Post-COVID Due-Diligence: Venture Capital model needed an upgrade long before COVID happened.

“The praised focus on margins sometimes takes attention from what really matters — the defensibility of the business.”

The talk about disrupting venture capital started long before 2020. You can see different fund managers shifting focus, thesis, industries, taking bets on low-hype industries, and empowering diversity. While this is contributing to change in the entrepreneurial world, what really needs to change is the due-diligence process.

Alert: Some of you might disagree with my next point. Have you mentioned that nowadays funds, especially big ones, tend to hire asset managers and analysts without first-hand startup experience? Back in 2014 when I just started working for Draper’s Network of Funds, the first thing my Managing Director told me was entrepreneurs make the best VCs. And I agree — I believe that there is more to the due-diligence process than math. You should be able to ask the right questions and assess risks and opportunities — and you can do it only if you have walked a mile in the founder’s shoes.

A16z made a great point in their recent post — investors have been favoring high gross margin companies making it the preferred business feature. And don’t get me wrong, it is understandable since we live in the startup world where the “how much runway do you have” question is asked at every pitch meeting.

“Higher gross margins allow for more % of revenue to be spent on growth and product development. It also tends to translate to a higher cash flow margin.”

At the same time, the markets show us that companies with low gross margins can be highly valuable, can still generate high cash flow. A great example is Apple, with a 38% gross margin, roughly half of that for many software businesses. Some of the most valuable companies have low gross margins: Disney, Netflix, Starbucks.

However, focus on margins sometimes takes attention from what really matters — the defensibility of the business. A.k.a business’ ability to maintain competitive advantages over its competitors to protect its long-term profits and market share from the competition. But what does “defensibility” really mean? We’ve compiled some key indicators, recently shared by thought leaders in investment space — and we had the audacity to add some of our own to list. Here they are:

Achieving economies at scale has always been under investors’ microscope — but what if we look at it from a slightly different angle: Are their per-unit costs improving while not degrading the unit economics? Does the business have negotiating power over its suppliers and/or buyers?

Differentiated technology — don’t you love asking this question? In reality, not every company will have a patentable IP that can protect it from competitors for many years to come. A great way to measure differentiated technology is pricing power. Are customers willing to pay a higher price for this product vs their competitors’? If the answer is yes, then this is a differentiated offering.

Leveraging unpaid channels can help ensure companies are not overly dependent on expensive customer acquisition channels. How much money should a company really spend on Google and Facebook ads? Where is your traffic coming from? Do you have an increasing percentage of your traffic and revenue coming from organic or paid channels over time? You don’t really want a startup addicted to click costs to drive its business.

Failed startup experience is king. I am a firm believer that entrepreneurs’ reaction to failure is the natural selection in the world of entrepreneurship. Failure and ability to analyze it and learn from it is what forges successful founders. In general, I don’t think we talk about failure enough, especially among early-stage startups. Shameless plugin here, I started a Startup Morgue — series of interviews with founders sharing their startup death stories and key learnings. I see it as a shared failure depository for resilient brilliant minds. I also think investors need to learn more about true reasons beyond “they couldn’t fundraise” — cuz that is a symptom. Knowing the problem under the problem can help minimize risks when investing in early-stage companies.

Traction — what is it, really? Au contraire some founder’s opinion, it is not just a number that you have to invent for investors, it is an indicator of how your business is doing. The number of Facebook followers is not traction, conversion rate/users/paying users/transaction volume, etc. are. How do you evaluate tractions? This is an open question from me to you, I’d love your opinion on this.

Adaptability and founders’ ability to stay calm during a crisis. COVID hit and I saw a clear difference between reactions — some founders started working on pivots and searching for ways to adjust their business, even if it was for a limited time, to keep their business going. Other founders got paralyzed as if their brain just switched off, they threw a white flag without even trying — and a lot of them really could thrive!

Team diversity as an advantage — and by diversity I mean differences in culture and mindsets that contribute to better team culture and open-mindedness, diversity in age and experience that contributes to better strategy and decision making. In general, figuring out how very different people with diverse backgrounds can collaborate and work together towards the common goal, regardless of gender, religion, age, race, or any other differences, creates a strong base for a growing company, becoming a competitive advantage.

Remote is a plus (when possible) — it enables founders to hire experts from a bigger pool of candidates, focusing more on better skill and culture fit vs being limited by location and proximity to the office. Figuring out how to manage and use timezone differences to your operational advantage can actually contribute to the higher performance of the company. The majority of people actually prefer remote — this contributes to the happiness level of your team, their motivation and therefore better involvement in the business and higher quality of outputs. At the same time, remote mode quickly filters out people who can’t manage their own time well and require lots of oversight — fire fast, you don’t want those people on your team anyways.

Having an exit plan has been a discussion point but I believe it becomes important, even if you don’t plan to exit soon. 10 years ago when Brett ran an angel group this was a must have on every pitch deck. Why did we stop caring about liquidity? COVID or not, stuff happens, things don’t go as planned. Even having an understanding of how to sell company assets when your company failed (and the majority of them do) is a huge plus. And it is also smart as it would help you as a founder to cover the outstanding company debts.

Too many advisors as a red flag — this became a recurring thing. If you have more advisors than team members or have to make a separate deck slide about advisors to your company — what’s wrong with you? What is their real involvement? Most of them probably contribute nothing to your company. Having 20 people holding your company shares does not make your cap table sexy. Do you really need that much help, is the team not fit enough? These are the questions that go through my mind when I see that We have 20 advisors slide.

Did we miss anything? Do you see parts of due-diligence process that could be improved — or already have been improved by you?

Learn more about UnVentures @ unventures.co

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