the Curtain: VC Due Diligence Is No Mystery
By Vince Occhipinti
April 4, 2006
If you ask ten funded entrepreneurs what happened during
the VC due diligence process, you will get ten different answers,
according to Vince Occhipinti of Woodside Fund. Some will say they
lost valuable months answering endless questions for VCs that never
produced a term sheet. Others may admit they gained valuable insights
to their business.
I am uncertain when the due diligence process gathered so much
mystique, but among entrepreneurs, there is still an urban myth
status about what happens behind close doors.
We believe it shouldn't be a mystery. Understanding due diligence
improves the information flow between venture funds and potential
entrepreneurs. Better information leads to better investment decisions
and better long term partnerships. In my opinion, due diligence
- A process designed to get a 360 degree view of the business.
- An evaluation of an entrepreneurs' ability to ascertain strength
- An opportunity to validate true customer demand.
- The beginning foundation of trust and partnership.
Due diligence is NOT:
- Slow torture in the form of a lengthy checklist.
- A stress test for the executive team.
- A chance to prove we are smarter than you are.
- A justification to ding your valuation.
- A delay tactic until another fund takes interest.
What You Can Expect
All VCs go about due diligence in their own way, but there are
a few key areas entrepreneurs should always expect. At Woodside,
our due diligence process focuses on three primary areas: market,
technology and team.
A good venture fund can do a lot to help a company, but we can't
make customers buy products. Ninety-nine percent of what comes through
our doors are nice-to-have products presented by entrepreneurs as
Customers can't just have a need for your product or service. That
need must be important enough to them personally
to cut through the 100 other priorities currently occupying their
day. Customers buy for personal reasons not just
for the good of the company.
Entrepreneurs must challenge their prospects to get to the real
truth. After a customer states they have a need for your product,
you might probe further: I appreciate your enthusiasm but you must
have at least 50 other projects right now. How realistic is it that
you would even find time to evaluate our product let alone buy?
If your prospect truly must-have your product they will defend their
pain. If they don't stand up to the plate, then it will not yield
a real customer.
Woodside would ask prospective customers the following questions
to understand that level of personal pain:
• How long have you been dealing with this problem?
• What have you done to date to address this problem
• What is the real impact on the organization?
• Can you quantify this
• What happens if you do not fix this
• Of your top 10 priorities, where does this fit
• How much would they be willing to pay
• How important is this to you personally
We validate these answers with dozens of customer calls. We'll
talk to the entrepreneur's reference list (undoubtedly well prepped),
but more importantly, we speak with prospective customers, technical
leaders and industry contacts where we have prior relationships.
No validated pain, no deal.
While this is the foundation of our market assessment, of course
every VC assesses the opportunity in terms of projected market size
and potential competition. The presentation with the proverbial
bar chart sloping up and to the right, however, does not impress.
We are less interested in Gartner and IDC market predictions than
realistic bottoms-up, total addressable market (TAM) analysis based
on your target customers.
We often see the obligatory competition slide with the company
logo in the upper right hand corner of a standard two-by-two matrix.
This is helpful but not sufficient. You must articulate beyond four
quadrants your competitive barriers to entry, your unique differentiators
and your future competition. The kiss of death is for us to find
unanticipated competition you neglect to mention. Know potential
Technology differentiation is a critical element to Woodside's
decision process. The important point is to not only have technical
differentiation, but also to insure it translates to compelling
differentiation to customers in the market.
As early stage investors we rarely are investigating a complete
product, therefore our technical review is as much about people
and processes as it is about the code.
Our technical due diligence typically starts with a full one to
two day review with the engineering and product marketing staff.
During this session we want detail on the following:
- Market requirements processes
- Feature specification processes
- Roadmap processes
- Architectural review processes
- Engineering schedule process
- Quality assurance processes
- Documentation processes
Our goal is to feel 100% confident that the team is capable of
building exceptional products-now and in the future. We validate
all of our due diligence with outside consultants and industry experts
close to our fund. Finally, we round out our technology assessment
with a comprehensive intellectual property and patent protection
review. We must ensure all technology differentiators are well protected.
Technical recruiting processes.
Looking back over our 20+ year history, Woodside's success has
depended on great talent. Our goal is to build world class teams
starting with talented founders and complementing their skills over
time. We believe we have a proven methodology for assessing founders
and executive teams. While I can't assure you that all venture interviews
will be like this, it will prepare you fully for what might come.
Typically we begin with the perfunctory questions that happen in
most interviews. After one hour, we will invite you to the whiteboard
to diagram the last two to three organizational charts associated
with your prior most meaningful jobs. These charts include managers,
peers and direct reports by name. For each individual on
that white board, we may ask the following:
- How would you describe this person's management style? (Getting
- If we where to talk to this person, (with your permission of
course) how might this person describe your strengths?
- How would this person describe your areas for improvement,
where would you be considered "less than perfect?
- Who might your supervisor or board say you had the most difficult
- If we were to talk to the previous CEO, how would they say
your were perceived in the organization?
- Among your superiors, peers and subordinates, which group would
rank you 1, which one 2 and 3?
This three to four hour process typically has the following outcomes:
- We are obtaining instant reference checks.
We have built a list of names to call that are off the official
- When we call these references, we describe the organizational
chart process and receive far more candid feedback.
- Most importantly, we begin a relationship based on trust. From
here on out, if we invest, the CEO knows they can come to us with
problems before they may have solutions.
Woodside believes the time invested up-front pays huge returns.
Remember the last time you interviewed an employee? Most have only
an hour to get to know the candidate, with the first 30 minutes
allocated to describing the company and the job. If this employee
does not work out, you will most likely spend more then an hour
getting on a plane to fire the employee than you did interviewing.
Parting Practical Thoughts
As you go through the due diligence process, here are some practical
tips to keep in mind:
- Continually take temperature. Only 5-10% of
entrepreneurs I work with ask closing questions like: Have I answered
all of your key questions? Or, even better: How do I compare with
the other 100 business plans on your desk and what is the likelihood
we'll reach serious due diligence? Get to the truth early. Waste
- Course-correct based on feedback. Chances are
objections you hear at one fund will be concerns at another. Incorporate
the feedback you hear-either by adding it or refuting it. Think
of this feedback as sparring practice. It is like training that
makes you stronger in fighting real challengers to your success.
- Conduct your own due diligence. This process
is the foundation for the long term partnership. Experienced entrepreneurs
know that the investor relationship is akin to marriage. Ask to
call the fund's prior and existing portfolio CEOs. Simple revealing
questions are: What are they like to work with on the board? How
do they add value? How did they react during a tough time? The
fund will be your operating partners and you need to assess them
like you would your own executive team.
Finally, don't sign the deal unless you can comfortably answer
the question: Will they be a good partner when things don't go according
to plan? Because we all know, they never do.
Vince Occhipinti co-founded Woodside Fund
in 1983, and has been intimately involved in the management and
success of the Fund and its portfolio companies. Woodside Fund is
an early-stage venture capital firm located in Redwood Shores, California.
The firm is typically a lead investor, and invests from $5 million
to $15 million in early-stage semiconductor, enterprise software,
and network infrastructure companies. Woodside Fund has more than
$350 million in capital under active management.