VCs renew their focus on due diligence

Venture firms are re-examining their due diligence practices in the wake of the FTX collapse and financial misdeeds reported at several other VC-backed companies.

Their renewed focus on investigatory strategies comes as they face heightened risk of litigation. New SEC regulations set to go into effect in April would lower the liability standard in LP agreements from gross negligence to simple negligence. If enacted, the new rules would put VCs at greater risk of being sued by their LPs for failed investments, especially if the investors can show that the fund’s failure to fully vet a start-up caused it to miss signs of fraud or deception.

Venture Capital Journal spoke to more than a dozen industry experts about how VCs vet companies and what they are doing to protect themselves from another FTX.

Although diligence approaches for venture capital are often different from those applied to other asset classes. “That doesn’t absolve you from still rolling your sleeves up and doing the work to uncover problems,” says Steven Novakovic, managing director of the Chartered Alternative Investment Analyst Association. His organization teaches best practices that should be used in a VC firm’s due diligence process.

Due diligence strategies vary depending on a firm’s investment stage, but an overarching theme is independent verification. Relying on a management team to provide you details and taking them as fact is a dangerous game, even at the earliest stages, Novakovic says.

Beyond using third-party sources to confirm information, utilizing your network is the next best thing to consider when evaluating a company for investment. Novakovic warns of a common pitfall, however – making sure whoever you call can provide an unbiased opinion without reason to sway one way or another. As he puts it: “The best references are the off-list references.”

The amounts of time and effort VCs are willing to spend on diligence can vary according to geography even when the market isn’t in a frenzy. “There’s some happy medium. You can never diligence every single thing,” says Harley Miller, co-founder of early-stage VC Left Lane Capital. The aim should be to try “with 50 percent of time, effort and resources [to get] to 99 percent of the right answer.” The last 1 percent sometimes requires undue resources, time, distraction and friction.

“For better or for worse, a very common practice in venture capital is trusting another firm’s due diligence”

“For better or for worse, a very common practice
in venture capital is trusting another firm’s
due diligence”

Steven Novakovic  
Chartered Alternative Investment Analyst Association

Miller breaks down due diligence into three categories: background checks on founders and c-suite teams; financial and accounting, typically with the help of an audit firm; and business and commercial diligence, which dig into a company’s customer usage data.

A subset of background checks is back-channel references that focus more on assessing team members’ integrity and reputation, he says.

For financials, Left Lane usually works with one of the big four accounting firms on an estimated 95 percent of its deals. “If something is so early-stage and there’s just not a ton of revenue, then you’re probably more doing manual checks of their balance sheet, their books – spot-checking trial balances – and we can do that work on our own or together with our [financial planning and analysis] team,” he says.

In light of the recent governance scandals, VC managers are likely to start asking portfolio companies for audited financials somewhat earlier than previously, says Bill Cilluffo, a partner and head of early investments at QED Investors. “A company needs to be built out into enough of a sizable company that there’s something to audit.”

Typically, it’s between the Series A and Series B financing rounds when investors start asking for audited financials. “How much money somebody has raised is an important consideration,” Cilluffo notes. “If they’ve only raised half a million dollars, the idea of spending several hundred thousand dollars a year on an audit probably doesn’t make a whole lot of sense. But if they’ve raised $50 million, then it probably does.”

Another consideration is the type of business. For a “pure software business [that is] super simple, you may wait a little bit longer,” he says. “Businesses [focused on] lending and payments that have a lot of regulatory risk, a lot of cash moving in and out of the system – I can see wanting to do that somewhat sooner.”

For commercial diligence, Left Lane “pulls raw transaction data and usage data from a company. Every transaction with the customer ID, the purchase date, how much they spent. It’s all the event data in an app or a platform, when something was opened, what actions were taken,” Miller notes.

Even for earlier-stage companies, this often entails millions of rows of raw data, which can’t be analyzed with Microsoft Excel. “We use big data SQL platforms to help synthesize that. So, our entire investment team are like well-trained data analysts,” he adds.

