VC Cliche of the Week

Due Diligence.

I've used those words so often I can't even count. 

I've used them a bunch of times on this blog.

Due Diligence is the name of the excellent blog by venture capitalist, Tim Oren.

But what do these two words mean?

I think they come from contract law where one party was required (due) to avoid harming another (by being diligent).

I am sure there are lawyers out there who can provide a better and more accurate history of the term.

In the venture business, it means the process by which the VC learns all he or she needs to know about a potential investment.

But in practice the due diligence process varies so much from firm to firm and deal to deal that it is more art than science.

Every VC firm has a "diligence checklist" that lays out all the things they need to know before they can close on a deal.  But very few firms do diligence by checklist.  For the most part, diligence is about making phone calls and taking meetings with people who know the company, the people, the market, the technology, and yes all you entrepreneurs paranoid about collusion - competition.

In the public markets investors often do a fair amount of work on a potential investment before pulling the trigger and buying stock.  But if they are wrong about the market, the people, the technology, or if a new competitor pops up, they can always sell their stock and take a loss (or possibly a gain) and move on.

It doesn't work that way in the venture capital business. Once you jump off the cliff, you can't get back on it. 

I often make the comparison between due diligence and dating.  The analogy goes further as the signed term sheet phase is the engagement and the closing is the marriage.  Hopefully all goes well and the marriage doesn't end in divorce.

I am not joking about this.  A VC investment is not marriage, but it's damn close.  One thing I've noticed over the years is that the VC does a lot of due diligence on the entrepreneur and his company, but entrepreneurs often do not do enough due diligence on the VC and his firm.

You can never do enough due diligence.  You can and should call and visit every competitor and their VCs.  You can and should talk to everyone you possibly can about the entrepreneur and the senior management team.  You can and should get into the market and talk to customer and/or potential customers.

And once you close the investment and get married, you should continue your diligence and never stop until the investment is exited.

Due Diligence and venture capital go hand in hand.  In many ways they are two side of the same coin.

Comments

[Randy Zaia]

Maybe I'm missing something, but isn't broadcasting the fact that you regularly meet with companies for the sole purpose of gaining market intelligence about a space that you plan on making a competitive investment in going to reduce your ability to get those meetings in the future?

[D. C.]

1. The term due diligence is probably an offshoot of section 11(b)(3) of the Securities Act of 1933. Generally speaking, that section provides an exemption from liability for directors, experts, and underwriters of an issuer if there's a material misstatement or material omission in the registration statement. The exemption applies only if the person "had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact ...."

2. You might consider softening your specific statements about what one should do as part of due diligence, especially the one about visiting every competitor and their VCs. Your specific statements might be quoted against you some day -- or against one of your partners -- as allegedly defining the standard of care, possibly raising the bar higher than the law might otherwise do.

For example, you might try saying instead, "You can never do too much due diligence. You can and should try to call or visit as many competitors and their VCs as practicable. You can and should talk to everyone you reasonably can about the entrepreneur and the senior management team."

(All categorical statements are bad, including this one.)

[Dave Chase]

A framework put forth by an extremely successful entrepreneur and current professor at Stanford's Graduate School of Business can help make the due diligence process more science than art. Mark Leslie is a rare entrepreneur who sat in the CEO seat from $0 to over $1B in revenue during his time at Veritas. He's proffered a framework that has relevance to the often flawed or incomplete due diligence process. This article (http://www.imediaconnection.com/content/5791.asp) summarizes his Enterprise Sales Learning Curve (ESLC) framework that addresses the fact that most startups misallocate resources to their demise particularly in the sales & marketing arena. Altus Alliance developed a ESLC Assessment based on Leslie's framework that is starting to be used by VC's as part of the due diligence process.

When companies are pushing a product out of beta, it is not unusual for a startup to have a relatively poor handle on important questions like these:

* What is the true customer ROI?
* Does the company have a clear segmentation and customer-focus strategy?
* Has the sales model been clearly defined?

The assessment (aka due diligence) process gets a handle on these questions (and more) with an eye towards the company's product, sales and marketing readiness levels and the accompanying deficits that are often missed in a traditional due diligence process. Leslie's presentation, whitepaper and an overview of the assessment process are posted here -- http://altusalliance.com/ceoInfo.html.

[Charlie Crystle]

Fred, on another topic, you've inspired me to post about the venture process. Fred was straight up with us--doesn't like our space because of the customer mindset--I like that. Clear and to the point. I just read theVc.com again, and wow--things haven't changed since I left ChiliSoft 6 years ago.

On the VC blow-off: http://charliecrystle.blogspot.com/

comments invited.

[Gary]

I love the marriage analogy.

Isn't every good business partnership and relationship like that? Whether someone is doing distribution and channel deals, developing affiliate programs, finding technology partners... shouldn't all such business relationships be coveted and made to grow and prosper in the same ways?

While I don't think that all VCs have their act together, I also think that most are a lot better than most other businesses at assessing the quality and potential of their investments and partnerships.

Maybe Time-Warner and AOL would be a lot happier today if they read your blog before signing the deal.