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Venture Capital (VC) Due Diligence

Venture Capital Due Diligence Framework for Early-Stage Companies

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Venture Capital (VC) Due Diligence

Key Takeaways
  • What is the “power law of returns” in venture investing?
  • How would you assess the management team of a start-up?
  • Which characteristics would you look for in a potential early-stage investment?
  • What are the main types of risks associated with early-stage companies?

Venture Capital Due Diligence Introduction

Peter Thiel once stated, “The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.”

The return distribution that Thiel is referring to is known as the “power law of returns,” where the majority of early-stage investments are made under the presumption that most of the portfolio will inevitably fail. Yet, a single investment could enable the fund to meet its return hurdle.

The implication is that when performing due diligence on potential investment opportunities, venture capital investors should only pick startups that can return the value of the entire fund.

Given the risk profile associated with these investments, only potential market leaders in large enough markets are chosen as investments – anything less, and the fund would more likely than not fall short of meeting minimum fund return thresholds.

Venture Capital Due Diligence: Management Team

The first key point of diligence is assessing the management team in charge of the company. Throughout this diligence phase, numerous qualitative topics need to be addressed regarding each member of the leadership team to learn more about their:

  • Domain Expertise
  • Total Experience Level (and Relevance)
  • Individual Value Contribution

Collectively, the management team must have:

Venture Capital Diligence: Management Team

To further expand on each point and what Early-Stage Venture Firms assess before investing:

Long-Term Vision
  • The management team must hold a long-term view regarding the direction the company will be steered
  • At this stage, countless unforeseeable variables could impact the company – for example, market conditions could change or development could arise that causes the company to change course to adapt
  • Still, management must set long-term goals as the foundation of the company (i.e., the values of the company, overarching impact on society)
Technical Product Specialty
  • Product specialty refers to having the technical skillset to create a product better than any other company
  • Specialization often stems from experience and the gradual accumulation of product expertise, which are some of the most important characteristics of a compelling team
  • For mass adoption of the product to occur, the product benefits must exceed the current offerings by a significant margin (and make the switching costs secondary to the incremental value received)
Business Acumen
  • Business acumen is having the right team supporting the product development
  • Regardless of how valuable a product is, an ineffective sales and go-to-market strategy could inhibit the growth of the company
  • Being able to convey the vision for the product and company is just as important as the product value when it comes to raising capital from investors
Management Cohesion
  • Management cohesion suggests the skills of the founders complement each other, and the team can delegate tasks and collaborate efficiently
  • One proxy for management cohesion is the number of years the team has been working alongside each other (and their achievements)
  • This experience is especially valuable if the company faced periods of difficulty and were able to figure out a solution without falling apart (i.e., significant employee churn)

Product Analysis

There are three fundamental components to the product being offered:

Venture Capital Diligence: Product Analysis

Product-Market Fit (“PMF”)

The concept of product-market fit is one of the major determinants of the outcome of an early-stage startup venture. PMF is defined as the validation of the product concept in the target market, as signified by consistent organic consumption and word-of-mouth promotion.

Achieving product-market fit is the most important element to growth and scalability.

Early on, the management team should have a single-minded focus on demonstrating the potential for product-market fit, as doing so is crucial to raise funding.

PMF Marc Andreessen

Product/Market Fit Defined by Marc Andreessen (Source: pmarca)

PMF is more of a qualitative trait as determining the degree to how a product meets a particular market’s demand and the extent of how much a product resonates with the market.

Often, PMF is described as one of those attributes that can be recognized from customer engagement and feedback. The product also begins to “sell itself” as marketing seems to take off on its own.

In addition, PMF suggests the current pricing mechanism and sales & marketing strategy are effective – albeit improvements to the business model are going to be inevitable.

Product Differentiation

Consistent outsized returns that can be sustained over the long term stems from differentiation and high barriers to entry.

Most industries where VC funding activity is active tend to carry a “winner takes all” aspect, thereby firms pursue companies that are inherently different.

That said, another important component to assessing a product is the presence of proprietary technology or patents that make it difficult to replicate, which reduces the external threats to the company.

In short, there should be significant technical barriers that prohibit competitors from replicating their products.

An economic “moat” is a differentiating factor that contributes towards a sustainable, long-term competitive advantage – as well as protection of its market share and profit margins.

