Globally, in Q2’17, VC-backed companies raised $40.1b across 2985 deals. Due diligence was a layer implemented in every single one of those deals.
Due Diligence is the lifting of the hood – a chance for Investors to look around inside, poke, challenge & see whether the business they perceived from a deck & set of meetings, is what meets the eye. Why then do so many investors under-utilise DD?
DD appears to have become a box-ticking exercise. In a recent article (https://www.thetimes.co.uk/article/true-and-fair-no-annual-reports-are-as-clear-as-mud-70drdd2fh) Luke Johnson from the Times points out that annual reports are ‘as clear as mud’, DD appears to have fallen into the same trap.
DD should be about uncovering anything you might have missed at first pass, for that, investors need to hire people who will look at the company differently. Often investors just hire mini-mes, which leads to key data and trends being missed, then they are surprised they do not get to the CRUX of the target acquisition or firm. This behaviour is costing everyone.
SO WHY HAS DD JUST BECOME ANOTHER TICK BOX IN THE INVESTOR’S EYES?
Investors often solely focus on Financial & Tech DD, which gives you a one-sided view of the business. They hire people to do DD who they are comfortable with – people just like them. These people often only talk to the Board of the firm. There is so much more to be uncovered & so much more to consider. Good due diligence will take in a 360-degree view of the firm, it will look at the culture, management and product. It will talk to staff, clients and competitors. The clue is in the word diligence, DD should be all-encompassing.
An obsession with looking at the hyper-rational side of DD – the Financial & Tech DD – blind-sides the investor and hurts the firm. Here’s how:
- Tech founders fall into the trap of thinking as long as they have a good piece of tech, their company will thrive.
- Financial manipulation to cover up the true state of the P&L and balance sheet is more likely to occur where people see financial DD as a hurdle they must clear rather than see this as an opportunity to understand what’s working and what needs improvement.
- Unfounded emphasis placed on the leadership & board members’ CV and background means companies are forced to pull in members to name-drop rather than hiring based on ability to do the job.
- The culture of the firm – from top to bottom will go unnoticed and companies like Zenefits end up rising fast but falling even faster.
- Firms are busy trying to bag any investment rather than the right investment. This results in misalignment between the firm and the investor. This means investors end up buying into something that might look very different in reality.
- Loss of investment as firms are unable to deliver to the investor’s demands.
- Investments are made based on hype in the market causing valuations to be mispriced and impending the investor’s ability to price accurately.
- The DD process doesn’t add any value and help firms add clarity to refine their roadmap and strategic route forward to get from where they are today to their vision and ambition.
- Speculative bubbles & hype continue to drive up market prices.
- Tech firms continue to die 20 months post-funding round, destabilising the market.
HOW DO WE FIX THIS?
It is time investors looked through both a qualitative & quantitative lens.
This means the financial & tech DD should be married with thorough, insight-driven commercial Due Diligence. The customer, pricing, proposition, culture, team, projections must all be assessed. This must be done with rigour and evidence.
It must feed into the Financial & tech DD not sit as a siloed set of expensive “customer calls”.
Neotas, a human threat intelligence firm is leading the way in the market & helping PE firms break the cycle of siloed DD and help them dig into the management team beyond the typical criminal and financial records.
Having worked with and partnered with VC & PE firms on Commercial Due Diligence we know that when qualitative and quantitative data work in tandem, there will be strong signals which point at a firm’s problem areas.
Investors must be open to where these come from. It may be the P&L, or their CRM data by customer, but it also might be a junior developer or the way the team respond to challenge.
It is this combination of insight and data that actually shows an investor where they’re putting their money.
If you don’t look at your target acquisition through a 360 lens & continue to focus solely on your passion areas rather than the whole business then don’t blame your investment when you don’t get what you bargained for.
Find out more about Laven Partners’ due diligence services here.
We want to thank the author Alexandra Cheung, Associate Strategist at CRUXY & CO for allowing us to publish this article and for the great insight she provides into the importance of due diligence.