Due Diligence: Where Art Meets Science

I had an interesting conversation with a group of venture capital friends about due diligence. We talked mainly about early stage IT companies and for almost an hour we couldn't agree on the profile of the perfect process. About half of the group argued that the most effective due diligence is the one conducted by a highly analytical person, while the other half believed that most of the red flags could be uncovered only by polished interpersonal skills.
We analyzed some data and shared our experiences about deal-breaking facts we uncovered conducting due diligence and how we came across them.
  • Looking at the financial model the company was expected to grow to more than 100% of the TAM… deal-breaker
  • When sensitivity analysis was done the projected growth was extremely sensitive to a variable that was extremely out of line when compared to industry standards… deal-breaker
  • A relaxed lunch/dinner with the entrepreneurs revealed they were looking for funding to build a lifestyle business… deal-breaker
  • When talking to potential customers that were not on the reference list the solution proved to be more of a vitamin than an aspirin… deal-breaker
There was still not consensus at the end of our conversation so we decided to move on and talk about something less controversial, such as politics and religion…
After thinking about the issue for a while, however, I can say that it is not a question of either/or. A thoughtful due diligence, focused on revealing the true risks and opportunities of a startup, needs to be both: an art and a science. The science needs to understand the financial model, total addressable market, sensitivity to critical parameters, etc. The art, on the other side, needs to focus on understanding who the entrepreneurs are, what do they want, who the customers are and why they are willing to pay for the company’s solution, among others.
You can have extensive checklists to follow, but at the end, if you don't master the art and science required to conduct sound due diligence, you can jeopardize what matters most to you and the firm you represent: reputation. Don't forget that even though you might uncover deal-breaking red flags in your process you still need to be respectful of the entrepreneur's work, passion and dedication. It might take a couple of tries but eventually they could figure it out and you want to be there to support them. You will only accomplish this if you do your job with a long term vision of building a network and protecting your reputation.