What is angel/VC do diligence!? It’s not magic…
It’s about asking a lot of questions to get a better understanding and create clarity.
For some reason, we call it “due” diligence when it should be “do” diligence… get the point?
This article below and the potential subsequent regulation/frameworks that might come from it is a BIG potential problem! I’ll write another post on this eventually.
First things first while this was always a concern, this wasn’t a BIG issue until crypto came along with their pump and dump rug pulls that financially affected consumers/retail etc. So I do blame most of this unwanted attention on that but not all because as an investor we never truly 100% know what we’re investing in and a lot of it has a leap of faith that the founders are 100% truthful as well.
99% of startups don't work out (create venture scale liquidity), so investors can't be to blame entirely for that, though sometimes it’s our fault for other reasons (growth, unrealistic expectations etc). Startups are super risky alternative assets.
As you can see starting in Q3 2020 and exploding in Q1 2021 things started to get really crazy… not meeting face-to-face (Covid), among other things definitely decreased the ability to do some do diligence but doesn’t negate the fact that proper research was done before investing. So when investing pace increases and diligence decreases, we’ll see a lot more companies than usual go out of business, some more spectacularly than usual.
So what is do diligence?
At pre/seed where I play, I recently came across a really good diagram of most things we consider when we meet a startup/team we’re interested in.
When an investor says “we invest in teams” what does that mean?
- Are you an expert? How many years have you been doing this
- What is your unfair advantage? What can you do that few others can
- Who do you know? Networks help
- Why can you execute this better? Can you actually get stuff done
- Can you raise capital? Part of the job
- Can you hire? Need someone to do the work
- Can you sell? Founder-led sales is key early on
What is a market or TAM?
- Is the market bigger than $1B? We need $1B+ exits so if that’s not possible, we wont invest
- If it is >$1B+, how fast is it growing? Can it have a winner take all or just lots of small/medium competitors?
- Hopefully some public comps so you can understand their margins. Basically, is this a good industry and is there money to be made?
- Who are your clients/customers? Big enterprises with long contract cycles or long-tail small purchases
What metrics do you need to raise? I invest 50/50 pre-product/rev so it’s more about what metrics you need to raise your next round…
- Are you one-time (DTC) sales or recurring (software)? Lately recurring is king
- Can you grow 50–100% year over year? Taking VC capital has high expectations
- Do/will you have healthy margins? Need a buffer so you can spend on hiring, marketing, ads etc
- How capex is the business? Software > hardware etc but they both have their upsides/downsides.
Technology assuming you’re a software company / DTC CPG is a logistics business so what’s your tech stack
- Is your MVP good enough / have you spoken to customers? What do you need to show/ask people to pay
- How well built is it? Can it scale and how much tech debt do you have
- Is it easily replicable or suck less than the competition?
Deal terms
- Is your valuation reasonable based on what you have? We need 100x but want to know how at worst it will be 10–20x
- Cap table / ESOP? Who owns what % of the company and will you properly incentivize employees
- Who has already invested? Are they strategic or just capital
This might seem overwhelming and it is but you dont need to check off all these boxes or have answers to most. Being a founder is very difficult and just because you start a company also doesn’t mean you have to raise VC money. You can grow a business organically, on your terms at your pace. Please don't always feel the pressure to “have to” raise money just because you started a company — it changes expectations significantly and you’re no longer your own boss really…
