Venture due diligence for family offices: Balancing thorough analysis with gut feel
‘Gut feel’ is a big part of venture investment, but that doesn’t preclude the need for thorough due diligence to assess the business fundamentals. Doing so is even more important in the current climate and particularly for those with less experience in the VC space.
For family offices investing in venture, it’s time to hold your nerve. The current reset of the global economy is bringing increasing and greater risks to the surface, as the cost of capital increases and consumer confidence takes a hit. But, even with these macro worries, there are still vintage venture deals to be had.
Despite plenty of dry powder available for venture, much of it is sitting on the sidelines as investors are distracted with issues in their existing portfolios, as well as macro headwinds. That means potentially less competition for new deals, along with more time to spend doing deeper due diligence on potential investments. Consequently, we are seeing a renewed focus on ensuring the business fundamentals are in place before deploying cash.
I always talk about the importance of gut feel in VC deals, but that doesn’t preclude the need to thoroughly assess and analyse the team, market, product, business model and KPIs – to identify any red flags while gaining conviction, comfort and understanding the prospects of the company. This is even more important for family offices, who typically may not have the experience picking deals that dedicated VC firms have.
Due diligence in venture
When it comes to due diligence, VC is a different beast from investing in the public markets or in larger more established firms via private equity. As startups are so early in their growth, while also operating in cutting-edge technologies and business models, investors don’t have the same level of information to work with regarding trading history, market opportunity, or potential risks. So, it demands a different approach.
When assessing a startup, you are heavily reliant on how well founders communicate and the extent of the information that they provide. Entrepreneurs vary widely in their ability to explain what problem they are looking to solve, how they are solving it, their plans to scale, potential hurdles, and the size of the prize. Investors, therefore, need to be skilled at asking the right questions and getting hold of the right information from within the business.
Most startups will have a data room prepared for due diligence where they will store all the relevant information. This is unlikely to be on the same scale as a data room you would find in a private equity transaction, and the resources provided will vary hugely from one deal to another. However, it will certainly give you an idea of how a startup is thinking about governance, how structured they are, and whether their paperwork is in order. It should also help you to identify additional questions around topics and areas not fully considered.
It starts and ends with the team
When investing in early-stage businesses, due diligence should always start and end with assessing the founding team. Startups all grow and evolve differently, but the ones that turn out the best are typically those with the best individuals at the helm. Thus, people are key, more than in any other asset class, and as venture capitalists, we need to select best-in-class entrepreneurs.
Building a category-leading business is a gruelling task, demanding a team with the combination of skills and attributes to cope with the many ups and downs they will face on the journey. Look at their track record: for example, have they built a successful business before? Do they have a particular domain/industry knowledge? If they are a second-time founder then this is usually preferable, as it shows they know what they’re in for, plus experience can bring improved judgement.
Our research into what makes a great founder revealed seven characteristics that successful entrepreneurs tend to share: resilience, motivation and persuasiveness, vision and humility, curiosity, and the ability to manage stakeholders honestly. Naturally finding one person with all those traits is virtually impossible, which means that having two or more founders is usually better, with a balance of the seven key characteristics across the team.
At a more personal level, you also need to check whether there is a chemistry fit. Can you work effectively with these people for the next five or more years?
Assessing the founding team comes through firstly, spending plenty of time with them, and secondly doing peer referencing, through speaking to those who have worked with them. You need to get an idea of how well they cope with adversity, and how they interact with those around them. Are they forthcoming with information, and open about challenges and problems within the business?
There are also some useful tests that can help get the core of somebody’s character. One is asking how much they are paying themselves, i.e., are they in it for the money, or something deeper? Looking at who they hire can give you a good insight into their humility and maturity, i.e., do they hire people that threaten them? Finally, try to meet their partner and family outside work, to get a true insight into what makes them tick.
Digging into the business
While the team is critical, it is equally important to dig into the premise of the business idea, so you’re not taking founders at face value. You only need to look at cases such as Theranos, and more recently FTX or Frank, to realise that founders can be “economical” with the truth, and investors can fail to question basic assumptions when faced with a charming, persuasive individual. Getting caught up in startup hype or FOMO (fear of missing out) is the enemy of good due diligence, as it causes important checks and balances to be bypassed.
To review a company successfully, you need to become knowledgeable about the sector in a short space of time – unless you are already. That involves extensive research and speaking to as many subject matter experts as possible, including product people, analysts, corporates, and competitors, about the various facets of what will determine the success of a company.
If you’ve done your internal research, then you should know the market opportunity and start to see if there is a product that consumers or corporates would like to buy. Critical to this is timing; understanding whether there is a market here and now, or if it is a maturing market that is waiting for the demand. It comes down to being tapped into technology trends and development, so you have an instinct for when something is about to take off. A lot of it also comes down to luck. One example is autonomous cars. They’ll be on the roads one day, but when?
Understanding the competition is another key part of the picture. If the market opportunity is huge, there will be other players attracted to it. And if not, why not? Founders themselves should have a good understanding of the competitive landscape, and why some companies have been successful and some not. If it is already a crowded marketplace, then what is the ‘secret sauce’ that this team brings to the table?
Product due diligence
Get to know the product and assess whether it works for the target market. Is there a product-market fit? Does the product match the maturity of the market, or is it too complicated? And does the team have what it takes to execute the product vision? An important part of the product-market fit is the ability to expand a business beyond the initial “test” customers and create a fast-scaling business through efficient go-to-market and scaling.
Business model viability
Look at the revenue, cost structures and go-to-market strategy. What do the key metrics look like, such as lifetime value (LTV) and customer acquisition cost (CAC)? In the absence of extensive trading figures, how the other metrics are growing is a good indication of whether the model has potential.
Financial due diligence
What are the unit economics and P&L like? Look at the status of the balance sheet, including potential debt. Are the founders realistic and responsible with their outgoings? How have they used previous funds and how much have they achieved with historic funding? What about future budgets and spending plans – are they realistic?
Legal due diligence
Finally, does the company have all the statutory documents in place, such as a memorandum of association, articles of association etc? This is an area that can often get overlooked, potentially causing huge issues down the line. So, ensure that founders really do have any required licenses, are compliant with relevant regulations, and have the correct IP documentation in place. Review the minutes from past board meetings and ensure that there aren’t any red flags in their employment and supplier contracts. Shareholders’ investor agreements should be in place for current backers.
Due diligence in venture requires a different approach. As startups are so early in their growth, investors don’t have the same level of information to work with regarding trading history, market opportunity, or potential risks.
An ongoing process
While certain elements of venture due diligence are more structured and formal, in reality, it should be seen as an ongoing process. As a long-term venture investor, you build up long-standing relationships with innovative companies and start dialogues with them very early in their lifecycle. All this groundwork should be considered a part of the due diligence process and can help you to move more quickly once the time is right. Similarly, this allows any issues or stumbling blocks to be brought up continuously with the company throughout the process.
Managing due diligence for family offices
Carrying out effective due diligence in VC takes time, experience, and an understanding of what makes venture different. For family offices with limited resources spread across multiple asset classes, it can be particularly challenging to get right, and the consequences can follow a company, or portfolio, throughout its lifecycle.
Family offices can do it themselves but need to be prepared to build a dedicated team, along with the processes, consistency, and brand to succeed long-term. For that reason, working with a specialist VC firm, or implementing a hybrid model, is often a good solution, giving family offices access to a team of experts whose full-time job it is to assess potential deals – and deliver outsized returns.