamentals behind these guidelines.

The reality is that diligence varies for every deal and company. No two companies are the same. Each unique opportunity demands different checks to perform and each investor has their own “list” of company information/data they prioritize.

The Core of Diligence

Due diligence is, in essence, an extra effort to validate certain elements:

Validating the Founder's Narrative: At its most basic, investor diligence is about holding the founder accountable for the claims they made in the pitch. The investor wants to see, "What backs that story up?" and "Are these statements accurate?" Investors will want to take a step back to look past the spin and the storytelling to gain a deeper comprehension of the business, verifying any information the founder shared.

Validating the Investor's Gut Feeling: A big part of diligence is confirming the investor’s gut reaction, which is influenced by past experiences and the pattern-matching they’ve developed over their careers. When they first hear the story or read the deck, they’ll have their own impressions- and the best investors have the self-awareness to check these, especially the overly positive impressions, to ensure they aren’t jumping into a deal haphazardly.

Part of this is double-checking the reference/introduction of how the deal came in. VCs often rely on warm intros as a screening mechanism and when a deal is introduced by a trusted & vetted deal source, it’ll often come with a positive gut feeling already attached. Diligence is all about giving another layer to make sure that there is something more beyond the initial impression.

Uncovering Red Flags or Deception ??: Investors actively look for red flags or signs of deception that indicate potential problems in the future. Each investor has their own set of rules and criteria based on their moral code or past experiences.

For example, they might have scar tissue from previous deals:

• “We did a deal with co-founders who were dating before, and it blew up spectacularly. We will never do that again. So if we find out the co-founders are romantic partners, then we're going to skip that.”
• "We‘ve had a hard time with any founders that come from [INSERT COUNTRY]. It's not universal, but it's just our experience, so we're going to avoid any deals like that” (this sucks and no one will admit to this, but it happens nonetheless).

The same goes for founders with a criminal history or bad press - diligence helps investors feel they are safeguarding against potential pitfalls and ill-informed decisions they’ll have to defend afterwards.

Intricacies of the Diligence Process

Diving deeper into the due diligence process reveals more layers that founders need to understand:

Verifying Claims and References

Founders make various claims about their products, customers, and market opportunities. Diligence involves scrutinizing these claims to ensure their validity.

If a founder of an alternative-to-sugar product claims that "We will find out In the next couple of years that sugar is the most dangerous substance that humans consume," they will probably have references to academic studies to support this and other claims in their deck. But that's something that investors will seek more perspective on. Can you reach out to other experts in the field to confirm the claims?

If someone says "We are growing at 30% month-over-month," a quick diligence check would be to say, "Can you show me the data that supports that?"

Investors do these checks for a couple of reasons. One, it could be a complete lie. Two, It could be 30% month-over-month where six months prior it was tanking. And so they weren't lying, but they were telling a misleading story.

Probing Subjective Claims

Subjective claims are both more important to diligence and more difficult to do. A founder could claim "We have an amazing team. People love following us. Our recruiting funnel is super deep with tons of talent." But how does an investor know that’s true?

Here’s where reference checks on past working experiences or people they worked with help. These give a better indication of whether or not this is a beloved leader, someone that people would follow to the end of the Earth, and you're not going to know that for sure without doing diligence.

The Psychology of Due Diligence

When we double click on why people are doing diligence, this is where some of the important psychology and understanding of what's going on behind the scenes is crucial.

Gaining conviction

The first layer is diligence as a part of an internal (or personal if its a solo investor) process to gain conviction.

Getting a term sheet is is all about moving investors to the level of conviction where they are pumped to do the deal. To put this in terms that I’ve used before, they need to be committed to jump out of the plane with the founder.

What actually moves the needle to get someone to jump varies. Solo investors, especially new solo GPs who don't have a ton of experience, usually will have a very informal approach to gaining conviction. As you get more experience and as the size of the firms grows, there's more process and more is needed to get a firm to say, “We’re doing this deal.”

Influencing internal politics

At larger firms, internal politics play a large role in how diligence is conducted. It’s less about conviction and more about proving you’ve done the work and/or that there is good reason to believe the conviction that you've built.

It’s the difference between:

“You know, I just feel good about this one.”

and

"I feel really good about this one. After my first meeting, I talked to these five enterprise customers, I did a reference call with this industry expert, three of my trusted friends have vouched for this founder."?

Each of those individual things might not not have actually been the factors that led to conviction, but it was necessary to play the politics game within the firm so that everyone could sign off on the deal and feel good about it.

Managing LP expectations

The third layer of diligence is communication with Limited Partners (LPs) aka “CYA” or "cover your ass."

Guess what? Venture capitalists have bosses. They’re the people that put money into their funds to invest. Just like other relationships with bosses…sometimes you do things to keep them happy. Same thing goes for VCs. When they do deals, they generally have to do some reporting to the investors to demonstrate why they did the deal.

That level of diligence and reporting, in my experience, is less about convincing LPs that they should do the deal. In most cases, well-run firms don't have to get LPs to sign off on every deal. It's more about being able to CYA afterwards if the deal blows up and goes to zero right away.

If an investment turns into a bagel (a zero… ??), LPs may want to do a post-mortem analysis. They’ll ask, "Why the hell did you invest in this company??It failed spectacularly, what’s up with your judgment?"

In this scenario, the investor needs to be able to go back to a memo that says, “Here's the diligence we did. This is what we checked into. This is where we thought it was going.” Having a solid reasoning serves as a CYA in those downside scenarios.

Woof. That was a lot on diligence! but wait…

…there’s more ???

Next week, I’ll give you a more tangible example.

I’ll break done how I did diligence for a recent deal and tactical advice for founders managing the diligence process. Stay tuned!

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