Venture capital (“VC”) is a game where the pool of potential opportunities to review is large, but only a select few result in an investment. According to a recent Harvard business review survey, for each deal that a VC eventually closes, that VC firm considers up to 101 opportunities. This means that the process behind sourcing deals into the funnel and screening deals against an investment mandate, needs to be designed for scale. Effective sourcing and screening will result in timeous due diligence only being conducted on opportunities that have a higher probability of receiving an investment.
Deal sourcing into the funnel:
The first step in reducing the potential opportunity pool is to attract high quality deal flow. Focusing on high quality deals, as a first port of call, reduces wasted time spent reviewing opportunities that would stand little chance of ever making it into a portfolio. The source of the deal can often correlate to the quality of the deal. Examples of higher quality leads, or so called “warm leads”, would be deals referred by another reputable VC firm looking for co-investment partners or perhaps a procured introduction to an entrepreneur of an exciting company in a fast growing sector. An example of a lower quality deal flow channel, or so called “cold leads”, would be an approach from unknown brokers who don’t have any skin in the game after the deal closes and are adopting a “spray and pray” approach.
Deal screening – determining alignment to mandate:
Once a pipeline of high-quality deals has been established, it is crucial to quickly assess a potential deal against a clearly defined investment mandate. In simple.Capital()’s case select criteria for investment would include a business that is early-stage, tech-enabled, with clear routes to market and founded by an entrepreneur with a proven track record and a missionary purpose. Where an opportunity is not aligned to mandate, this should be communicated with the founder and pens should be put down on the opportunity. If not currently aligned to mandate, however there is a possibility of meeting the mandate in the future then a relationship with the founder should be maintained and the company kept within the deal funnel.
Where the opportunity is aligned to mandate, an initial meeting with founder should be conducted to establish a relationship, learn more about problem that the business is solving for, assess the vision for the business as well as determine practical deal considerations such as timing, investment quantum, valuation and high-level deal terms.
Advancing an opportunity to due diligence (“DD”)
At the point that a deal seemingly ticks all the boxes, a formal vote should take place to advance the opportunity into full DD phase. The premise being that there is a high probability of investment, provided the DD doesn’t reveal any “deal breakers”.
Optimising the DD process:
DD is a unique process that needs to be tailored to every unique investment opportunity. If a surface level DD is performed there is a high chance of overlooking key risks and red flags that may come back to bite down the road. That is why it is critical to narrow down the number of opportunities on which a more timeous DD is conducted.
Although each DD is unique, a structured approach can optimize the process. A standard pre-populated DD checklist that covers the core areas of legal, addressable market, product, competition, team, strategy, operations and financial should be tailored for the particular investment and then sent to the founders.
Having the right team members and clearly defined roles within the due diligence team is paramount. A dedicated team member with the requisite skills set should be assigned to focus their attention on each core DD area. For example, a legally trained team member will be familiar with documentation such as SAFE note agreements, shareholder agreements, subscription agreements, employee contracts, company terms and conditions, etc. Their familiarity and training will allow them to review documentation efficiently and quickly identify onerous provisions or off-market terms that could impact your protection as an investor. Financially trained team members focus their attention on reviewing management accounts, understanding and stress testing the drivers behind the financial model and assessing unit economics, KPI’s and valuation metrics. Tech experts focus on the product and so on.
All the key findings from each core DD area should then be summarized in a standard template investment memorandum which is then presented to an investment committee of diversely experienced individuals for a final vote.
There are some basic tools that, while they may seem obvious, are important to get right to ensure a smooth DD process:
- Open and regular communication between DD team members and the founders
- A DD timeline should be set and adhered to
- A shared access data room should be setup by the investee company
- Shared access documents such as Google docs should be utilised
- Making use of financial model and valuation templates
- Deal pipeline tracking tools.
Limitations to DD scalability in early-stage companies:
Proper DD of early-stage private companies will unfortunately always include more of the “human element” and will be less automated than for public companies for some of the following reasons:
- The founders are paramount to the success of early stage ventures so time needs to be spent building founder relationships, conducting background reference checks and assessing a founder’s track record of scaling start-ups.
- Financial data is publicly available or readily available through data providers such as Bloomberg, Reuters, etc. Direct data feeds that pre-populate financial models simply don’t exist in the VC world.
- Analyst coverage reports and scraping of news articles and company new releases aren’t available.
- Valuation is an art rather than a science in the early days of a company’s lifecycle and relative valuation exercise vs peers is more opaque.
Whilst you can’t fully automate a DD process or take the “human out of the loop”, increased scalability can be achieved through designing a high-quality deal funnel, efficiently screening deals against mandate and utilising a basic toolkit for optimizing the DD process. This will focus time and effort towards higher probability investment opportunities and will increase DD turnaround times without compromising on quality.
Author: Blake Musgrove | Chief Investment Officer @ simple.Capital()