Venture Capital Due Diligence: Does Outsourcing Work for the Desired Moonshot?

Introduction

The business of Venture Capital funds depends on the targets it invests in. The more the chances of its portfolio companies hitting a moonshot, the more successful the fund is in general. Venture Capital Due Diligence is a process that ensures the appropriate targets are locked in at the seed or early stage to ensure 50-1000X returns in a 5 to 10-year horizon.

The way a VC fund looks at a target is fundamentally different from how a Private Equity or a lender would look at it. A VC fund looks for that one silver lining that can make a portfolio company a roaring success. PE firms mostly weigh pros and cons and generally invest if the Pros outweigh the cons. A lender analyzes if anything at all could go wrong with the company and may jeopardize its investments. Different objectives of investment require different lenses for analysis.

Challenges regarding Venture Capital Due Diligence

VC firms invest in small firms, primarily start-ups, often only at the idea stage. The biggest challenge for due diligence, in this case, is the availability of data. When the idea has not shown any traction, the research needs to be more outside-in. That is finding out the market information and if any customers may be willing to pay for such services of the potential portfolio company. If there is any traction, then the analysis needs to be both outside-in and inside-out. An inside-out investigation is more towards getting into the details related to the operations and finance of the company along with the opportunity that the market offers.

Another challenge is to keep the deal pipeline active for multiple due diligence exercises to happen. Due diligence can throw numerous red flags. If there are various deals in the pipeline, a VC fund can walk away from the opportunity till they get into the company that justifies investment in terms of money and time. Many VC funds park small amounts with the companies they know or are from their circle of friends and family. That biased approach would result in sub-optimal results in the long run. Deals found from networks or events are usually the hot deals that others are also evaluating. That leads to FOMO (Fear of Missing Out) on the part of VCs and hence the overvalued assets.

Advantages of Outsourcing Venture Capital Due Diligence

The advantages the outsourcing brings are numerous like it saves costs, resources are available on-demand and there is a certain specialization with the vendor who works with multiple VC firms, which raises your own investing game.

However, when it comes to outsourcing, there is always a lingering threat in the minds of asset managers. Will the quality be any good? Or what if the deal gets outed due to many individuals knowing about it? Or do they even understand it, ours is anyway a specialized investing or a niche industry?

Challenges around Venture Capital Due Diligence Outsourcing

It is easy to make a business case for outsourcing on an excel sheet, where it can produce 30-70% cost savings while in most cases improving the quality of due diligence. However, concluding everything is hunky-dory with outsourcing is far-fetched. Here are the top challenges with outsourcing venture capital due diligence

There are way too many generalist research and outsourcing players out there, who offer to do research, list generation, and make company profiles, but most of them lack a deep understanding of how VC investing works. There are very few specialist VC research players. Magistral is one of them

VC itself is a new and upcoming industry. In the US alone in the first 8 months of 2021, the number of unicorns created has crossed the number of unicorns ever created in the history of VC investing. That is the acceleration. Though outsourcing provides the access to talent that can deliver, you can be assured the talent itself is half baked, purely due to the massive acceleration that this industry is witnessing

Even the outsourcing home country is witnessing the talent crunch. For example, India itself lacks VC talent and there is a huge demand for trained resources. In a typical FTE-based outsourcing model, it is very possible that you train someone offshore in your diligence processes and he is poached by the competition, leading you to train offsite resources again and again and again. It’s a massive headache

VC investing is more of an art than an exact science and some of the DNA of VC investing is very difficult to outsource.

Magistral’s proprietary process aims to do away with the shortcomings related to Venture Capital due diligence research outsourcing.

Before we dive into the Magistral’s process, here is how we evaluate targets. The things that we analyze closely to ensure the target you invest in has the best chance of becoming your next moonshot and increasing the profile of your fund

Magistral’s Process to Outsource Venture Capital Due Diligence

Venture Capital Due Diligence: Key Components

Venture capital due diligence involves looking specifically around the following aspects of a potential portfolio company before committing to investing:

The opportunity size

Assessing the opportunity size carefully gives an idea of whether there is a possibility of a moonshot with the investment. If the total addressable market (TAM) runs into billions and the company solves an acute pain or saves cost or saves time, or makes the process easier, then there is a massive chance that the company will scale up faster. Sometimes the addressable market is at the conjunction of two or more big markets, and there the TAM needs to be arrived at, with careful triangulation and estimates. Calculation of TAM carefully gives an idea of the upside possible if the strategy and team are right.

Strategy

The opportunity size almost always coincides with the Go to Market (GTM) strategy. This is where lots of VCs add value with their network and connections along with the domain experience. The company suggests a GTM, which experts in the due diligence phase verify. A well-presented GTM has level 2 and level 3 steps, along with the timelines and business outcomes. There is also the requirement of funds laid out clearly for every stage.

The size of the opportunity and how the company plans to seize that opportunity is almost a make-or-break part of the due diligence process.

