VC due diligence. Important, and helpful for everyone involved.

VC diligence is not a scientific process. I like to think every investor does some level of diligence even though there are some signs in today’s ‘hot’ market that some are willing to write big checks based on just a hunch. That should not be the case as due diligence is a good thing. It helps everyone involved.

Due diligence is a good thing. It is not just good investment practice that we certainly take very seriously at Lux Capital, but it also has additional benefits that accrue after the investment is made. It helps investors understand the space, its particular dynamics, strategies deployed by the company and its competitors, and the likely scenarios of how the story unfolds better. Knowledge about the company one invests in can help investors be better Board members, advisors, and strategic thinkers. Thus diligence across various aspects of the business, such as team, technology, competition, market size, capital needs, exit outcomes are very helpful.

I have also noticed that investors don’t often share with entrepreneurs what questions they might be stuck on. I am not sure what the reasons might be but maybe it has a little do with the fact that VCs can be conflicted if these are the right questions in the first place? Their gut and mind are at odds with each others? or they are trying to find lessons from history (pattern recognition), when short term and long term history has conflicting stories to tell?

Anyways, below I am including some thoughts I tweeted out this morning (hashtag #vclogic) on some questions investors sometimes ask that fall into that category. There is nothing inherently wrong with these questions, but good investors are careful about contextualizing the answers they may get back in cursory diligence.

  • What if Google/Amazon/FB were to do this internally? Would they buy or build?
  • If this is such a good deal, why hasn’t it been picked up as yet by others?
  • This team has no senior management, just a bunch of hipsters. Who on the team has deep experience in the space? Conversely, this team is all grey hairs. Where’s the passion and fire to walk through walls?
  • Isn’t the TAM too small for us? Conversely, don’t unicorns form when they create new markets?
  • This is a crazy price for this round. Conversely, why was last round done only at a modest step up?
  • Why does this company not have the same buzz as the other company I recently saw on TC and WSJ?
  • This is a nice widget/toy. But how do you build a business around it? Conversely, isn’t this a science project?
  • When do you reach cash flow break even? Conversely, why aren’t you growing faster and owning the space?

My partners and I at Lux try to be transparent about the process we engage entrepreneurs in. We aspire to be prepared about spaces we invest in, but we are often surprised by what great entrepreneurs cook up to bring to us. My partner Josh calls it the “hmm, that’s interesting’ moment. When exposed to a new space or a new take on an existing business area, we quickly try to get educated by calling upon people in our network who know and understand the dynamics and economics better.

If we choose to dig further, we talk to technologists deep in the space, we call some reference and some potential customers, and we call personal references. We talk to people you might know, and some you may not, some partners of yours and some competitors. We meet key team members (sometimes individually) and talk to existing investors. And more…There is no laundry list of diligence items (except for legal diligence which seems to have such laundry lists), but our process hopefully shows a genuine curiosity on our part to figure out how the value chain works and where will dollars accrue, how would this particular company play and win in the space, what protective moats can it build, what are its strengths and weaknesses, and how Lux and our amazing set of LP partners can help if we were to make the investment. We try to be fast and respectful of your time. And by the way, if we end up choosing to not invest (which happens more often than not), we are happy to share our learnings with you so you can be helped regardless.

And yes, entrepreneurs hold us to that standard, and we love it.