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?

Some might argue that diligence doesn't really matter in the long run and that investment outcomes are mostly a function of luck. Isn't this much like what we've read in history books about Napoleon—that in order to win his battles, his biggest desire was for lucky marshals to lead his troops? There is little hard research evidence that the degree or competence of the diligence improves the number of wins for a VC firm. Even for many of the biggest and best‐known VC firms, only about 15–20% of all their investments make any money at all, and lots fewer are home runs.

Does diligence help pick winners (or reduce the number of losers and the magnitude of their losses) or just provide false comfort for the naïve? Can an investor's rigorous diligence stack the odds so that her investments are more like a bet with the casino's proverbial “house odds”?

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.

Return on Due Diligence Investment Tough to Quantify

So what is the cost in time and effort to the entrepreneur seeking venture capital, and the return to the investor on the time and effort put into due diligence? Even though top‐performing VCs will tell you that rigorous due diligence is essential, these can still be tough questions to answer, and the responses you get may differ substantially by constituency.

Consider the entrepreneur we heard at a seminar sponsored by a top‐tier accounting firm, who described recently going through a major venture capital “physical”:

On the plus side, if you're running the company right, due diligence underscores your credibility to potential VC investors. The VCs reason that you're likely to carry on business after you're funded the same way you were able to describe it before. On the negative side, you are burning up a lot of time and energy, often answering and preparing to answer the same questions over and over again as you may meet with many potential VCs prior to successful funding.

Make No Mistake: Due Diligence Is Important

We VCs are trustees for other people's money. VCs raise funds either from institutional sources, which are also trustees for other people's money, or from high‐net‐worth individual accredited investors, who take a dim view about losing their own money. So the VC's job demands care and a degree of caution while investing in inherently risky ventures. His or her clients expect achievement of some of the highest rates of return and multiples on funds invested of almost any investment asset class. Think about the VC's stress (and the investor's stress, too), as he or she commits substantial dollars, often without any real control, but still feels responsible for the ultimate outcome. If the entrepreneur doesn't really know the market and what he or she is doing, or hasn't considered and planned for the venture's major risks, it is easy for all to be lost.

The answer to this risk/reward stress dilemma is due diligence. This is a practical necessity and also a legal term for checking things out, for looking closely before leaping, and for being prudent before investing rather than having regrets the day after.

What Due Diligence Is All About

VCs usually ask a lot of basic, and sometimes even seemingly dumb, questions. Those questions may sometimes seem worthy of a ten‐year‐old, yet that may be necessary in order to illuminate what the company and hence the VC's investment is all about and its chances of success.

Starting with a tabula rasa on a subject and asking questions that may seem worthy of a child but can also be illuminating is not child's play. This is serious and can be scary stuff. The VC image may be of a smart, sophisticated, knowledgeable, perhaps even artful, high‐powered money‐man, but behind that façade always lurks fear of the unknown and perhaps the unknowable.

At their core, the due diligence questions are basic: What does this venture or its product do? How does it work? Who will buy it? Why do they want it? How many can we sell? What's the cost to make it? Can it be scaled up? Will the dogs (customers) eat the dogfood? Who are these people who want to build a business? Why and how will they succeed against the odds? Will the competition kill them? Will they be good partners or, even if they succeed, not worth the aggravation?

Time and again, an effective venture capitalist must reveal ignorance. This is not a business for people who need to appear smart. The VC in the due diligence process is revealing vulnerability.

Of course, there is a sharp edge to this seeming vulnerability. The venture capitalist stills holds the gold, and the entrepreneur wants it. For the entrepreneur, after a while the questions may begin to grate and to annoy. The savvy entrepreneur, however, begins to realize that behind the seemingly benign questions is a loaded and essential purpose. The venture capitalist is probing for both strengths and weaknesses, looking for the home run deal while probing for the tragic flaw and for any red flags as to why not to invest.