Headline relies on analytical software it built in-house to scrutinize all potential deals. Partner Jett Fein says the firm asks start-ups for basic financials and raw payments and usage data from sources such as Stripe and Google Analytics. Those numbers are imported into Headline’s Deepdive software, which analyzes and visualizes the data in a matter of seconds.

Deepdive also uses forensic accounting to look for abnormal patterns in the raw data submitted by a company. That process has uncovered at least two cases of fraud at companies pitching an investment, Fein says.

Talking to customers

When investing in later-stage companies, some VCs make a point of communicating with the company’s customers, who can alert fund managers to potential problems down the road, including complications as they scale, possible competitors and customer retention metrics.

“We don’t do a lot of technical diligence, but we check out the customers,” says Mark Volchek, co-managing partner of Las Olas Venture Capital, which invests in seed-stage B2B software start-ups. “Because in the end, if customers love it, then it’s probably a good product.”

Las Olas involves some of its LPs in its diligence process if they are subject matter experts. Because many of its LPs are high-net-worth individuals who own their own businesses, “we can run things by them and ask if they’ve heard of a certain product,” says Volchek.

Beyond talking with current customers, VCs sometimes reach out to past prospective customers who decided against using a company’s product. Doing so can highlight possible market constraints an investor may not see.

“There’s some happy medium. You can never diligence every
single thing”

Harley Miller  
Left Lane Capital

“We ask a company for a list of customers, but also do our own homework later on about who could be a customer and a competitor, or people who might have been in contact with the company but decided not to buy the product,” says Sascha Berger, general partner at TVM Capital, a German firm that invests in life science companies. “This is an even more interesting set of people to talk to. It’s more challenging to get them. But we often are able to.”

Fein says Headline makes it a point to talk to customers about how they are using a company’s product. The firm also gets hands on. “We have a team of engineers, and so oftentimes we’ll ask our engineering team to try out a piece of software and weigh in on whether it’s an interesting product,” he says.

Issues of ownership

Given how many venture-backed ­start-ups differentiate themselves based on innovative products and services, analyzing intellectual property claims and the freedom to operate is often an essential part of VCs’ due diligence process. This is generally overseen by an attorney specializing in intellectual property. When Oliver Libby, a founding partner at deep tech-focused H/L Ventures, sees that a founder isn’t already working with a law firm, he finds one.

“We can’t move forward with an investment if we are not confident that there is either documentation of the intellectual property or that there’s a credible plan to do so,” says Libby.

When a VC foregoes due diligence because another, possibly larger, VC firm has already conducted its own process, it can lead to companies getting larger than they should before someone discovers a problem, says Novakovic at the Chartered Alternative Investment Analyst Association.

Analyst Curriculum

“For better or for worse, a very common practice in venture capital is trusting another firm’s due diligence,” he adds. “Say that Sequoia is invested in a company. Some firms take that as a stamp of approval and invest without doing their own due diligence. That’s obviously a huge problem and can lead to situations like we’ve seen with FTX.”

In fact, Shark Tank judge Kevin O’Leary told CNBC in December that he and other FTX investors “relied on each others’ due diligence” and “we all look like idiots.”

Sequoia held a conference call with LPs in November in which it apologized for the $150 million loss that resulted from its FTX investment and told investors it would improve its due diligence process on future deals, according to a Wall Street Journal report.

The storied venture firm appears to be following through on its promise. In January, Bloomberg reported that its Southeast Asia investment operation was in talks with Ernst & Young about doing “special audits of several investments in the region following allegations of financial irregularities at firms such as Zilingo and GoMechanic.”

Not addressing perceived due diligence failures risks more government scrutiny for venture capital firms. In a January speech at Wharton, Commodity Futures Trading Commission commissioner Christy Goldsmith Romero said FTX revealed a “a trust deficit with venture capital firms, pension funds and other large equity investors who owe fiduciary duties to their clients to conduct due diligence.”

She noted that “questions arise whether these investors turned a blind eye when conducting due diligence to facts that would normally serve as flashing red lights because of the promise of innovation, hype surrounding FTX, and what is now understood to be misplaced trust in FTX and its founder.”

Lawrence Aragon and Ryan Hibbison contributed to this story