When it comes to venture capital and financing tech startups, how can potential investors tell the future Facebook from a potential Groupon? The only way to avoid an investment disaster is to perform due diligence.
The process of mitigating investment risk through analysis and investigation is known as due diligence. For an angel investor, the goal is to determine if the risk is worth taking; for a venture capital group, the goal is to determine if an investment will fit adequately within a portfolio without dragging down other projects.
The three most important aspects of due diligence as a Venture Capitalist:
Full Trust in Management
Some of the most notorious failures in the history of tech startups involve malfeasance, ethical issues, fraud, and misconduct perpetrated by entrepreneurs and managers. Investors are not obligated to like the principals of a startup, but being able to get along with the entrepreneur and his chosen team is essential. Personality and human conduct are not acceptable risks because they rarely change. Honesty and integrity are not only critical but also vital; business activities cannot take be conducted without these traits in place. Trust also means transparency; to avoid a Theranos situation, there must be an understanding about full disclosure between directors, managers and investors.
If a startup is stuck on a single concept and is unwilling to seek other approaches to profit generation, investors should strongly consider their commitments. What if a product or services fizzles despite the good judgement of the entrepreneurs? Will they agree to switch gears? Will they be able to come up with a new idea? Investors must investigate the level of creativity and functionality of their entrepreneurs. The rule of thumb in this regard is to consider whether the startup leader would make a good job candidate for a highly paid managerial position.
Market and Competitive Analysis
Not all tech startups will end up being a huge success. Some will make their money back and then gradually fall out of favor. When this happens, it is usually because a competitor was too imposing or the market conditions were not adequate. To this end, the initial due diligence process should also include some ideas related to a potential exit strategy.
The three initial considerations above should not be the end of due diligence; if the observations are positive, they may signal that the road is clear for further investigation of the startup and what it has to offer.
Chris Burch is a leading venture capitalist and the founder of Burch Creative Capital.