VC Diligence in Fast-Moving Deals

A Strong Start for Global Venture Capital in 2021

The global venture capital market experienced a remarkably strong beginning to the year. Building upon the peak performance of 2020, VC investment totals in the United States and Europe, as well as within competitive sectors such as insurtech and AI, are currently projected to surpass previous records in 2021.

The accelerated pace of deal-making and the increasing trend of larger investment amounts at elevated valuations, as consistently observed by The Exchange, necessitate quicker decision-making from private-market investors. Consequently, the timeframe for venture capitalists to establish confidence in a startup’s core concept and complete thorough due diligence has been significantly reduced.

In response, some venture capitalists are leveraging data analytics to expedite their processes. Others are dedicating more effort to preparing for their own scrutiny. Still others are proactively conducting preparatory work in advance.

The Rise of Pre-Diligence

The concept of pre-diligence was brought to our attention during research into recent fundraising patterns within the AI/ML sector. Sapphire investor Jai Das explained that, when navigating a highly competitive and rapidly evolving market for AI startup investments, “the majority of firms are completing their due diligence well in advance of the actual financing event.”

Specifically, startups that swiftly secure Series A and B funding are “monitored by [early-stage] investors almost immediately following their seed funding rounds.” This proactive approach eliminates the need for extensive due diligence during the financing process itself, leading to more preemptive investments.

Venture capital is increasingly focused on securing deals, demanding a more sales-oriented approach than ever before.

Today, The Exchange is examining how VCs are adapting their diligence practices to a landscape where promising opportunities can materialize and conclude with unprecedented speed. Traditional methods of in-depth diligence and deliberate deal-making are becoming obsolete.

The shift highlights a need for efficiency and foresight in the modern venture capital landscape.

Investors are now prioritizing proactive research and continuous monitoring of potential investments.

This allows for faster, more informed decisions in a highly competitive market.

The Rise of In-House Tech in Venture Capital

Investors are increasingly focusing on enhancing their own capabilities through technology investments. This strategy aims to accelerate the due diligence process and improve decision-making speed. While venture capital traditionally prioritized relationships, this shift towards internal tech development is noteworthy.

Creandum, a European early-stage venture capital firm, is actively investing in its technology infrastructure for deal sourcing. General partner Fredrik Cassel emphasizes the ongoing need to upgrade their tech stack to effectively identify and prepare for promising opportunities.

Recent reports highlight that firms like Correlation Ventures and EQT Ventures are leveraging machine learning and artificial intelligence, respectively. The core idea is that computers excel at tasks requiring speed and data processing, surpassing human capabilities in areas beyond creativity and speech recognition.

Innovative Approaches to Deal Evaluation

Some venture capital groups are exploring more advanced methods for gaining insights into potential investments. For instance, a team comprising members from Bessemer, Google, GV, and Pantera Capital is utilizing a custom algorithm to inform their investment decisions.

Beyond technological solutions, accelerating the deal process can also be achieved through efficient execution. Jenny Lefcourt, a general partner at Freestyle Capital, recounts an instance where a portfolio company secured a term sheet from a leading VC within just eight days.

This rapid pace necessitates both a concentrated focus – minimizing distractions from other potential deals – and strong collaboration. As Fredrik Cassel points out, Creandum has consistently succeeded in securing deals through teamwork.

The Importance of Teamwork and Network Mobilization

Cassel explains that their firm rapidly mobilizes its entire network, extending beyond the internal team to include successful leaders within their portfolio companies. This broad mobilization becomes even more crucial when deal timelines are compressed.

Therefore, while technology can streamline option filtering and decision-making, venture firms can also enhance their performance through strategic resource allocation and dedicated effort.

Ultimately, a combination of technological advancements and a focused, collaborative approach is proving effective in the competitive landscape of venture capital. This allows firms to remain at the forefront of identifying and securing promising investment opportunities.

