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"How to Keep the VCs From Snooping Around"
March 09, 2005
By Michael V. Copeland

Due diligence is that part of the dealmaking dance when the venture capital firm investigates the people, technology, and markets of the company it's interested in funding. During the bubble days, due diligence often consisted of little more than making sure everybody's name was spelled correctly on the checks. In the postbubble hand-wringing that followed, VCs dragged out due diligence for months, more out of a reluctance to invest than out of thoroughness.

Now we've returned to a place somewhere in between, says John Occhipinti, Woodside Fund's managing director. The process of due diligence happens in little waves, he says. It's not back to the spell-check days, but in some sectors and for some startups the rigor of due diligence is taking a backseat to VCs' eagerness to get in on hot deals. "You are seeing deal activity picking up and due-diligence cycles getting strained in terms of what you can do and should do," Occhipinti says. And if the funding is for a later-stage startup that VCs have previously funded, forget about it.

Occhipinti points to e-mail-security startups CipherTrust and IronPort, which both banked rounds of more than $40 million last year. "Big piles of money are going in at inflated prices," he says. "A company is not worth more just because someone needs to write a larger check for the company."

What's happening these days is that a startup with considerable revenue and profits, like CipherTrust or IronPort, will want to bring in a new outside investor to bid up its price in advance of a sale or an initial public offering. A VC eager to get in, with a fund that needs to put its cash to work or risk returning it to investors, will pay that high price with nary a look-see.

The Woodside gang is fanatical about its due diligence, a process that typically takes six weeks or more and includes a four-hour CEO grilling session. But even Woodside recognizes that it needs to light a fire under its process on some deals if it wants to get in.

But it's not always the quickest and biggest check that wins the day. In fact, Woodside got a piece of a $7 million second round of funding for wireless equipment testing company VeriWave because of its extensive due-diligence process. In the course of finding out more about VeriWave and its business, Woodside demonstrated that it had a deeper understanding of the company and a connection to potential customers. So VeriWave went with the Woodside team, even though its offer wasn't the highest among the three term sheets submitted.

It's less frequent among early-stage companies, but the same rush to get in on a deal can happen with them too, especially if a startup is staffed by a proven team. Sometimes, though, the VCs will wait until one makes a move before the others rush in, assuming that the first firm has already done the work. Fabless chip company Stream Processors, which focuses on developing programmable digital signal processors, came out of Stanford with a known team. It was recently raising its first round (Occhipinti won't say how much), and the Woodside team had done its usual exhaustive due diligence and wanted in. As soon as Woodside dropped a term sheet, seven other firms scrambled to get in even though they didn't have the time to mount their own investigations. Still, the round was completed quickly. The lesson of the day: "The best way to get venture capitalists motivated is to get another VC interested in the deal," Occhipinti says.



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