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By Nicolas Sauvage

Due diligence has made a comeback. According to a study of 700 venture capital firms, a typical deal once took 83 days to complete. On an average deal, VCs would spend 118 hours on due diligence and call 10 references.

During the frothy “funding party” in 2021, VCs began prioritizing speed and cutting corners, leading to compressed cycles and less robust vetting. The assumption was often that someone else had already done the diligence. As interest rates rose and capital contracted, the ramifications became more clear.

In all four quarters of 2023, 19% to 20% of funding rounds were down rounds — well above the 10% to 12% pre-pandemic norm. While this was emblematic of the tightened capital environment, it also was an indication that the “incredible valuations” of 2021 were reverting to the norm.

With that, high-quality diligence has returned, and it is both art and a science. In venture investing, the intent of diligence is to thoroughly evaluate an opportunity and develop a high-conviction investment thesis.

Getting started

There are no hard and fast rules. A checklist can be useful but the “art” of due diligence is about homing in on the key issues involved in the upside and downside of the opportunity. For one startup, this could be about validating market traction; for another, it could be about unit economics.

There are patterns when it comes to diligence. In a survey of VCs, founders were cited the most often as an important factor, with 95% of VCs agreeing.

Other areas that investors may consider include the competitors and market dynamics, technology/IP, customers, financials, operational metrics, regulatory risk, governance, cap table and deal terms.

Reference calls are typically needed, both with contacts introduced by the startup as well as backchannel checks. Thorough diligence might involve dozens of calls with customers, supplemented with conversations with employees and analysts.

Diligence can look very different in early-stage investing, with investors indexing more heavily on the founders and market; 31% of early-stage VCs don’t even forecast financials, instead looking for a large exit and cash-on-cash return. When time is of the essence, such as in a competitive situation, investors might shift more of the diligence to the post-term sheet.

A later-stage investment takes longer to close and might look more like a private-equity deal with a data room. Investors will look for detailed financials, revenue breakdowns, contracts, corporate documents and IP portfolio, and dive deeper into technical due diligence.

Due diligence looks different for CVC, or corporate venture capital, firms. In one study of CVCs, 66% had “mostly” or “purely” strategic motivations. These CVCs spend more time validating the strategic overlap between the startup and their corporate parent. They may consider the product portfolios, synergy with channels and customer base, the potential for R&D collaboration or privileged access, and options for licensing or acquisition. CVCs are also evaluating how the cultures will mesh.

Due diligence mitigates risk not only for investors but also for founders. If well-managed, it can be a positive experience for all parties — a process that balances speed and rigor, and from which both sides can emerge with greater insight into the business and the challenges ahead.

As reality sets back in, investors are rebuilding the important muscle memory of how to do diligence — the yeoman’s work of venture capital. Looking ahead, 2024 has the potential to be one of the power-law vintages — assuming valuations stay reasonable and we learn our lesson from 2021. It’s no wonder that “diligence is the new black.”’

Nicolas Sauvage is the president of TDK Ventures, a technology-focused venture fund investing globally in early-stage startups that use material science to unlock a sustainable future for the world. He launched TDK Ventures five years ago with $350 million in assets under management and several investments, including the unicorn Groq. Previously, Sauvage worked at InvenSense and was responsible for strategic ecosystem relationships including Google and Qualcomm. He was also part of the NXP Software management team. He is an alumnus of Stanford, Insead, Institut supérieur d’électronique et du numérique and London Business School.

Illustration: Dom Guzman