The Importance of Human Interaction

Although technology can significantly aid in creating a more informed decision-making process, it cannot handle the entire workload, according to Manuel Silva Martínez, a general partner at Mouro Capital. He emphasizes that there are often misunderstandings regarding the practical capabilities and limitations of data.

The constraints of data-driven strategies become more apparent as one progresses further along the investment pipeline, he explained. A machine, despite its advancements, cannot replicate the discernment of an experienced investor when deciding which company to offer a term sheet to.

Cultivating Relationships

Consequently, venture capitalists continue to dedicate substantial effort to relationship development, irrespective of the investment stage. Das shared that even companies focused on seed-stage AI and ML are tracked and relationships with their entrepreneurs are established following the completion of their Series A funding round.

This principle extends beyond startups to encompass co-investors and other sources of potential deals. Rebecca Lynn, co-founder and general partner at Canvas, stated that her firm has prioritized strengthening relationships with seed funds and angel investors, particularly given the accelerating pace of funding rounds. Canvas recently finalized its third fund with a total of $350 million.

Challenges of Remote Interaction

The traditional methods of relationship building, such as frequent in-person meetings, are becoming less common, and the reduction in direct human contact has presented obstacles. Jeff Grabow, U.S. venture capital leader at EY, described this shift as an independent advisor.

He noted that limited opportunities for spontaneous networking and interaction hinder investors' ability to identify emerging companies. Historically, these crucial conversations occurred at industry conferences and networking events, but these avenues have been disrupted by recent circumstances. However, he also believes that both entrepreneurs and investors have adapted effectively.

Technology as an Enabler

As expected, technology has stepped in to bridge the gap, making fully remote deals – once considered improbable – a common occurrence. Critically, technology doesn't replace personal connections; it enhances them.

For example, Affinity, a relationship intelligence platform, highlights how VCs can leverage its specialized CRM to maintain contact with key introducers, nurture relationships with co-investors, develop watchlists of companies within their network, and monitor strategic advisors.

Leveraging CRM for Investor Relations

Maintain contact with top introducers.
Strengthen relationships with co-investors.
Create watchlists of companies.
Track strategic advisors.

The Importance of Preliminary Investigation and Accountability

Reinforcing the observation made by Das concerning pre-diligence, Jocelyn Goldfein, an investor specializing in AI from Zetta Ventures, has stated that her company has invested in internal systems over the past three years. These systems utilize data to pinpoint startups and prospective founders even before they begin fundraising.

According to Goldfein, this proactive approach grants her firm an “early look” at companies, providing the “option of preempting” investment opportunities.

The development and implementation of Zetta Ventures’ proprietary AI technology allows for, as Goldfein explains, a “deeper understanding of the market.” This enhanced comprehension subsequently aids the firm in “evaluating startups before they reach typical seed traction metrics.”

Considerable effort is expended simply to gain the possibility of investing capital in another entity. Previously, securing even a modest $2.5 million Series A round often required significant concessions, such as relinquishing a 25% equity stake. The balance of power has demonstrably altered.

To understand the current landscape, it’s crucial to recall the historical context: Following the global financial crisis of 2008, interest rates experienced a substantial decline. Consequently, returns on traditional debt investments diminished, with negative real yields becoming a possibility.

This led to a greater influx of capital into alternative investment avenues, including venture capital. Venture capitalists were able to raise larger funds, and a proliferation of private-market investors emerged, launching funds spanning from pre-seed to late-stage investments.

Given the choice, a founder would likely favor the appealing and readily available offer, rather than delaying to address an extensive list of inquiries from another firm presenting comparable terms. While other elements are at play, this encapsulates the evolution that has led to investors developing their own AI models to gain an advantage in securing seed deals.

The actions of Tiger Global, now influencing the venture market through larger, quicker investments without the conventional venture capital prerequisites of board representation and post-investment control, represent a further progression in the ongoing transformation of private-market investment standards.