How Do VCs Conduct Due Diligence: "How Big is the Market!"
Demystifying VC Series - Part 2 (December 2020)
This is part 2 of our ongoing Venture Mini-MBA (aka Demystifying VC) series. In part 1, we talked about deal sourcing for VC funds. Now we have some quality deals as investment candidates. What’s next? How do we make investment decisions through the so-called “Due Diligence” process? In this post, we will cover this very topic.
First, let me just say that the term “Due Diligence” often implies that there is a rigid question list [1], to which a VC will need to get very concrete answers and plans, before making an investment decision. While there is truth in that, in reality, an early-stage VC tends to pay more attention to the unknowns: the unknowns of market growth rate, the unpredictability of go-to-market strategy, and even the uncertainties of the product-market-fit.
A good VC understands that plans almost always change but what doesn’t change is the founders’ ability to learn and evolve quickly.
Unlike later stage investors / PE firms who simply hand out a binder of question list for the company to fill out, a VC usually conducts her diligence through a series of formal or informal conversations.
Sequoia Capital’s founder Don Valentine described the process as “stringing the questions” [2] for entrepreneurs as a way to better understand their unique insights to the market (or the lack of).
So how do VCs “string” those questions for the diligence process? We will break it down into a few components: 1) Market; 2) Team; 3) Product / Tech; 4) Company Financials.
Market
Venture-backable companies live and die with market sizes. It is the fundamental for building a billion-dollar tech company.
During this part of the diligence process, VCs gain the conviction through the following: a) education by the entrepreneur; b) internal research on the competitive landscape; c) reference calls by talking to existing / future buyers on the market.
a) Education by the entrepreneur:
Typically, a VC has a broad sense of knowledge on a certain market - say healthcare, payment, enterprise SaaS, etc - but a good entrepreneur is expected to have a more granular sense of the market dynamics. And that’s what VCs are looking for when they interact with founders.
Investors will try to ask probing questions such as “how big do you think the market is?” or “why now?” or “what would Amazon / Google/ Microsoft think of you?” - the questions will certainly be varied based on cases but the goal is to obtain a clear conviction that the market is huge, if not soon-to-be huge.
A lot of times, it’s not that clear - especially for the B2C type or business-model-innovation type of companies.
Take Airbnb for example, there are much talked-about stories on how many early investors missed out on the seed round of Airbnb when it was at $1.5M valuation, simply because they don’t get it.
Make no mistake, it was hard to “get it”. And Airbnb could have easily failed.
But it didn’t.
The founders’ very own personal experience transcended into a billion-dollar category. And Airbnb now stands as a Pre-IPO company (note: when I drafted this article two months ago, the company’s last round was $18B, now it’s ABNB with $89B market cap!).
Similar early stories with Snapchat, with PingDuoDuo, even with Bytedance. Entrepreneurs who start companies out of their own life story/frustration carry a special weight in how they see the world evolves.
The moral of the story for VCs is that when founders talk, listen. And listen hard.
Sometimes, it’s a bit more clear - especially for B2B companies where the industry value stack and the ROI position are more well defined. For example, as the internet and work-computers became mainstream in the 1990s, the need for enterprises to digitalize and manage their CRM seemed obvious - which called for the emergence of Siebel System.
Then in the early 2000s comes Salesforce as the CRM disruptor, as the enterprise applications shift from on-premise to Cloud. Since then, we have seen a wide proliferation of SaaS companies that are empowered by massive cloud infrastructure providers like AWS.
Going forward, the next market trend for B2B companies lies in the Intelligent Automation that’s powered by AI (we have discussed some of the reasons in the previous essay). While investors can see the general trend direction clearly, we can not (and maybe *should* not) see what the next-to-be unicorns will look like in this AI transformation trend - i.e. what would the next AI-first Salesforce, AI-first Oracle, and AI-first Adobe, look like; and how would they create more profound values than the existing incumbents? Those are the questions an investor like myself would be very interested in.
When we talk about a visionary founder, investors certainly expect a crystal-clear articulation of how she sees the market.
b) internal deep-dive research on the competitive landscape
Early on in the venture business, pioneer firms like Sequoia, KPCB and Walden can “afford” to be more horizontal and maybe even more reactive to deal flows. Part of the reason is that the VC industry was a new thing (so were high tech companies in the 1970s) and there were simply more deals than capital [3].