The Due Diligence Process

The due diligence process is rather straightforward. The venture capitalist will call several weeks after an office introductory meeting and say that it is time to do some additional homework on your deal. He'll tell you he will be in your area on a particular date and will ask if you and the key members of your team can make a tire‐kicking meeting. Unless it's absolutely impossible, cancel all your other meetings and don't appear to have a full calendar. You need the money, and one of the first venture capital screens is a measure of your availability to the VC and your attitude about having an investment partner. The VC is signaling that he may invest in you and in return wants your full time and attention.

Once the initial diligence meeting has been set, the entrepreneur should be certain that other key managers are also available for the meeting. It's frustrating for a VC to arrive at the entrepreneur's place of business and find that the marketing VP is on the road selling or the product development VP is attending a design meeting. Common business courtesy requires that the entire senior management team is ready and available. Such courtesy is an important signal to the VC. If you treat the VC with such courtesy appropriate to his need, he is likely to conclude that you will do the same for your other critical customers as well.

After appropriate introductions are out of the way, including getting to know the history and backgrounds of your key team members, the VC may want a tour of your facilities if there are any of significance. Alternatively, he may begin to discuss with the team key elements of the company's business plan, presentation deck, elevator pitch, or bumper‐sticker slogan.

An experienced VC can sense much from this early part of the diligence process and begin to form a picture as to the merits of an investment. At this juncture, integrating his pre‐meeting background homework with his initial observations from this meeting, he will have some view as to how you fit into the industry universe, how likely it is that you can capture a very large market share quickly, and whether you have a handle on a rapid go‐to‐market strategy.

VCs, of course, come from various backgrounds. Some have managed plants; some are most comfortable with balance sheets; some focus mostly on the people. During the prelude to the tour, the entrepreneur will probably focus mostly on the people. Before beginning the tour, the entrepreneur and her team should also learn enough about the VC's needs and interests to tailor communications most effectively. The ability to learn quickly about the VC's needs and interests can signal the venture team's ability to listen, a critical skill since they need to be able to listen effectively to customers as well in order to better understand and address their needs.

As the entrepreneur conducting a facility or plant tour, it's important to highlight the venture's strengths, pertaining both to people and to physical assets. Be sure introductions are made to other key employees on the tour and that a feel is provided for the focus and chemistry of the business organization. This is also an ideal time to inspect and demonstrate, if possible, an engineering or production prototype of your product. You can point out the interesting features of your product, engineering, and sales and marketing processes that enhance your uniqueness as an investment opportunity. You can show how the device or service works in real time.

Time is often relatively short in this initial due diligence meeting—perhaps a half‐day—so concentrate on the informative and dramatic in this initial tour. Show the venture capitalist what you have that others will want to buy and why major money will be made.

Of course, the facility tour is not only an opportunity to judge product or market uniqueness. It is also an opportunity to show the venture capitalist what you have that others will want to buy and why major growth in revenue and profit will occur, and to begin to outline the likely growth evolution of the business. The VC is attempting to gauge just how fast the company can scale revenue and move to positive cash flow and profitability, especially if those are near‐term goals.

After the facility tour, the venture capitalist will often want to quiz the management team on their business plans. Some of the questions will be very basic, but others will be very specific, getting into market, competition, forecasts, and financial projections, as well as other subjects.

The Focus of Due Diligence Questioning

Generally the earlier the deal stage—such as seed, startup, or a Series A investment—the more the questions will be about management and their capabilities. For an early‐stage investment, the jockey (i.e., founder and management team) is often more critical, and so less emphasis is placed on the horse (the specific business/market opportunity and projected details). The later the deal stage, the more the questions will be about margins, growth rates, scaling, and time to positive cash flow and profitability.

Often in an early‐stage investment, the management team is not fully complete. There is a jockey, the founding entrepreneur, but the company is short on the groomers, stable hands, track workers, and so on. Prior to seeking venture capital, the entrepreneur should analyze the management team's soft spots and develop a plan to fill the gaps. Potential new members of the team may not want their identity disclosed prior to venture capital funding, as the venture may not yet be able to pay them for their efforts or may falter for lack of funding prior to liftoff. Nevertheless, the lead jockey/founding entrepreneur may be able to provide sufficient information on targeted recruits' prior experience to convince the VC that a complete management team is on the horizon.

