Originally posted on November 23, 2022
I wrote about due diligencing ethics in my last post; I want to follow up and write about due diligence in general.
Typically, people think that due diligence involves getting answers to a checklist. This is a small (and easy) part of the due diligence. Going through a checklist is just the beginning of a due diligence process. The process itself has many steps to unpack, synthesize, diagnose from bits of information given to the investor. The ultimate goal of this process is for the investor to make a definitive decision to invest or walk way.
Answers to a due diligence checklist are not sufficient to cap off the due diligence process. These answers need to be carefully evaluated. These answers will often beget new questions, and investors have to decide which ones to follow up. This type of follow-up due diligence requires prior relevant operating and investing experience, and it is not taught in the text books.
Due diligence is a multi-faceted process that requires understanding of the market, business strategy, finance & accounting, law, governance, operations, technology and data, intellectual property & patents, human resources, cybersecurity, ethics, organizational design & culture, and communication. Legal and IP due diligence are important, and having effective law firms as partners is a must. For the other functional due diligence, the ideal case is for the investor on the case to have relevant experience to tease out potential areas of risks for deep dives.
Risks in some areas can be remediated. Risks in other areas should emerge as immediate red flags. For example, if the company has technical debt, that can often be fixed. If the company has an IP assignment matter, that typically raises more questions and needs scrutiny. If the company lacks governance, that could be a potentially red flag. If the CEO/founder is not open to building up governance according to market standards or doesn't think governance is important, that is a big red flag. In this case, I recommend (to lead investors) to walk away and stop wasting time.
Another area is ethics. This area is very hard to due diligence because if you ask ethics questions during due diligence, you will always receive the answers that you want to hear (the right text book answers). So in my experience, detecting ethical behaviors has to come from other type of behavioral questions and watch how those answers are delivered.
Different investors have different risk appetite but investors / VCs are paid by their LPs to do the right level of due diligence and research to find attractive opportunities and avoid disasters. Investors are inherent risk takers and optimists but in order to deliver long periods of spectacular return and be in a position to weather storms, investors must perform the appropriate due diligence and research to understand deeply what they are underwriting.
A misconception is that due diligence slows down deals. That is not true if both parties (investor and founders/management team) are aligned on the value of due diligence. Taking extra two weeks doing due diligence will not hurt MOIC or IRR but it can help avoid disasters. CEOs/founders are often impatient in the due diligence process but I actually would say that it is to their benefit because the prospect investor is taking the time to learn about their business. Findings from the due diligence can help strengthen the business assuming the CEO/founder is open to feedback.