Examples of deterrents that create a barrier against the rest of the competition are:

Economies of Scale
  • Improved cost structures from the increased scale can be a barrier to entry that deters competitors, as the existing incumbents have a clear advantage in profitability and thus have more cash flows to reinvest into the business
  • Since the unit costs of a product decline as the volume increases, new entrants would come in with a significant cost disadvantage right away
Network Effects
  • The network effect refers to when the value of a product/service increases with each incremental user and increased adoption
  • Network effects compound once critical mass is attained, meaning past this inflection point, new customers’ acquisition experiences a domino effect where less effort and monetary investments are required
  • For example, Facebook benefited greatly from network effects, as its advertising revenue took off once its user base and customer engagement grew
  • By becoming the largest social media platform, Facebook obtained a durable moat in the advertising market, which led to an influx of advertisers wanting to place ads on Facebook’s platform and new opportunities for different products/services to be introduced
Proprietary Technology / Patents
  • Having a differentiated offering that no other company has can cause competition to be near non-existent, especially if there are patents involved
  • Under these circumstances, it would be difficult (or illegal) for competitors to sell competing products
High Switching Costs
  • Unless the new entrant has a significantly better product/service than the current offerings, switching costs can serve as a barrier (i.e., the switching costs outweigh the benefits)
  • There are also “convenience” switching costs – e.g., Apple’s line of products, which create a loop that reinforces the value of each offering through pairing devices like the iPhone, Apple Watch, and AirPods with seamless compatibility and add-on benefits
Branding
  • While arguably not as important as the others, premium branding can help increase pricing power (e.g., Louis Vuitton, Gucci)
  • As another example, branding based around sustainability such as using only environmentally friendly material and promoting eco-friendly behavior could help establish an emotional connection with customers (e.g., Patagonia)
Product Commoditization: Price-Oriented Competition

If there are competing products/services available in the market that offer the same (or similar) amount of value with minimal differentiation, the product is said to be commoditized.

Eventually, competition in a commoditized industry will become based around pricing (i.e., race to the bottom), rather than competing on product quality or value.

To not be undercut by competitors and suffer from margin erosion, there must be differentiation that sets the company’s product offerings apart from the rest. Otherwise, if the products in the market are virtually identical, the opportunities for growth (e.g., price increases) are basically no longer an option.

Value Proposition

Churn implies the constant need for new customer acquisitions, which brings uncertainty as to whether customers derive adequate value or not.

Simply put, the value proposition to customers can be described as the extent to how much the product is needed.

The value of a product/service offering is tied to how essential it is for business continuity.

If the removal of a certain product causes significant disruption to the customer, the product would be categorized as being “mission-critical”.

There must be a clear explanation as to:

  • Why does the customer need the product(s) of the company?
  • What backs up the belief that the business relationship will continue?

One proxy to determine the value of a product to customers is by looking at past attrition rates and the duration of existing customer relationships. If a company has constant customer churn and its customer relationships comprise short-term durations, the product may not offer enough value.

Pricing Power

An important concept closely related to the value of the product is pricing power.

There is no formulaic method to calculate a company’s pricing power; however, one useful question to ask is: “If the company raised prices, what would the impact on customer retention be?”

If a company has pricing power, it can raise prices and not see a substantial increase in customer churn. And so, the net impact from the pricing increase would be positive.

Pricing power is a function of how indispensable a product is to users, how “unique” the value provided is, and the availability of (or lack of) other alternatives in the market.

If all three of the aforementioned components are found in a product, the result will be:

  1. Strong Retention Rates (i.e., Low Customer Churn)
  2. Increased Pricing Power
  3. More Upselling / Cross-Selling Opportunities

Venture Capital Due Diligence: Business Model Viability

Unit Economics

To assess the viability of a business model, the unit economics of the business must be closely examined – which consists of breaking down the revenue and cost structure into the smallest units possible.

Unit economics represent the smallest piece of a business that can be measured to understand where revenue and costs fundamentally come from (e.g., average contract value, or “AVC” is an often-used metric for SaaS companies, or for a consumer goods company, it could be price per bag of chips, for example).

The traditional metrics used to assess established companies cannot be applied to early-stage companies. Therefore, industry-specific metrics tend to be used to assess start-ups, especially for software companies.

For instance, the LTV/CAC ratio is considered to be among the most important KPIs to track for software start-ups:

LTV/CAC Ratio

But before these types of metrics are analyzed, the total addressable market (“TAM”) and market penetration assumptions must meet the fund’s requirements. This illustrates why VCs only target markets of a certain size where the company can achieve its revenue targets (and with a reasonable margin of safety).

Warby Parker: Direct-to-Consumer Model (“DTC”)

Warby Parker obtained significant success in acquiring customers and scaling by being among the first generation “direct-to-consumer” (DTC) companies, which distinctively had lean supply chains whereby the non-value added costs were removed.

Additionally, online retail channels, in-house distribution, and social media-oriented marketing were other common features of DTC companies.

Particularly important to the retail industry, Warby Parker crafted a unique visual brand identity built upon transparency to customers and sustainability that clicked with the market.

Warby Parker History

Warby Parker History (Source: Warby Parker)

Despite the premium brand image associated with Warby Parker, pricing was intentionally kept low – and any abrupt increases in pricing would contradict the principles the company was founded on, which ties back to the earlier point on the company needing a long-term vision.