However, as the venture ecosystem matures, the passive approach no longer works. Thus, we are seeing more venture funds becoming more thematic, even more vertically focused (i.e. Enterprise fund, AI fund, Bio Fund, Crypto fund, etc.). Externally, by sharing the insights and even by building a vertical brand around the firm, the vertical VCs can attract entrepreneurs who think on the same wavelength.
Internally, VC firms start to have more and more deep-dive sessions on certain vertical / topics. The goal is that VCs need to form a strong thesis on a given trend, to have their own point of view, so that when the right opportunity appears, they can jump on it!
Two of the more high-profile examples are Benchmark/UberCab and Sequoia/Youtube - in both cases, the investors have done the homework of market research and they have concluded that a) mobile will have a tremendous impact on the transportation industry, and b) in Youtube’s case, as the internet speed kept scaling upwards, the leader in UGC video platform will inevitable emergence. And Youtube’s superior, ultimately more efficient tech-algorithm stood itself apart from the rest.
In the investment business, a) the decision speed, b) the check size, and c) holding duration all speak volumes to the investors’ very own pursuit of value creation.
Venture capital, as one of the most illiquid assets, by definition, is a form of value investing.
By conducting internal research on the market size, VC firms get to exercise their independent (hopefully contrariant) thinking that will lead to a high-quality investment decision, which in turn will generate long-term value for the society.
c) reference calls by talking to existing / future buyers on the market.
The third angle VCs often use and request is to conduct reference calls with existing/potential users and buyers of the product. It’s important to acknowledge that VCs don’t have all the answers, no matter how experienced they appeared to be. Any investors who pretend to be able to see the future are often met with a painful punch by reality, sooner or later.
That’s why we “trust but verify.”
After the exercises of a) talking to the entrepreneur and b) have a point of view from internal research, it’s time to triangulate the information with the market - the real users/buyers who can benefit from the product that the startup is set out to provide.
Investors would hope to see or hear that the pain-point is so severe and so wide-spread that tons of value will be unleashed once the pain is alleviated. [4]
Specifically, here is a sample layout of the diligence list to “verify” some of the hypotheses through the customers’ POV.
Four direct customers reference calls, including 2 largest customers and your 2 oldest enterprise customers;
Reference calls for any key partnerships;
Customer Data: a) Rev by Customer; b) top 10 customers ACV, sales cycle, key winning value prop positioning; c) key engagement KPI; d) churn; 5) NPS score (if applicable).
Almost always, VCs - as a third party in the mix - can find surprising insights from these customers' calls - good or bad. For example, maybe the product is not as valuable as it claims, despite many impressive logos on the pitch deck; or maybe the pain point is so bad that most of the potential customers are already on the edge of the writing checks and the startup is under-charging them!
Goes without saying, the latter scenario is music to VCs’ ears.
Parting Words
A good investor is a journalist, a scientist, and a detective - in the research of truth and truth only. By conducting diligence as listed above, we are looking for the truth of “the market” - where it is at, how big it is / could be, and how fast it will evolve.
By triangulating from entrepreneurs, customers, and internal data points, a VC should be armed with information to make an initial investment decision. [5] But this is not all, there are other parts a VC needs to “investigate” in order to paint the complete picture as well.
We will talk about the diligence on team/product / financial at our next series.
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[1] Every investment firms have their very own checklist of diligence questions. VCs have their own version as well. YC has compiled a comprehensive list here https://www.ycombinator.com/library/3h-series-a-diligence-checklist. But the point is that VCs use the checklist as a reminder tool for truth-seeking, rather than the truth itself.
[2] I really like the term “string” as it implies that a good VC asks questions in a very thoughtful manner. The questions, like strings, are cautiously layout to optimize the quick measurement of the entrepreneurs/ startup’s potential. It’s an art.
[3] In the early life of KPCB, the firm had invested in a company that a tennis shoe resoling company as well as a company that turned motorcycles into snowmobiles! https://www.encyclopedia.com/books/politics-and-business-magazines/kleiner-perkins-caufield-byers
[4] A good VC usually treats the customer reference calls courteously, respecting the could-be-sensitive dynamics within a startup’s sale journey.
[5] Of course, completing the diligence process does not equal to 100% success. But it does help you eliminate the obvious risk downside (i.e. false market pull or even just to prevent outright fraud) while putting you at the best chance for upside.