Due diligence: Avoid pitfalls with proactive approach

During the bull market when venture deals reached fever pitch, leaving little time for careful vetting of investment opportunities, Thomvest Ventures doubled down on an approach to due diligence that it had been using for more than a decade.

The San Francisco firm’s strategy is proactive, based on identifying themes it has great conviction in that it believes will yield the highest returns. Teams of two within each of Thomvest’s investment segments spend three to four months on “research projects” twice a year.

After a month or so of “desk research” to form a hypothesis, the research teams spend two to three months talking to incumbents and others who know an industry – typically 25-30 people – to learn which areas are ripe for disruption. The aim is to eventually find the most promising start-ups developing products and services in line with that theme. “In a way, you do your diligence upfront,” says Thomvest’s managing director Don Butler.

The verticals that Thomvest has done deep dives for are fintech, proptech and cybersecurity/cloud infrastructure. Vertical teams sometimes need to pivot midway and adjust their hypotheses if they realize they’re asking outdated questions.

The firm’s framework is dubbed “right time/right place analysis,” based on lessons learned about when investments work best, Butler says. It starts with looking for metrics within a subsector such as how much cash the leading incumbents are generating or whether they are high gross-margin businesses with very low net promoter scores. “We want [a subsector] where there’s a lot of money to be made and hopefully incumbents are on an older vintage of technology [such as from 1990s] that is inefficient,” and where consumer sentiment has been fairly tepid, he adds.

Several years ago, Thomvest zeroed-­in on insurance tech where net promoter scores were depressed. It talked to providers to gauge how much time they had to devote to innovation.

“We want [a subsector] where there’s a lot of money to be made and hopefully incumbents are on an older vintage of technology that is inefficient”

Don Butler 
Thomvest

Butler asked the chief technology officer of a very large insurance carrier in the Bay Area whether his firm would adopt any of the new online features that promised to make financial services more convenient for consumers. The CTO said he was aware of them and recognized their importance to customers but that the carrier’s priority for the next three years was integrating three mainframe computer systems into a single system. That’s common when, after multiple acquisitions, a company’s back-end systems are amalgamations of assorted technologies.

A head-start

“If a lot of their IT spend is wrapped up in consolidation, that’s workable,” Butler says. “We can start a company and try to get to some scale before the incumbent gets to some of their other priorities” and has time to catch up.

Once a compelling subsector is identified, Thomvest team members evaluate which companies have the most breakout potential and could become leaders in the space. That entails meeting with founding teams and comparing companies at various stages of development that often have arrived at similar insights contemporaneously.

“The frameworks we would use for early-stage and late-stage companies differ,” Butler notes. “We have the same things we’re looking for, but the weighting shifts around. In the end, it’s which team do we want to back?”

Although Thomvest tries to hold its own teams across all verticals to a single standard as to what should come out of the research process, there can be variations in what they’re looking for.

“In cybersecurity and cloud infrastructure, oftentimes the key innovations are technological,” which puts more weight on the strength of the tech team, Butler says. For proptech, it’s more likely “a business model, or the key to innovation is something about the service or product that you’re proving and that could be part of the business model,” he notes.

Fintech is more in line with proptech, but Thomvest has chosen to back some fintech start-ups based on a key technological advantage that brings efficiencies to a financial process.

Thomvest’s due diligence approach has played an increasingly important role in the firm’s investment decisions. In 2021, nearly one third of the start-ups it considered seriously were identified through its thematic research by vertical approach, as opposed to a referral from another venture firm. But “85 percent of the ones that proceeded to the memo stage where we said we want to close an investment” were proactively sourced, says Butler. “The market really has shifted, because normally that would have been around 50 percent.”

While Thomvest has backed start-ups referred by other VCs that turned out to be great investments, when the companies are not in one of its verticals, “we probably don’t do it as much because we’re self-conscious about how little we know about that space,” Butler says.

Financial benchmarking

With deal volume hitting a high in 2021, ThomVest fortified its theme-based diligence in two ways.

First, it created some working groups comprised of executives in the industries it focuses on. One was for strategic information security officers, another was for chief information officers, and a third, led by Butler, was for chief risk officers.

Working group meetings, held every other month, proved to be safe spaces where 10-12 participants could freely discuss common problems their companies were facing, such as how to protect against fraud, and ask if anyone had found a vendor with a good solution. They would then invite certain vendors to give a brief presentation at upcoming meetings.

“That’s been super helpful to understand the problem but also to understand what solutions are out there today,” Butler notes. After vendor presentations, the working group reverts to a closed session where people give honest feedback about vendors they have used and which aspects of their services did and didn’t work.

Tying that into the team research efforts has provided a better grasp of the range of problems customers face and the leading vendors available, which provides “a good signal for us,” he says.

The second way Thomvest has fortified its theme-based DD was by adding Eddie Ackerman as a strategic finance operating partner last October. Ackerman, a former CFO, specializes in financial benchmarking, comparing companies that have reached some scale, typically in the Series B and later rounds, to others the firm has seen, as well as to incumbents that have gone public. (Ackerman rejoined Thomvest after leading finance and operations at venture-backed start-up Styra. He had previously served as head of financial analysis for ThomVest from 2019-­2021.)

For example, benchmarking will show what the financial profile and growth rate for subsequent years were for a public cybersecurity company like Cloudflare when it was a private company pulling in $10 million to $20 million in annual revenue. For a company Thomvest is considering, if “we find that not only on revenue growth but also efficiency metrics this is a top 25 [quartile] company, that’s further validation of the investment decision,” says Butler.

The financial analysis ensures that Thomvest doesn’t invest solely on the basis of its thematic due diligence. It wants to invest in the right start-up in the right subsegment but only at the right valuation.

In addition, having one person who owns the financial analysis role enables the firm to weigh identical multiples for a fintech company and a cybersecurity company against multiples in their respective publicly listed counterparts and decide which would be a better investment from a purely financial viewpoint.

“Having that degree of specialization has helped us get a sense of the tradeoffs between valuations across sectors,” says Butler.