Did you ever ask yourself: Are we doing the right kind of technology and product due diligence on our startups? Many Venture Capitalists are confronted with this question, and the main reason for that is that there really aren’t any clearly defined standards for tech due diligence. What we see in reality is that TechDD is often based on self-developed procedures, trials and errors, and a somewhat common understanding of best practices. The result of this is that tech due diligence can mean anything from a 30-min call with a CTO from another portfolio company to a 14-day in-depth analysis with industry experts and technicians. So, there clearly is a need among VCs and their target companies to get clarity on whether they are doing the right kind of tech due diligence.
FutureWorldVC: Investors, CTOs, and Tech Advisors Have A lot to Talk About
Zoe Peden, Principal at Ananda Impact Ventures, tapped exactly into this need when inviting the FutureWorldVC community to a panel discussion in London. I was happy to join the panel with Perran Pengelly, CTO and co-founder of DrDoctor and Sara Stephens, CTO and co-founder of Rest Less. It was a perfect setup of VCs, founding CTOs, and technology advisors coming together to exchange ideas and experiences.
On my part, I talked about our approach to TechDD at Philipps & Byrne: What are the objectives, timelines, and deliverables of such a tech assessment? I went into how we work with VCs and startups, and what both sides can and should expect from a proper tech due diligence based on best practices. We also shared some -anonymized- examples of typical red flags or positive impressions. Perran spoke about his experience of working with us and provided some honest reflection of the challenges and positives that came out of the experience. Sara brought in her experience from two TechDDs performed by other service providers and shared super insightful feedback she had gathered from surveying members of the CTO community. These numbers were a great basis for the further discussion among us and with the audience.
Takeaways: What We learned at FutureWorldVC
Despite being a speaker at this event, the exchange with the different participants gave me plenty of fresh input and insights. Also, let’s be honest here: I have been exercising tech due diligence for ten years, and yet we are still trying things out and are keen on finding a better approach for everyone being involved. So for us this was a perfect learning opportunity. Here are some of the things I learned during the conversations with VCs and tech leaders in London:
Investors want clear(er) guidance from Tech experts
Understanding what is going on is of the essence for investors – especially if they do not come from a tech background. Many of the investors – but also the founders – shared their experience of getting a 2-pager TechDD “report” without a clear indication of whether to invest or what to do after the investment.
What they actually want is clear advice on action items, dos and don’ts, next steps, and priorities for both themselves and their target company. There is definitely also a desire for clear benchmarking, rating, and comparability with other investments. In general, investors want tech assessment to be derived from the business context, and how that context translates into tech solutions, set-ups, and processes should be an essential part of the TechDD.
TechDD Findings can be a Conversation Starter for Delicate Topics
One aspect we brought up during the discussion is that the results of a tech due diligence can serve as a well-founded basis to address difficult tech topics on board level. I know from attending board meetings myself, that often slow time to market is being discussed with or without naming Tech issues as a root cause. Having tech assessed by an external expert and going through issues in a structured way is always better than discussing on the basis of a gut feeling or a hunch. Having a structured and honest discussion in the DD phase contributes to more fruitful board meetings with shared expectations clearly set.
Founders and CTOs: Transparency is a Real Game Changer
One of the most interesting findings was brought forward by Sara, who did a survey on two CTO networks. She found out that two-third of founders feel stressed during a technology and product due diligence. But even more important: Apparently there is a direct correlation between stress levels and the degree of transparency regarding the assessment process. In other words: The more transparency, the less stress. As simple as it sounds, the data was impressive:
This begins with having clarity on the deliverables and continues during the assessment itself, all the way to the report. Transparency throughout the entire process makes a real difference.
Secondly, the mode of operation is very important. Here we can see, the more the due diligence is done in a sparring mode, the better. The less this is done, the more useless the experience is conceived by founders and CTOs. Among the CTOs she surveyed, Sara found out that half of respondents felt a TechDD was useful for both investors and founders/CTOs, and half of them felt it was not. This indicates misalignment and inconsistency around the TechDD process and outcomes.
Thirdly, Sara’s survey also found that 80% of TechDD conducted focused on the technology being used in the target company at some point in the process, but only 50% of the tech leaders felt that was actually important. This is an interesting indicator for the business context, often not being considered enough during a TechDD. Meaning, those conducting the assessment are not applying a true 360 degree approach. This channels back to the investors’ desire of tech assessment being derived from the business context.
And finally, and this cannot be overestimated, if the TechDD and the following report provide concrete and actionable guidance for the future, it can function as a long-lasting leverage for tech in discussions with non-tech founders and investors. Perran mentioned in this context that almost two years later, the engineering leaders in his company still bring up the findings from the TechDD as a gentle reminder for keeping certain standards up. This is what true value derived from a best practice tech due diligence looks like.
Wrap-up: Whether You Do TechDD Right or Not Makes a Huge Difference
So, what can we say about the FutureWorldVC panel wrapping up? First of all, it was a blast! Second, these kinds of dedicated spaces to exchange, learn, and get inspired are so beneficial and valuable, also for us. So many thanks to our client Zoe for putting the whole thing together, as well as to the two post-series-A Tech startup founders, Perran and Sara, and all the participants who so actively contributed to the discussion.
