The truth about due diligence

There’s an expression in venture capital. It’s called the “Oh, shit” board meeting. “That’s when you learn all sorts of things that you wish you’d known after writing a company that first check,” says general partner David Hornik of August Capital.

It’s easy to imagine that they’ve been happening regularly across the startup industry. The pace of funding in recent years has been feverish, giving investors less time than ever to assess the startups they’re funding. That once-celebrated companies like the blood testing outfit Theranos, and the wireless charging company uBeam, are seemingly fighting for their lives raises plenty of questions, too.

A recent Vanity Fair piece blamed Silicon Valley media (and TechCrunch in particular) for the rise of certain companies. Meanwhile, a story published earlier this week in Fast Company suggested a culture of spin is at the root of the problem. As one founder told the outlet, “Being honest in Silicon Valley is like being the one member of an Olympic team that isn’t on steroids.”

Of course, none of us would likely have heard of Theranos or uBeam if not for investors, who’ve given the companies $686 million and $25 million, respectively. Were these backers overly optimistic? Did they get duped? Were they even paying attention? It’s easy to wag our fingers as we wait to see how these narratives unfold, but here’s the truth: due diligence only goes so far. While some may think it a scientific process that insulates venture firms from bad investments, due diligence is a surprisingly imperfect process with plenty of limitations.

“If you’re looking for a black or white answer in doing diligence, it’ll be a fail,” says Matt Murphy, a former Kleiner Perkins Caufield & Byers partner who joined Menlo Ventures a year ago as a managing director. “You’re usually dealing with shades of gray.”

The truth will set you free

As you might imagine, due diligence means different things, depending on the sector in which a startup is operating and the stage of its development. At the outset, say VCs, it usually involves some combination of gut instinct, research into the market opportunity (when there’s a market to research), and, done properly, lots of calls about the founder who’s pitching them.

“The challenge you have when it’s early days is an entrepreneur with nothing to sell but vision,” says Bob Ackerman, the founder and managing director of Allegis Capital.

Typically, VCs are handed references, and those are easy enough. “You’re usually introduced to a set of people who’ve worked with the entrepreneur, and you have that set of calls and they go well, because the entrepreneur has steered you to those people,” says Hornik.

If a VC is really doing his or her homework, that person will then find former colleagues of the founder who aren’t on their list of referrals.

Even then, some reading between the lines is required. “The natural inclination of people is say perfectly nice things, even when someone hasn’t done a good job,” says Hornik. “When someone tells me that someone ‘did a great job,’ and that they were a ‘good leader,’ that’s a bad reference. A good reference is, ‘This person is amazing. I would work with her again in a heartbeat.’ That’s what you want.”

The same is true of customer calls later in a startup’s trajectory. Naturally, VCs are given the names of customers who are predisposed to like the company. But “you have to find off references,’” says Murphy of Menlo Ventures. “If the potential buyer is a chief security officer, then you talk with some CSOs who the company hasn’t spoken with and you explain the product and the pain point and you ask if they would take a meeting or, sometimes, whether there’s another competitor that they are working with.”

Due diligence looks different depending on the opportunity, too. Jonathan Abrams, the founder of social news aggregator Nuzzel, is a limited partner in the funds of Data Collective, a San Francisco-based venture firm that prides itself on making wide-ranging bets, from satellites to antiviral therapeutics. Abrams notes that, as with many firms, Data Collective has advisors who are PhDs in numerous specialties to help them with due diligence around products the partners might not understand as well.

“If you’re investing in the next Snapchat or Slack, many VCs might feel confident investing on their own,” says Abrams. “When you’re investing in something that’s harder to understand, that’s less likely to happen.”

Just the facts, ma’am

That’s not to say that VCs couldn’t be doing a better job. For example, it’s easy for investors to lose touch with what’s happening, especially when they’re funding more mature startups, sit on a large number of boards, and/or don’t feel the need to keep close tabs on things. (One founder who asked not to be named calls one of his follow-on investors a “good-time Charlie,” implying the firm doesn’t do a whole lot for the company.)

