A few years ago, VCs were expected to perform extensive due diligence on startups. Investors dove into financials, called customers and vetted founders.
But power has now shifted toward the founders after a long run of investors holding more than half the power thanks to the commoditization of capital. The pace at which deals were done increased, and the time to reach what VCs love to call “conviction” fell sharply. This compressed diligence cycles, leading to less intrusive vetting.
The acceleration of venture capital and the burgeoning check sizes in the last few years has led to a decline in traditional due diligence. The full impact of private-market investors doing less preparatory diligence than in previous years and cycles will not become clear for some time.
But, in the meantime, we can see a few clear ripple effects: Inflating valuations can lead to unnecessary pressure, making startups rush product development and hiring, and faster checks can lead to an over-reliance on existing networks, exacerbating an already brutal gender fundraising gap. Throw in the concept of Tiger Global bringing pre-diligence to deal making, and preemption is becoming the norm, with venture players rapidly changing how they make decisions.
TechCrunch’s Alex Wilhelm, Natasha Mascarenhas and Mary Ann Azevedo, the trio behind the Equity podcast, dive into what’s in store for startup due diligence.
Natasha: Informalization will continue, so long live the back channel
Back channeling has long existed in tech and all industries as a way for two parties to exchange information about a third in an informal, and hopefully illustrative way. In venture investing, back channeling can be used by an investor to gut check an entrepreneur they’re about to wire millions of dollars to — or vice versa, by the snappy founder who wants to make sure the money behind their money is stable. The process also helps stop predatory investors from winning deals, because, well, founders talk.
“Founders need to take their heads out of the clouds a bit and pay attention to what the investors can bring to the table.” Mary Ann Azevedo
The venture market doesn’t appear to be slowing down, so I expect next year will bring an even greater focus on back channeling in the world of first-check fundraising. The broader argument behind the growing importance of back channeling is that the only way to keep up with fast checks is to offer more channels for gut checking.
Before, due diligence looked like a months-long process with back-to-back in-person meetings. But as founder friendliness becomes the norm, it’s more important than ever for entrepreneurs to assess the check writer, understand their options and have better navigation in this capital-rich environment.
Founders will need to build alliances with investors, customers and even other founders so they can help each other when it comes to fundraising. This may help getting an outside investor to write a check, but more interestingly, it may help entrepreneurs simply build better and learn how to ignore a lofty valuation from a well-vetted partner. In the background, investors have to get comfortable with the idea that a founder may have already pinged a portco before they pitch you — it’s one to two minutes of work that can save time, resources and a doomed relationship.