Coming back to the initial question: Are we doing the right kind of tech due diligence? What we see is that whether a tech due diligence is done right or wrong has a great impact on all parties involved. If done wrong, investors lack understanding and visibility, founders and CTOs suffer from enormous stress due to intransparency, and tech advisors have a hard time accessing information and gaining insight, due to a possibly hostile environment. But if done right, meaning with a clearly pre-defined and transparent process according to best practices, TechDD can be the most thorough, honest, and valuable external feedback investors, founders, and CTOs can get. It can provide beneficial findings and actionable recommendations that can help support tech and product strategy and future growth. And last but not least, it can be an important conversation starter between investors and founders about uncomfortable truths that will appear on the board level anyways at some point in time.
As the first half of the year lies behind us, we in the Venture Capital and Startup world find ourselves in a very different place than 12 months ago. From your perspective, what is happening right now?
Simon: We are definitely seeing a slowdown in investment activities, especially in the growth segments (series B onwards). There are a couple of reasons for that: First, 2021 was a record year in venture capital. A remarkable amount of deals and funding happened with much higher valuations than previous years. Inevitably there had to be some sort of slowdown sooner or later. So in this sense, I’d rather call it a correction, as opposed to a market collapse or anything like that. And that can actually be quite healthy.
Second, money is no longer cheap. Interest rates are slowly rising, which of course has enormous implication on funding on one hand, and where people allocate their investment on the other. In times of zero interest, there were not many investment options that promised yield, so it was logical that more investment went into venture capital. As more investment options are yielding interest again, less money will move into venture. However, keep in mind that there is still quite a lot of dry powder around that is somehow committed.
And thirdly, uncertainty around inflation and the underwhelming stock market performance of some startups and scaleups that recently went public, has caused some nervousness. Especially among those investors who see companies they are engaged in going public in the near future. After all, we have seen some companies that reached high valuation before going public, but afterwards haven’t necessarily fulfilled expectations at the stock market. This is channeling back into the pre-IPO phase. Investors are rethinking where valuations should be during funding rounds, as they might not actually see the anticipated returns, once these companies go public. And if that proves to be right, people are going to shift that capital to other investments that can generate higher returns.
What implications are these overall market corrections having on VCs and startups?
Simon: Well, we are definitely seeing VCs pushing their portfolio companies from hyper growth to profitability. That means cost reduction, first and foremost, but also reassessing and restructuring organizations in light of the current market climate. Basically, VCs and founders are asking themselves: What are the implications of inflation and higher capital cost, investment reorientation and reallocation, and fluctuating demand? How does this change priorities and roadmaps? Uncertainty drives desire towards investments that can produce near-term certainty and profitability, and this is a proof startups need to deliver now. This will be a decisive factor, for new funding rounds or in securing bridge funding from current VCs.
Is the investment cool-down noticeable across all funding stages, or are certain stages more affected than others?
Simon: The ability to raise funds for startups does depend very much on the stage right now. The stock market climate impacts later stage companies much more, and they are currently struggling to get deals done because investors are skeptical about the exit prospects. Right now, investors don’t really want to pour money into a company that plans going public in one or two years. For seed and early stage startups, IPO is still far on the horizon.
However, early stage startups are starting to reassess their funding goals and valuation expectations in light of the general market cool-down. They, too, realize that those hyper valuations of 2021 might not be realistic anymore. And overall, closing funding rounds is taking longer and there is more risk analysis and due diligence from the venture side again. Which, again, is actually a good development and very healthy.
So you expect risk evaluation and due diligence will play a more important role again during funding rounds
Simon: Yes, very much. In the recent past, we have seen VCs completely skip due diligence to get deals done quickly. In some cases, this might have contributed to the underperformance we are seeing now. And as the market is less favorable in general, more uncertainty and higher capital cost, of course risk management and due diligence are and should be top priorities for smart and sustainable investment decisions. And as we are in an ongoing digital transformation of entire societies and economies, technology will play a crucial role in all of this.
In which way?
Simon: Technology and product management are extremely important in any startup today. The way teams work with tech, how processes are designed and how well they are automated, the degree of maturity of product roadmaps and their development can make or break a young business. Also, how well business decisions and strategy are based on metrics and data, simply matters, if you want to secure future funding or convince your current VC to provide bridge funding. For this, you need data intelligence and technology.
What should VCs and Startups do now with regard to tech when working towards profitability?
Simon: As technology plays a crucial role in the capability of startups to shift from pure VC backed growth to profitability, we currently advise all our clients – on the investor but also the founder and startup side – to do a thorough check-up on their technology and product set-up to get a realistic understanding of how resilient and capable their tech leaders, teams, processes, and architectures are, and how well they manage the transformation towards profitability.
A lot of startups that are venture backed already will now have to have a frank conversation with their board on the perspectives of fundraising and in many cases, bridge financing will play a role. Doing their homework on the tech side, can be a decisive factor. However, to prove this, VCs might want to see an expert tech advisory report rather than just taking your word for it. But given this, they likely will be open to provide capital you need to get through the rest of the year.
What do you expect to happen in the Startup ecosystem moving forward?
Simon: We could actually see things get worse before they get better. There is still somewhat of an overhang from 2021 spilling into this year: Deals that have been done under a high valuation in late 2021 that have been announced recently or are still to be made public. As these run out, we could see the next quarters perform even worse.
Definitely, we will see the overall market correction settle in, which will most likely go hand in hand with some layoffs at strong growth startups. And we expect much more consolidation and M&A activity between startups as well as private equity and startups. Also in this context, risk analysis and due diligence will be key for making the right business decisions.
And beyond 2022 – well, that very much depends on how monetary policy will develop and if the economy is heading towards a recession. But, despite all of this, we are very confident that technology will remain the number one investment area and the passion and excitement of venture for tech will be going nowhere.