Considering broad, global volatility spanning economies, markets, and geopolitical matters, the state of venture capital has shown signs of cooling off after a red-hot 2021. Global venture funding reached $143.9B raised across 8,835 deals in Q1’22, down 19 percent from the previous quarter’s funding.
Still, despite the slowdown, Q1’22 marked the fourth-largest quarter for funding on record. This came after a record-breaking $621bn raised by global tech startups in 2021, double the prior year and ten times 2012 levels. Data for the second quarter of 2022 suggests VC investors continue to take a cautious deal-making approach in navigating the impact of the public market slowdown on their industry and investment markets broadly. Even with the considerable amount of dry powder investors are holding on the sidelines, inflation and the prospect of recession preoccupy capital markets and continue to influence valuations; while most of the larger VC-funded private companies sit on warchests raised last year, and so can delay their valuation reckoning, companies forced to raise additional capital illustrate the likely damage – take Swedish fintech startup Klarna, which raised capital in July in a “downround” priced 87 percent below its valuation one year earlier. By the end of June, more than two thirds of VC funds were reporting valuation markdowns in their portfolios. Secondary markets, where private company and fund stakes can be bought and sold, are also showing double-digit declines: Investment Bank Jefferies estimates in its mid-year report that “Pricing decreased across all strategies as the year progressed, including most notably for venture funds, which declined precipitously to 71 percent of NAV in the period.” This compares to an average 86% discount across buyout, venture capital and real estate strategies during 1H22, illustrating investors’ greater concern surrounding startup valuations.
Some things, however, never change. Regardless of widespread uncertainties, during any period, the indispensable role of thorough due diligence as part of the VC investment process remains constant, which makes instances of shortcuts taken by VC investors – including “household names” in the industry – even more notable. A review of recent VC “misses” reveals that some seasoned, successful VCs may not be doing the type of due diligence needed to make informed investment decisions.
As it turns out, even some of the savviest VC investors are susceptible to biases that can arise in the process of choosing whether to invest in a business.
Venture Capital Due Diligence Practices Unevenly Applied
It is standard practice among VC firms to approach due diligence from two levels. The first stage of due diligence involves determining whether a potential investment opportunity makes sense strategically. In other words, would an investment be consistent with the investing thesis on which that target firm is focused? Identifying companies that are valid candidates for a VC firm’s “funnel” is rudimentary, and is meant in each case to answer core questions such as: “Is this business in our sweet spot? Is this a company we believe will succeed long term?” This first stage is typically handled in-house by seasoned partners guiding associates and analysts who know their industry focus and how to identify winning business models and management teams.
It is in the second round of consideration, after a company has met funnel criteria, that a VC firm must dig into the specific business in each case, screening for feasibility, validity, and viability as a going concern. It’s here that a surprising number of VC firms can slip up, and where third-party due diligence, subject matter expertise, and vetted local contacts can add value.
Large shifts in economic and business climate conditions can have the effect of disrupting the usual thoroughness associated with due diligence. A market space experiencing rapid expansion and a spurt of new entrants can create enough “noise” to distract even the most disciplined due diligence teams from their customary mission. By way of example, “traditional” VCs often grumble about the disruptive effects of new entrants – such as hedge fund crossover, Tiger Global, as well as Softbank – both of which move quickly, write large checks (often before being approached by a startup), and make fewer demands such as board representation. “Fear of missing out” on the next Google pressures VCs to cut corners, shorten periods they conduct due diligence, and eliminate usual protections.
Recent examples of due diligence failures among top VC firms underscore the VC community’s degree of vulnerability, and call attention to the importance of having the resources, systems and, importantly, the discipline to surmount distractions and stay true to the firm’s established best practices when it comes to conducting due diligence.
Missteps in Venture Capital Due Diligence
It may surprise some to see iconic VC names succumb to insufficient due diligence practices, but it’s far from uncommon. Over the last year, the emphasis on technology that characterizes VC investing has suffered, owing to the sharp stock market decline that has punished unprofitable tech companies with fast revenue growth; such companies’ value is based on profits projected far into the future, so they are disproportionately impacted by rising interest rates. Technology is the very category that has drawn investors as it flourished during a decade of low rates.
The most prominent recent example of the perils of insufficient due diligence for VC-level investors is the swift rise and meteoric fall of Theranos, the blood testing startup founded by entrepreneur Elizabeth Holmes. Theranos shut down in 2018 following claims about its blood-testing technology, which were shown to be false. Holmes was later convicted on four counts of fraud for intentionally deceiving Theranos Inc. investors; however, her appeal process is expected to continue for some time.
How did VCs go wrong? One Theranos investor, a lawyer and power broker among wealthy families, requested audited financial statements from Theranos but never received any. That didn’t deter him from investing $6 million in the company anyway. Despite lacking a detailed grasp of the startup’s technologies or its work with pharmaceutical companies and the military, Hall Group sunk $5 million in Theranos in 2013.
And the head of investments for Michigan’s wealthy DeVos family later acknowledged that she did not visit any of Theranos’s testing centers in Walgreens stores, call any Walgreens executives or hire any outside experts to verify the startup’s claims before investing $100 million in the company. This is precisely where IntegrityRisk can add value, as we regularly provide discreet, local source expertise around the world.
In addition, global tech and venture capital investor SoftBank Group Corp. reported a record quarterly loss of more than $23 billion in early August, a development that Chief Executive Masayoshi Son attributed to a market rife with “delirious” valuations that quickly turned sour on his watch. SoftBank’s startup investment arm, the Vision Fund unit, has lost more than $50 billion in gains from its peak, leaving the firm with just a slight gain above its cost. Losses were spread across its vast portfolio. Additional attention to the market aspect of the due diligence process in this instance may have served SoftBank well, as the rising risk in the technology sector, driven by interest-rate increases and China’s crackdown on tech companies, could have been identified as a greater red flag.
These recent two examples highlight the degree to which pressures on VCs to get in on the ground floor of what may be the “next Amazon” are intensified when market valuations become overheated.
Renewed Emphasis on Due Diligence in the VC World
There’s no question that many VCs have adopted thorough, comprehensive due diligence practices. Yet the preponderance of accomplished VCs committing substantial capital to companies that never should have made the final cut attests to the perilous draw of market exuberance, even on the brightest investment minds in the room. One founding partner in a successful VC fund told IntegrityRisk over lunch, “You would be shocked by how little due diligence we perform,” having confessed that his firm is frequently invited into deals by “the big boys” and presumes they have done their homework. We are starting to see this change, however, as market conditions deteriorate, and younger VCs start to “lead” rounds. We work with university-backed VC funds, which tend to be more conservative as fiduciaries to their LPs’ funds. We have also found chastened VC, having been forced to write off an investment when red flags could have been identified, eager to outsource due diligence that complements analysis performed in-house.
Identifying the appropriate due diligence in any case, and activating that plan, is made substantially easier with the help of a qualified, experienced advisor. One who specializes in knowing exactly what due diligence and/or compliance measures are necessary to mitigate current venture capital-specific risks, and thereby helping VCs keep pace with steadily evolving regulatory actions and enforcement measures.
Charting a course to a sound, comprehensive approach to VC-focused regulatory due diligence can be readily accomplished. Contact the experts at Integrity Risk International to learn how we can help.