The Business of Venture Capital, 3rd Edition

22Diligence

Due diligence is the art of sizing up an investment opportunity — its potential outcomes and major risk factors. A good opportunity tests the limits of our observations and experiences, even the limits of our networks and imagination.

Identifying the potential for value creation and estimating its sustained advantage is the heart of any due diligence activity. Mitch Lasky of Benchmark Capital says, “I almost hesitate to use the word due diligence because it implies a certain methodical rigor — rather we ask, what are attributes of successful venture investments.” Investors primarily focus on the two primary attributes:

• Management. Do the CEO and the leadership team have a sparkle, a sense of enthusiasm, penetrating intelligence, and courage? Even if they have not done it before, these qualities are essential. Is there a glimmer of greatness?
• Market. Does this opportunity have the potential for creating outsized returns? Is the market ready for this product?

Early-stage investors seldom start with valuation or financial projections. Though it is important to understand financial budgets and capital needed to accomplish major milestones in the next two years, far-out, “five-year” projections or exit multiples are useless artifacts. The two major criteria — management and markets — trump the rest of the diligence criteria by orders of magnitude. Warren Buffett summarizes his due diligence process with four simple criteria:¹

1. Can I understand it? Buffett defines “understanding ...