Even board members who are engaged can be deceived in tough times. “It’s no problem for entrepreneurs to mislead you when you’re on the board,” says Hornik. “Where [you] find out that a CFO has been lying or someone has stealing, you sort of say, ‘What could I have done?’ But the reality is that as a board member, you aren’t auditing the company. The best thing you can do is have a close relationship with people throughout the company, so you can hear what’s going on from a range of sources. If you don’t, it increases the likelihood that you can be vaguely misled.”

VCs can also perform too much due diligence, apparently. “You can overdo it,” says Murphy. “You can talk yourself out of a lot of things by talking with the right or wrong people. It’s easy to wobble between calls. A lot of this stuff is a leap of faith, which is what makes this business so damn hard.”

“You can understand VCs wanting to avoid investing in the next Theranos,” agrees Abrams, who has raised millions of dollars from VCs across four companies and has personally invested in roughly 50 startups. “But getting too risk averse isn’t good either. Sometimes, companies where there are red flags in the beginning end up producing the largest wins.” Uber is a prime example, he notes.

Yet the biggest sin committed by investors is simply relying too heavily on their peers’ reputations as a form of due diligence. (It is not.)

Clinkle — a payments company whose $25 million “seed” round in 2013 was billed as the “largest in Silicon Valley history” —  is perhaps the highest-profile example of this type of misguided thinking. Its syndicate included Accel Partners, Andreessen Horowitz, Intel and Intuit, along with more than a dozen tech celebrities, including Peter Thiel and Marc Benioff. The company’s product never reached the market. Instead, by the spring of last year, Clinkle had largely imploded.

The WSJ has similarly suggested it was the endorsement of DFJ, which has backed Space X, Tesla Motors, and Planet Labs, and that wrote Theranos its first check, that attracted further investment to the company. Star power seemingly attracted star power to uBeam, too. Its backers include billionaire Mark Cuban, Yahoo CEO Marissa Mayer, Peter Thiel’s Founders Fund and Andreessen Horowitz.

“I don’t think [founders] are necessarily trying to mislead anyone,” says Ackerman. But they “borrow credibility from others – their advisors, their directors — knowing if they borrow that stature, it will make it easier for them to fundraise. You especially see that behavior become pronounced when the money is flowing.”

“I’ve been surprised how some investors will oftentimes just go in behind a big brand, like, ‘Hey, if this is KP and Sequoia, and [the deal includes] this partner and this sector, we need to move quickly,’” says Murphy, who insists that smart VCs know better.

“If there was a blind spot you could have checked out [and didn’t], then shame on you,” he adds.

Three sides to every story

Of course, venture investing is based on taking risks. It means making bets on technologies in a world that’s changing faster than ever. Aside from the obvious challenges around fraud and founders who inflate their abilities, there’s always a danger that a company’s technology will check out on paper but not survive in the marketplace for one reason or another.

“Environments change. People change,” says Ryan Sarver, a former product director at Twitter who joined Redpoint Ventures two-and-a-half years ago as a partner. “After you invest, things sometimes change that you couldn’t have predicted.”

It happened to Ackerman, he says. “A bunch of years ago, we invested in a technology out of Stanford, and based on our review and the developers of the tech and what was going on in the marketplace, we viewed it as really disruptive.”

What Ackerman says he didn’t understand was “how much of the fundamental science was left to be proven. We were doing groundbreaking stuff, and we weren’t as close to the end of the process as we collectively thought we were. We started making assumptions about where the problems were going to be, and we realized there were a lot more problems to be resolved than we’d anticipated.”

In the end, says Ackerman, the product missed its window.

He regrets that, but he doesn’t beat himself up about it, either. It’s the nature of the beast.

“There was no real road map. We thought we were at Y but we were at X. I’m not sure there was another way to discover that.”