Is Venture Capital Due Diligence An Art or Science?

Having a streamlined and consistent due diligence process is one of the hallmarks of a disciplined investor. Whatever asset class you invest in (public markets, private markets, real assets, etc.), it’s important to follow a process and continually refine that process over time. There is no best way to perform due diligence. However, for investors interested in private markets investing (e.g., venture capital and the like) the due diligence process will sometimes feel inconclusive especially if you’re the type of investor looking for 100% clarity before making a decision.

What is due diligence? Crudely defined, due diligence is the act of gathering information for the purpose of making a decision. There are two types of information that investors seek to acquire: quantitative information and qualitative information. Quantitative information is information that is discoverable, analyze-able, and unambiguous. Qualitative information on the other hand is the complete opposite. When it comes to private market investing, what can separate good investors from great investors is their ability to synthesize and make sense of qualitative information that can be used as guide to make better investment decisions. Quantitative thinkers may, at times, underestimate the value of qualitative data because it is subject to interpretation. Therein lies the rub. Is investing in venture capital more an art than a science? Or is there a science to analyzing qualitative information such that it’s just as useful as quantitative data?

To become an effective private markets investor, it is important to abandon the world of certainty and embrace the concept of probability. In other words, as a private markets investor you’re not going to be get it right every time, and that’s okay. However, it’s not okay, nor financially feasible, to be wrong more often than being right. According to Scott Kupor at Andreessen Horowitz, “Venture capital firms with the highest batting averages do not usually make the best VCs.” He goes on to say, “Good VCs get a win about five times out of ten investments. This may sound good, but it’s not. The reality is the average distribution of returns is that 50 percent of investments are likely to fail, 20-30 percent will do okay, and 10-20 percent may return ten to one hundred times the original investment. To use a baseball analogy, where the average investor seeks a high batting average (i.e., smaller but regular wins), venture capital investors should care more about at bats per home run. That is, the frequency with which the VC gets a return of more than ten times their original investment (1).”

Qualitative due diligence takes the form of meeting with entrepreneurs to understand their vision, mission, or objective, making numerous reference calls, and evaluating market assumptions. The ultimate objective in gathering this type of information is not to be correct per se, but to better inform yourself so that you can make a ‘best guess’ given the information that you have. Experienced private markets investors have developed an ability to recognize patterns when collecting qualitative information which is an important skill that is usually learned over time.

As stated previously, a thorough due diligence process consists of performing both quantitative and qualitative analysis. Both are equally important, and neither should be underestimated. However, as a private markets investor it’s important to establish a process for performing due diligence so that you can feel more comfortable making decisions based on probabilities when you’re operating in a world where outcomes are generally unpredictable.

If you’re interested in further reading on the topic of investing in venture, thinking in probabilities, and venture capital due diligence, I suggest reading “Secrets of Sand Hill Road” by Scott Kupor, “Thinking in Bets” by Annie Duke, and “Beyond the J Curve, Managing a portfolio of Venture Capital and Private Equity Funds” by Thomas Meyer and Pierre-Yves Mathonet.

Cheers – Kevin Moore

Sources:

(1). Secrets of Sand Hill Road by Scott Kupor.