Experienced VCs, of course, look for both a good horse and a good jockey. The earlier the stage, though, the more management is critical, as the VC is particularly interested in management's ability to make the initial reference sales that launch the company as a real business rather than just an idea. In the early‐stage deal, the VC will want to understand the uses of the capital invested. Often at this stage, the major use is to begin to implement a go‐to‐market sales strategy, so this strategy will be closely scrutinized.

In a later‐stage company, where there are more hard assets as well as hard or soft liabilities, the venture capitalist will want to understand their placement and deployment in support of the company's strategy, as well as how effective and efficient the company has been with previous capital invested. The VC will be attempting to judge if the company will need more investment capital as well as both the upside opportunities and downside risks for the investment. The VC is particularly interested in the downside risks for soft‐asset companies such as those selling software (which, in the memorable phrase of iconic VC Mark Andreessen, may both eat the world and also eat the company). The VC must be particularly diligent where the product or software as a service (SaaS) can easily walk out the door with the proprietor.

Judgments will be made as to whether the entrepreneur is a business realist or a dreamer, and whether she has sufficient hands‐on experience and knowledge of the industry and market to succeed. The venture capitalist is not in the business of providing the entrepreneur with a business education; since venture capital is one of the last refuges of the business generalist, the venture capitalist will want the entrepreneur to demonstrate the specific knowledge and skills required to succeed in the highly specific marketplace.

The price the VC will be willing to pay with his investment, and the terms on which the VC may be willing to invest, will be strongly influenced by his impressions and conclusions from this inspection tour and evaluation. This is not a time to withhold and be wary. The VC is not in the business of stealing others' business ideas or products. In such a still relatively small and highly networked industry, poaching behavior would soon result in being out of business. Provide full disclosure and treat the VC like a trusted partner.

Importance of Treating the VC with Respect and Sincerity

One of the worst feelings a VC can have is when the entrepreneur forgets the VC's name after the money is in the deal. This sometimes occurs when the entrepreneur really didn't view the VC as a helpful partner; the entrepreneur wanted no‐strings money so that he could continue to build his business in his own way without outside governance contributions or management interference.

Since entrepreneurs are often very independent and resourceful, some have the attitude that they can do it all without any support other than capital. This go‐it‐alone attitude is fine if you really can go‐it‐alone, but it can be perilous for an entrepreneur who raises venture capital, as that entrepreneur will almost certainly need to go back to the VC for something, whether additional capital, customer references, a pat on the back, or having the entrepreneur's back in tough times. Once a VC realizes that the entrepreneur doesn't want to act as a real partner, trouble begins. As long as a VC has money invested, he needs to be treated like the entrepreneur's best customer.

When America Online, after its escape from near‐early‐death, was restaged, management of the investors was accorded high priority and tended to wholeheartedly by Jim Kimsey, the new chairman and CEO. As a former restaurant and bar owner, among other talents, Kimsey knew that the VC investors—and there were several of them—were his best customers. He recognized that he would need more of their money and lots of their patience and faith. Jim knew how to “get them the best table, a cold drink, and a good pour.”

While he saw to the care and feeding of the VC investors, Marketing VP Steve Case was freed up to concentrate on product development, the marketing message, and initial customer acquisition. The inside/outside team of Kimsey and Case made America Online happen. The investors included many of America's major VC firms, and careful handling of their needs and interests was critical, particularly for a company that had come so close to death and had to be so fully restaged.

Some entrepreneurs believe that it is most effective, when “whetting the venture capitalist's appetite,” to appear relatively aloof and in no real need of funds during this due diligence process, often dropping subtle hints that there are many others interested in the opportunity and that the VC must move fast to make an investment. This may work with the newer recruits to the industry or with the desperate VC who may then be inclined to pay up a bit for the investment, but in the long run the relationship will suffer. The VC is in a position generally to get even in later‐round investments if he believes he has paid too much, too soon, or that he has not really had full disclosure.

In the discussions with the VC, it is best for the founding entrepreneur to avoid appearing as if walking on water is one of the skills perfected. The venture capitalist is looking to back those entrepreneurs who have solid self‐confidence but not too much arrogance. The late Pat Lyles, a legendary Harvard Business School instructor and a general partner at early Boston‐based VC partnership Charles River, said, “I want to invest with ‘I want to do well’ egos rather than with those that are essentially delusional over their self‐importance.”