Competition

Competition sometimes is assuring and occasionally threatening. Competitive intelligence in itself throws light on multiple possibilities. If it’s a product or service promised to be one of its kind, it will be challenging to find an exact competition. The task is not to find the competition per se but carefully checking if the market makes sense, to begin with. Is it just too tricky a market to crack, or is there no market at all, or it’s a service or product no one wants to pay for? Competition or absence of it here is a great pointer. In moderately accepted business models, the company is expected to face competition, big or small. The competition is studied for traction. If all the competition out there is growing at a healthy pace, it shows that the industry may have a place for someone who could do the job better. If competition is shutting shops or taking too long to be profitable, then also it’s a pointer towards the choppy waters ahead.

This also needs to be seen in the light whether the target can be number 1 or 2 in a vast market as it all works on the “winner takes it all” philosophy with VC investing

In any scenario, a careful evaluation of the competition throws a guiding light and is an essential step in the due diligence process

ESG

ESG has picked up in the recent past and for a reason. ESG stands for Environmental, Social, and Governance aspects of an investment that indicates sustainable investing. Though it’s far more critical towards the later stage funding rounds, planning yields rewards in the earlier rounds too. It is estimated that the majority of the deals in the future will be impact or sustainable investments, which will fulfill the criteria of ESG maturity. Some studies show almost all investments would be impact investments a few decades down the line. A VC not only plans for an exit from the portfolio but to raise following funding rounds too. Chances of raising rounds at higher valuation increase if the company is primed to be an ESG investment right from the seed or early-stage rounds.

Financials

If the company has been around for a few years and has seen some traction, financial analysis becomes crucial as any other factor in the due diligence process. Financials feed into the valuation of the company. Financials are also essential to forecast future revenues, profitability, and cash flows. In the due diligence process, reasonable estimates are made to project the company’s financial statements for the next five years. That drives the valuation of the company on which the funds are to be raised. In the due diligence process, sometimes, the assumptions made during the preparation of financial models are tested thoroughly. If there is an assumption that may not stand the scrutiny of the financial analyst, it is flagged. If there is a massive impact of an erroneous assumption, this exercise alone could save millions of dollars for the VC investor.

The team

The founding team in a smaller company is the driving force. Suppose the team is experienced, has relevant skills, produced returns for investors in the past, and is motivated to make a difference. In that case, it can be the difference between an investment that reaches out for a moonshot and another one that proves to be a dud. Checking the team’s credentials, experience, qualifications, and connections is an essential aspect of the due diligence process.

Red Flags

Apart from significant aspects discussed earlier, the due diligence team also looks for red flags in the documents submitted by the company seeking investment. It could either be a legal hurdle, financial irregularities, or any other problems with the documentation. Discussing these red flags with the company may well turn out to be fruitful.

Magistral’s proprietary process for Venture Capital Due Diligence

Magistral’s unmatched advantages in VC Due Diligence

Magistral works with multiple VC firms, some one-man companies, and others running a portfolio of hundreds of companies or start-ups with a few unicorns and soonicorns. After performing hundreds of due diligence exercises across industries like SaaS, healthcare, Tech, Industrials, Services, Real Estate, and others, Magistral has developed a proprietary due diligence service delivery method that counters almost all the drawbacks of outsourcing.

Magistral’s financial analysts take control of the data room. The VC or the company populates all the documents in the data room. We comb through the records with an eagle eye to spot opportunities or red flags. We have developed a standardized checklist to evaluate all types of documents. All our observations and questions are collected by the VC and discussed with the company. We also prepare a detailed report on the business. The information on the company comes from secondary research, discussions with the industry experts, and our in-house expertise in the area. Finally, Investment Memo or pitch deck crystallizes all the insights. These pitch decks are designed consistently with the global marketing standards of the financial industry.

All FTE-based engagements of Magistral have an ever-evolving Standard Operating Procedure (SOP) document. This helps in standardizing the process irrespective of the personal capability of the analyst working on the project. It also ensures a smooth transitioning in case the trained analyst leaves. There is also a shadow analyst always ready to take on in case the analyst leaves permanently or takes off or holidays. It’s so much like the cockpit of Boeing 747, planned for all eventualities.

Our experience has made us more knowledgeable about VC investing than some of our clients. That helps our clients improve their investing game too. Templates, Systems, and our experience and DNA of VC investing ensure due diligence that meets the global standards of investing at competitive valuations. If it sounds interesting, for a conversation with, drop an inquiry here

About Magistral

Magistral Consulting has helped multiple funds and companies in outsourcing operations activities. It has service offerings for Private Equity, Venture Capital, Family Offices, Investment Banks, Asset Managers, Hedge Funds, Financial Consultants, Real Estate, REITs, RE funds, Corporates and Portfolio companies. Its functional expertise is around Deal origination, Deal Execution, Due Diligence, Financial Modeling, Portfolio Management and Equity Research

For setting up an appointment with a Magistral representative visit www.magistralconsulting.com/contact

About the Author

The Author, Prabhash Choudhary is the CEO of Magistral Consulting and can be reached at Prabhash.choudhary@magistralconsutling.com for any queries or business inquiries.