A few years ago, VCs were expected to perform extensive due diligence on startups. Investors dove into financials, called customers and vetted founders.
But power has now shifted toward the founders after a long run of investors holding more than half the power thanks to the commoditization of capital. The pace at which deals were done increased, and the time to reach what VCs love to call “conviction” fell sharply. This compressed diligence cycles, leading to less intrusive vetting.
The acceleration of venture capital and the burgeoning check sizes in the last few years has led to a decline in traditional due diligence. The full impact of private-market investors doing less preparatory diligence than in previous years and cycles will not become clear for some time.
But, in the meantime, we can see a few clear ripple effects: Inflating valuations can lead to unnecessary pressure, making startups rush product development and hiring, and faster checks can lead to an over-reliance on existing networks, exacerbating an already brutal gender fundraising gap. Throw in the concept of Tiger Global bringing pre-diligence to deal making, and preemption is becoming the norm, with venture players rapidly changing how they make decisions.
TechCrunch’s Alex Wilhelm, Natasha Mascarenhas and Mary Ann Azevedo, the trio behind the Equity podcast, dive into what’s in store for startup due diligence.
Natasha: Friendliness will continue, so long live the back channel
Back channeling has long existed in tech and all industries as a way for two parties to exchange information about a third in an informal, and hopefully illustrative way. In venture investing, back channeling can be used by an investor to gut check an entrepreneur they’re about to wire millions of dollars to — or vice versa, by the snappy founder who wants to make sure the money behind their money is stable. The process also helps stop predatory investors from winning deals, because, well, founders talk.
The venture market doesn’t appear to be slowing down, so I expect next year will bring an even greater focus on back channeling in the world of first-check fundraising. The broader argument behind the growing importance of back channeling is that the only way to keep up with fast checks is to offer more channels for gut checking.
Before, due diligence looked like a months-long process with back-to-back in-person meetings. But as founder friendliness becomes the norm, it’s more important than ever for entrepreneurs to assess the check writer, understand their options and have better navigation in this capital-rich environment.
Founders will need to build alliances with investors, customers and even other founders so they can help each other when it comes to fundraising. This may help getting an outside investor to write a check, but more interestingly, it may help entrepreneurs simply build better and learn how to ignore a lofty valuation from a well-vetted partner. In the background, investors have to get comfortable with the idea that a founder may have already pinged a portco before they pitch you — it’s one to two minutes of work that can save time, resources and a doomed relationship.
Digging behind the scenes is somewhat contrary to what investors and founders will spew when announcing a new fundraising round. What they don’t include in the press release is that the entrepreneur actually asked their lead investor’s portfolio companies about partner performance and precedent. Even if the wire took days to write, those relationships aren’t a magical fit, and often require at least a few folks to verbally de-risk the risk.
My worry here is that back channeling’s growing efficiency is yet another way for historically overlooked individuals to be left out of “warm introduction” conversations. If I had it my way, back channeling would be less about “who you know” and closer to “do you leave a lasting, authentic impression” on people who meet you, use your product or have worked with you even in passing.
One app, Backchannel, could level the playing field a little: It works as an anonymous, private subreddit for founders to talk to each other about investors. While imperfect (and still invite only), it doesn’t require a first-time founder to have connections to understand an investor’s reputation. Other platforms like Landscape and VC Guide offer fund reviews, as well as net promoter scores for individual investors. These services have launched and sputtered in the past, but I think that they’ll be freshly relevant if anonymity and moderation is mastered.
Alex: A diligence differential based on fund size
My take here is only medium warm, but hear me out. I think that the diligence issue is going to sort out based on fund size, or more loosely, on firm AUM.
Why? Because the larger the fund, the more the capital to be deployed. Given that most funds are still operating with a closed-end fund model, timelines aren’t going to change much. More money and the same time to spend it seems like a recipe for haste, and haste doesn’t diligence make.
Some of the inherent pressure between rising fund sizes and status investing timeframes are solved by larger rounds. They allow firms to disburse capital in large chunks, helping them work through capital calls and their fund so that they can raise another, larger funding pool.
But I don’t think that larger rounds are going to solve the “what to do with this pile of money” issue. More simply, if Norwest is going to deploy $3 billion in its new fund, I don’t think that it’s going to be able to run a 2012-style process and get all the money to work. It’s going to have to push to get those funds to work given how competitive the market is for hot — read: attractive — deals.
It seems there are more dollars than deals out there for megafunds. This leads to younger, less-mature startups reaching unicorn status. These paper-only unicorns are not valued on earned merit per se, but essentially as financial options. Big funds can write checks that smaller funds can’t, but doing so requires higher valuations to make the math work. So, big funds are minting younger unicorns simply to buy access to later rounds should that company find product-market fit.
Big funds pay for that access, however, in the form of risk. My hunch is that big funds won’t put the same diligence oomph into smaller checks as they do for larger checks. So the big fund/small fund dynamic relates directly to diligence.
Small funds are not in the same jam. Sure, smaller funds may seem like the proverbial horse-and-buggy in the Tiger era of high-speed capital trains, but if a firm stays small, it can afford to be choosy and slower and still get its capital deployed, even if a slower cadence means that some deals will be missed.
In a sense, smaller funds with high hit rates could effectively become the venture capitalists for larger funds that are more like PE asset allocators anyway. Investing in late-stage SaaS is about as hard as training a child to beg for ice cream. You’re rolling downhill.
This is a bit messy, but I don’t think it’s a mistake that Tiger is changing the diligence game, while your local seed investor still makes bets on people. The latter takes time. The former you can just farm out to McKinsey.
Mary Ann: The prerequisites for FOMO must change
Founders need to take their heads out of the clouds a bit and pay attention to what the investors can bring to the table. In some cases, that value can come more in the form of solid mentorship, firsthand operator experience, industry knowledge or insightful advice, and can be even more important than the dollars that comes along with it.
I also think investors should also not rush to back just big names and ideas (ahem, Quibi) and also focus on, say, previous experience in a role at another company where an employee-turned-founder did some seriously game-changing, kick-ass things.
These are folks who have proven they can build awesome stuff and make it work. Sure, serial entrepreneurs are comforting because they’ve been there, done that. But just because someone did something great at one company doesn’t guarantee success at another. There are so many wonderful founders from all sorts of backgrounds with fabulous ideas. They may not have the traction (yet), but everyone has to start somewhere. Investors need to be more open-minded and talk to their employees, customers, former bosses and co-workers, heck, even their professors — potential sometimes can be more lucrative than a so-called sure thing.
We’ve talked a bit on Equity about how the time between funding rounds is shrinking more than ever. We used to see rounds for a given startup come 18 months or two years apart, and it’s becoming increasingly common to see them close within mere months of each other.
This can mean one thing when it comes to due diligence: There has to be less of it going on, especially in hot spaces like fintech and crypto, where investors are clamoring to get a hand in the next great thing. FOMO most certainly must drive a lot of term sheets, and while that may not change, investors may evolve on what they’re so worried about missing out on.
Comment