While a swelled head is not normally helpful to fundraising, the venture capitalist will want to deduce through due diligence that the entrepreneur is a visionary with a compelling dream, a big thinker. As VCs have in recent years become more interested in home run investments, a big thinker with a perceived opportunity to build a multimillion‐dollar, if not a billion‐dollar, business (the so‐called unicorns because they are so rare) has become essential. While spinning the dream, though, it is also important that the entrepreneur be grounded in the here and now, in the world of fast execution.

It's also helpful to convey that the founder sincerely wants to be very rich. The VC's search and due diligence efforts are not to find ego‐driven empire builders, but rather to find and qualify certifiable moneymakers. There's certainly nothing wrong with the modern mantra of wanting to save or change the world, but the VC recognizes that the world is hard to change and even harder to save. A number of VCs will not invest in projects that they view as detrimental to society but, in the end, they are judged on their ability to produce returns that outperform almost all other types of investment. So, as long as the investment does no harm, it really is mostly about the money.

Time Can Be of the Essence

For a VC investor pursuing a high‐quality investment opportunity, there is often not much time to conduct due diligence. If the opportunity is a good one, then there will often be many suitors and all will be driving fast toward the hoop. In these rapid‐fire circumstances, the only way to win is not to reduce the quality of the diligence, but rather for the VC to find opportunities before others so that he has a head start on other competitive investors, and for the VC to focus diligence efforts smartly on those areas that are most important.

As explained before, for a seed, startup, or early‐stage investment, much of the due diligence effort should be focused on getting to know well and understand the jockey and the team. For a later‐stage investment, the execution ability of the team will often already have been demonstrated, so the main question will be whether the team has a viable plan to scale up the opportunity toward a successful exit.

Recently, a Chicago‐based company in digital mass storage and security called Cleversafe was sold to IBM for $1.3 billion, one of the largest (if not the very largest) tech unicorn exits in Chicago venture capital history. The exit created over 80 millionaires, many from Chicago, including a number of Cleversafe employees, who are now reinvesting their gains in other Chicago‐based companies.

Early Series A investors in Cleversafe did not have much time to make their investment decision. Our firm, Batterson Venture Capital, had heard about the company through several respected network contacts, and we then attended a tech conference where the company's founder, Chris Gladwin, presented. Gladwin's presentation laid out a compelling case that his unique idea—to split up data into slices, send the data slices for storage over the cloud to a number of silos, and then in real time reassemble the data using a proprietary algorithm—presented the opportunity to both significantly lower the cost of big data storage (by up to 80%) and improve data security. Gladwin had also founded several earlier companies that did well, so his ability to assemble a team and execute was also clear and compelling.

Essentially the decision to invest was made during Gladwin's tech conference presentation. Due diligence follow‐up on the analytical issues was handled very rapidly soon after. A highly experienced venture capitalist can make these decisions quite rapidly. Less experienced VCs would normally be better served finding investment opportunities where time is not so much of the essence, perhaps even letting go of some of what may appear to be the highest value opportunities.

Some Advice for Less Experienced VCs

For those who are just beginning to invest in or have limited experience in venture capital, allowing sufficient time for diligence is particularly important to help reduce the number of losing investments and the magnitude of the losses, even though this may also reduce the number of major winners. In the beginning, reducing losses, rather than winning big, may be more important in keeping a new VC in the game. (Studies have shown that there is much more pain in losing than pleasure in winning.) So taking the time for necessary diligence to avoid losing is a winning strategy.

The more experienced VC (it is said that it takes a minimum of $15 million in losses to train a VC) can assume more risk by moving faster. This investor will be better able to recognize pretty much right away which potential investments are more likely to lose or to win. The ideal approach is to both have high‐quality deal flow (and also to create it through developed networks and reputation) as well as undertake extensive diligence, the amount depending on the level of experience.