So by cutting out the areas causing the margin pressure (e.g., brand licensing, frame costs), Warby Parker was able to offer frames and lenses at prices as low as $95, a fraction of high-end boutique shops, without sacrificing quality or style.

Even with the lower pricing, the start-up managed to turn a healthy profit as it eventually became EBITDA positive around 2017 for the first time since its founding in 2010.

One of the more critical aspects of the business model is how repeatable it is, as this directly pertains to the scalability potential of the start-up.

For this reason, capital-intensive companies attract far less venture funding relative to asset-light companies. And this also explains why the software industry receives such a disproportional amount of interest from VCs.

The main cause is related to a concept termed operating leverage, which represents the proportion of total costs that are fixed relative to those that are variable. Thus, companies with a higher proportion of fixed costs in their costs structure have more operating leverage.

If the operating leverage of a company is high, then each marginal unit sold comes with fewer costs and the product can be scaled more rapidly, in theory.

It’s easy to think how this could be true for software start-ups: once the software is developed, you could hypothetically sell the same software to millions of customers without necessarily needing many more developers.

For these software start-ups, once the product development stage is done, the most significant investment has been finished.

While the start-up will continuously be working on upgrading the product based on user feedback and fixing bugs, these developmental costs are usually marginal compared to designing and producing the initial core product.

High Operating Leverage Low Operating Leverage
  • If the company has high operating leverage, each additional dollar of revenue can be brought in at higher profits once the fixed operating costs are paid
  • If a company has high variable costs, each additional dollar of revenue may generate less profit as costs proportionally increase alongside increased revenue (i.e., the variable costs offset the additional revenue)
  • Thus, each marginal unit is sold at a lesser cost, creating the potential for greater profitability since fixed costs such as rent, and utilities remain the same regardless of output
  • If the revenue of the company were to increase, these costs would rise in tandem (or vice versa)

Note, high operating leverage is not always better and there are scenarios in which this type of business model can be detrimental to the company – akin to the use of Debt Financing.

Venture Capital Diligence: Risk Analysis

Venture Capital Diligence: Risk Analysis

Timing Risk

Early-stage start-ups must attempt to offer solutions that solve the problems their target market currently faces – thus, understanding the end customers and the issues encountered on a day-to-day basis is critical.

Often, being too early to market can result in limited market adoption and ultimately a failed venture (e.g., Fitbit wearables).

But then, later on, venture funding could rapidly flow into the same area with high-flying Valuation Multiples and mass consumer adoption just a couple of years later (e.g., Apple Watch).

The takeaway: when it comes to venture capital, timing is everything.

A simple yet important question to ask is: “Why now?”

The venture must be initiated at the inflection point right before mass adoption, which is very challenging to time precisely. However, there are “signs” when end markets are increasingly showing frustration in the current market offerings – making the segment ripe for disruption.

Execution Risk

Among the many risks in venture investing, another type of risk is called execution risk, which is the risk that the start-up will fail to execute its business plan.

For all companies, execution risk is unavoidable to some degree, but for early-stage companies, the most common root causes are:

  • Lack of Product-Market Fit (PMF)
  • Increased Competition (i.e., Emergence of Well-Funded Entrants, Incumbents Adapting)
  • Internal Organizational Issues (e.g., Conflict Amongst Founders or Existing Investors)

As the company matures and refines its business model and customer acquisition strategy (i.e., Growth Stage), execution risk tends to increase as the product has now entered the “go-to-market” stage with increased competitive threats.

Product Risk

Typically the most profound risk for early-stage companies still in the product development stage, product risk is defined as the chance the product (e.g., system, software) fails to satisfy or fulfill the expectations of the end customer/user.

The result of this is that the problem that the company identified (and aimed to have its product solve) was left unfixed.

The capabilities of the product fell short of expectations and failed to deliver on the proposed value that had originally enabled the start-up to raise capital in the first place.

Regulatory Risk

Another noteworthy risk to look out for is regulatory risk, which is the risk of regulations changing unfavorably.

To provide two examples of companies impacted by regulatory risk with different end results:

  1. Capsule: The digital pharmacy initially faced significant challenges in having to navigate regulatory risk related to patient medication confidentiality and comply with strict HIPAA regulations – however, this barrier was broken down by the normalization of telehealth and digital health companies (with COVID-19 becoming a major beneficial catalyst)
  2. Juul: The electronic cigarette start-up was once valued near $38bn and received a minority investment from Altria – but this appeared to be the peak of Juul as its valuation plunged to approximately $10bn following regulatory scrutiny from the public for marketing towards children/teenagers and nationwide bans on the sale of most of its top-selling flavors
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