PS#032: The Hidden Step – Preliminary Diligence
In the last issue of Preferred Shares, we covered how many of your leads should be converted into first calls. This along with our framework around the leads funnel should give you some guidelines around structuring your time at the top of the funnel.
Today, we are going to take this a step further.
As we discussed in the first issue of this series, the next step in the funnel is diligence.
This is a tricky step because it is a stepwise change in time/resource commitment. To help derisk the significant time commitment, most investors build a “hidden step” into their deal funnel – preliminary diligence.
Let’s dive into this hidden step and how we can use it to build our knowledge in a given space.
What is preliminary diligence?
As I mentioned above, preliminary diligence is used to derisk the time and resource commitment required by the diligence portion of the funnel.
Said another way, we are using preliminary diligence to decide if we should be committing our time/resources to perform full-blown diligence on a company.
A full diligence effort can require multiple team members, external resources, and 100+ hours of work, depending on the opportunity.
For preliminary diligence on the other hand, this is mostly work we can do ourselves in 20+ hours, leveraging a few close connections. The idea is to design a process that provides clarity into the 3-5 key risks (or “deal killers”) for the startup, while requiring very little effort or involvement from the company.
In short, preliminary diligence provides an “off ramp” before overcommitting to an opportunity.
As a bonus, it also helps us respect the startup/founder’s time and resources. Asking a startup to build out a whole diligence package for you to quickly pass based on market size will not help your reputation as an investor.
How can we use it to build our theses?
We can also use this work to help build our overall thesis. If done properly, we can start filling in the details of our thesis leveraging a real opportunity.
As I highlighted in the previous section, preliminary diligence is meant to be a lower overall commitment compared to full diligence. We want to try and tackle some of those “deal killers” before we commit more resources to the opportunity.
For the most part, we can focus our preliminary diligence efforts on two main risk categories:
Market – do the dynamics of this market make sense for a venture investment?
People – is this the right team to build a successful company in this market?
We focus on these risks for a few reasons…
These risks can often be better understood with little to no involvement from the startup
Red flags within market and/or people can typically kill a deal right out of the gate
When we look into the market, we’ll want to get a better understanding of the customers, market size (today and in the future), and the overall competitive landscape. This will help us come to an opinion on whether this market can support the expectations of a venture-backed company.
When we are thinking about the people (or the management team), we want to better understand their background, skill sets, experience (in building companies and in this space in particular), ability to recruit talent, and overall working style. Again, by working through this, we can better understand what we think is required to be successful in this space.
In both of these cases, the work is cumulative. We’re able to (1) build a perspective on the attractiveness of the market for an investment, and (2) explore the skill set/experience we think is required to build a successful company (assuming there is a market to support it).
We may not have it fully formed, but by doing this work, we should be creating a clearer picture for where we’d like to invest (or moving on from the thesis entirely).
Even better, assuming we still like the space, this will allow us to move more quickly through diligence on other opportunities.
*If you’re interested in learning more about my tactics and frameworks for preliminary diligence, check out my course: How to be a VC Associate.
Prioritize your efforts.
At the end of the day, this is all about prioritization.
As much as we would all like to go in-depth on all of the different startups and venture opportunities, we quite literally just don’t have the time.
We have to choose and pick our spots thoughtfully, prioritizing the theses and opportunities where we think we can achieve outsized returns as investors.
In the section above, I mentioned designing our process to provide clarity on 3-5 of the key risks or “deal killers.” That’s the point of preliminary diligence and the framework for the deal funnel (and diligence efforts) in general – prioritize your time and focus on the deal killers first.
If you can’t get comfortable with one of the deal killers, it’s time to pass and move on. These are deal killers after all. They will kill your deal.
Again, none of this is gospel. The key deal killers may depend on the prior work you’ve done in the space, the particular startup, or the dynamics of a deal. These are all factors to consider.
These are simply guidelines to help you think more about your time, resources, and prioritization as an investor.
