Due Diligence Important . . . Even for Entrepreneurs
Venture capitalists are both hunters and gatherers. They seek out the best and the brightest among entrepreneurs and their ideas. Once they have an initial intuition that they have found a likely winner, they go into data gathering and analysis mode, which in the industry is known as due diligence. All professional VC investment firms perform due diligence to some extent.
Is Due Diligence Really That Important?
How critical is due diligence to the probability of investment success? Since most VC investments fail, might rigorous due diligence be just a waste of time? Are there too many variables and chance events, particularly in a seed- or early-stage investment, for diligence to tilt the chances of success one way or another?
. . . In our minds there is no question that due diligence definitely does matter—a lot. Those VC firms that year after year produce big returns do it at least in part because of superior due diligence. While they may also see better deals earlier and have the reputation to sign them up before others, it is their due diligence skill and discipline that enable them to recognize which ones are indeed better deals.
A Warning to Entrepreneurs: Beware of Limited Due Diligence
As an entrepreneur, you may wonder why we’re stressing the importance of due diligence here with you rather than emphasizing this point in the first half of this book, which was directed more to investors. The answer is because a VC’s commitment to solid due diligence should be important to the entrepreneur, too.
If you come across a firm that does very little due diligence, you should avoid working with them even if you’re an entrepreneur who really needs funding. Try selling others instead. Firms that do little due diligence will have little credibility among their peers, whom they may need as co-investors with them. They may in fact be driven largely by the management fees they charge their investors (regardless of results)—or the fees that some of the equity crowdfunders even charge the entrepreneur—rather than being focused on achieving exceptional gains for their investors and for the entrepreneur by helping to build major companies.
Without solid due diligence, the investor may not understand what the entrepreneur is trying to accomplish, may not be able to evaluate the venture team’s ability to execute, and may not know when and how to help the venture management team when the going gets tough, which it so often does.
Ken Freeman is the co-author of:
Building Wealth through Venture Capital: A Practical Guide for Investors and the Entrepreneurs They Fund