“Week 3 of VC School: Qualitative Due Diligence” is part of a ten-week series from the interns at Bowery Capital. The series will cover lessons learned and concepts covered during the weekly “VC School” meeting, a program taught by the Bowery Capital team designed to teach interns the fundamentals of the venture capital space. This summer, we want to open our doors and share these lessons with the broader community.
Qualitative Due Diligence
So you’ve sourced a potential deal. Now it’s time to assess the positives and negatives, risks and rewards of the opportunity at hand. Most qualitative due diligence comes before the term sheet is written and signed, although post-term sheet due diligence is important too as term sheets are typically non-binding. Some main things to consider when conducting qualitative due diligence are below.
1. Market Size. The market in which the prospective company operates must be big enough to satisfy limited partners’ expected return multiple. Many Seed stage LP’s require 5-6x due to the outsized risk of early stage investing, so the market needs to be large enough for this growth to be attainable. Series A+ firms usually require 2-3x returns, so it is important to keep in mind that later stage pre-money valuations need to be reasonable as well.
2. Team. Getting to know and building a relationship with the core team of the target company is imperative. How do the founders and other key members compose themselves, answer questions and respond to criticism? Are they transparent and coachable? Or are they “yes men/women” or people pleasers? It can be a red flag if they are solely focused on keeping investors happy. In our view, the founding team is the most important variable when looking at success versus failure. Ideally, a founder/founding team is experienced, rational about the state of the business, and flexible enough to pivot if (and probably when) the road gets a little bumpy.
3. Product. Seed stage investing often entails investing in little more than an idea. In other words, it is largely about the founders’ vision and product road map, rather than the current product itself, that carry the most weight. It is important that the investment team is on the same page with the founders in terms of where they see the product going over the foreseeable future, and how they plan to get there with this Seed investment.
4. Competition. Ideally, a target company will offer unique features and operate in a space with mostly legacy competitors. At the end of the day, if the prospective founding team is better than other competing founders and the product is legitimately differentiated, there very well may be an opportunity. If the company has no real differentiators from its competition, it will probably be a pass.
5. Financials. Given that Seed stage companies typically do not have a long track of financial performance, much of the financial due diligence is focused on sales projections. It is important to focus on the key factors that drive revenue, such as the number of customers, current/anticipated pricing model, up-selling strategies, and so on. A conversation with the founders about how they think the business will succeed is a helpful way to gain a better understanding of the direction of the company. Later stage firms tend to be more metrics-oriented, focusing on more granular details such as customer acquisition cost (CAC), lifetime value (LTV), churn rate, and so on.
6. Deal Terms. As due diligence progresses, the investment team will take a look at the deal terms proposed by the founders. This usually entails the pre and post-money valuation, size of the round, size of the option pool, other investors in the round, and liquidation preferences. Additionally, regarding current and future ownership, it is important to analyze dilution in future rounds.
If the investment team decides that this company is worth pursuing, the next step is to draft up an investment memorandum. From a high level perspective, the purpose of an investment memo is to summarize the due diligence. Generally, the opening sections outline the positives and concerns, opportunities and risks, and potential mitigants for these risks. Subsequent sections outline the product and its features/benefits, competition (usually exhibited by a comps table), and the management team. When detailing the management/founding team, it is important to describe why they are the best suited to execute on this idea rather than other founders in the space.
1. Checklists. Y Combinator and Octopus Ventures both have very good Seed and Series A due diligence checklists. MicroVentures published a good visual representation of what due diligence in VC looks like.
2. Documents. For more details on what goes into an investment memo, check out NextView Ventures’ blog post. For a more in-depth look at term sheets, take a look at Early Growth Financial Services’ post.
As always, Pitchbook and CB Insights and are great resources for high quality information, particularly when assessing market size and competition.
If you liked “Week 3 of VC School: Qualitative Due Diligence” and want to read more content from the Bowery Capital Team, check out other relevant posts on the Bowery Capital Blog.