Even with the best diligence and intentions, it is often said, “A VC only really learns the actual state of affairs at the first company board meeting.” VC investing is an ongoing learning process about the venture team, the industry, the markets, the products, and the competition. As information increases and the company progresses through existing investments, the VC usually is able to make additional investments in the company based on this additional hard‐won knowledge.

In the end, diligence does matter, whether it is facilitated and accelerated by deep experience or more reliant on a deep and more time‐consuming dive into facts, as most VCs will invest in only about one out of a hundred companies that come to them, with perhaps five to ten out of the hundred going through diligence. The process of deal flow screening and due diligence in essence consists of (1) elimination of the lame, then (2) elimination of those who can only walk well, and then (3) investing in those that can run like a true winning athlete.

Some Advice for Less Experienced Investors

Working and/or investing at first with experienced investors will best serve the individual new to the game. Since it is very difficult for individuals to gain access to major institutional venture capital funds with long successful track records, an effective alternative approach is to seek out opportunity to invest with experienced individual investors or to rely on a venture capital firm with a proven track record that is accessible to individuals.

In recent years, new avenues for investment with the best and brightest individuals have been created, in particular through readily accessible online VC investment firms. One example is AngelList, which offers the chance to invest alongside and with investors who have successful track records as entrepreneurs and/or investors. These individuals do the work of a VC in finding deal opportunities and doing the due diligence homework and then form syndicates including other investors who may have less experience.

Other significant online VCs offering individual investors dozens of deals include FundersClub, CircleUp, SeedInvest, and Israel‐based OurCrowd. These emerging online VC investment firms offer the new investor the opportunity to co‐invest with experienced investors and to piggyback on the knowledge networks and diligence of qualified venture capital investors, so they may achieve something closer to playing with house odds rather than against the house. The chances should be better than investing with a brother‐in‐law or the local angel group breakfast investment club.

A word of caution: With many of these firms offering such a large number of deals, the buyer should beware, as the quality of the deals, the ability of the syndicator in the case of AngelList, and the level of diligence can vary widely. Doing 40 or so deals a year, like some of these firms do, requires a strong due diligence focus and substantial due diligence resources to do this job well. It is not yet clear if such a model will work in the end, as VC investment models over the years have had difficulty scaling from smaller boutique firms with several partners to larger organizations doing lots more deals.

In addition, while these VC firms have raised considerable capital both for the firms and their individual investment deals, these firms are so new that few of their investments have yet exited. Moreover, many of their deals are seed investments that will require considerable additional capital. Hence, only time will tell if their models will be successful.

VCapital is a new online VC investment firm, formed by the authors and their associates, which has distinct credentials and a distinct approach among these readily accessible online VC investment firms. The VCapital team leadership has about 35 years of highly successful venture capital investing experience, delivering an average annual gross IRR over that period of 28% and returning 3.6× the amount of funds invested. For perspective, 3× is considered an excellent return multiple. Over those 35 years, the team has never had a negative‐returning fund, with average annual returns ranging from 14% to 159%. It has participated in early investments in three companies that reached market capitalizations of over $1 billion. This includes helping to found and create America Online (AOL), which was part of the largest company merger ever (AOL–Time Warner) and which was valued at the time of the merger at $364 billion. The $1 million investment made by the VCapital founder (Len) would have been valued in 1999, just before the merger, at $4.6 billion.

As with the team's predecessor firms, VCapital is highly selective in its deal selection, seeking just four to eight high‐quality deals per year. It focuses about half its deals in the underserved Midwest region of the United States (and half in other areas of the country), where less intense VC competition than in places like Silicon Valley results in lower valuations/share prices for high‐quality investments.

VCapital team members have previously either created as entrepreneurs or worked with entrepreneurs very closely to create new business opportunities. This means that investment opportunities will be well understood, and deals we actually pursue will be followed closely and knowledgably, increasing the odds of success. Net, the VCapital team is throwing its investment darts more selectively and with a surer aim, rather than “throwing darts in the dark” (or with less knowledge, experience, and/or due diligence).

Considering all this, our advice to new venture capital investors is that you “look as far as the eye can see, and know all the wonder that will be,” but also remember to look hard before you leap. Falling repeatedly into the cavern of big losses can be awfully painful.