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What does due diligence look like at pre-seed?
The hunt for red flags when startups are only just getting started
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As we continue our break from the usual startup profiles this August, let’s take a look at due diligence.
There’s plenty written about how founders can attract investors. But it’s what happens after an investor is interested that’s often just as important to a startup’s future.
Meanwhile, a big thank you to Michael Spencer’s AI Supremacy newsletter for publishing a guest piece by me last week, rounding up some of the A.I. startups we’ve recently covered here on PreSeed Now.
Our regular, twice-weekly startup profiles return at the beginning of September. In the meantime, our Startup Tracker, available to paying subscribers, keeps you up-to-date about the 100+ startups we’ve profiled so far.
Hunting for red flags: What does due diligence look like at pre-seed?
Due diligence isn’t a topic that gets a lot of public discussion, but it’s an important one. Once an investor is interested in doing a deal, they’ll want to do some careful checks to make sure they’re not throwing their money away.
The very early-stage world that PreSeed Now covers isn’t known for deep and stringent due diligence. There’s not as much money at play as there is in later rounds, and there simply isn’t as much an investor can look into because the startups are only just getting going.
But due diligence does happen at pre-seed, and founders should be ready for it. If you don’t have your house in order, it could kill that investment you worked so hard to pitch for, or at least slow down the process when you’re champing at the bit to begin using the funds.
For all the talk you might hear, often from the US, of investors who put money into startups after one meeting, this is very much an exception rather than a rule. While it can be different with some angels, institutional investors do have checks they need to run.
Giles Moore, a regional development manager at Par Equity, says the firm’s due diligence process can take anything from eight to 12 weeks. While this can be fast-tracked if necessary when other investors are involved, Par Equity will still do its own checks.
Moore says founders should be ready to have their market size and opportunity tested. So if you’ve plucked figures out of the air, that could come back to bite you.
He says technical due diligence is an important step, making sure the tech underpinning the startup is credible and scalable. And then the startup’s team can expect to be analysed to make sure they’re a good fit for working with Par Equity.
If team analysis sounds like it might be a bit ‘unscientific’, well that can sometimes be the case in due diligence processes. But investing in startups is about relationships, and as a founder it makes sense too. If you’re going to have someone potentially on your board, or even just on your cap table, it makes sense that you should get on and have a positive working relationship.
“We ask them why they founded the company and see what their drivers are, to see that they're not going to give up when times get tough–because they will inevitably at some point–and then see how they respond to challenge, and questions as well.”
Under the hood: technical due diligence
If you’re the kind of founder who thinks you can sway investors with talk of how your product incorporates A.I. when it very much doesn’t, or pretend you have built your product in a unique way, technical due diligence is the stage when you might come undone.
While some investors do their own technical due diligence, others look to third-party specialists. Thestartupfactory.tech offers a technical due diligence service. And CTO Aleksa Vukotic says startups have begun to come to them as well, wanting to make sure their tech will pass muster when investors look under the hood.
Vukotic says tech due diligence tends to involve a number of different questions. Questions like: what tech are they using? Is there a defensible ‘secret sauce’ (if the startup needs one)? Is it built with scalability and security in mind?
The point about security is perhaps under-appreciated by many. Vukatic recounts an investor telling him they pulled out of a deal to invest in a profitable, growing startup because its tech wasn’t built with strong enough data security - a problem even the founder wasn’t aware of.
Meanwhile, the tech stack you’ve used can impact more than just the capability of the product. If you use obscure tech, it can make recruitment a challenge.
And no matter what you use, are your code and processes well-documented to make onboarding quick and simple? One mark in a startup’s favour during tech due diligence, Vukotic says, is a clearly communicated product design and development roadmap.
Ben Grubert is co-founder and CEO at INEVITABLE, another company that performs technical due diligence on startups. He says the process can be beneficial for a startup whether or not a deal ends up being done.
“The pre-seed and seed rounds are the first opportunity to be able to correct problems that will become quite large later on,” says Grubert. “There's a concept in testing known as ‘left-shifting’. The earlier you catch the problem on a timeline, the cheaper it is to solve or the less impact it will have.
“This is particularly important when you're talking about the whole strategic alignment of how you go about using your technology; how you can make it safe, how you can build it so that it scales.”
One problem that can be exposed in technical due diligence is when a technical co-founder is completely out of their depth. Grubert shares a hypothetical example of a founding CTO who, straight out of university, builds an initial MVP based on technologies they learned about on their degree course, because that’s all they know.
“[The founders] don’t realise that their MVP is the equivalent of a car chassis made out of gaffer tape and wishful thinking. They don't realise it because the person who built it is now their CTO, who is now hiring other people and absolutely bricking it, because they're afraid that other people will find out that they don't know what the hell they're talking about.
“They won't want to migrate from that tech because that's why they have a job, because they know it better than anybody else. They will want to do anything in order to keep that as the core… but that technology should have been used not as an MVP, but as as proof-of-concept or proof of traction.
“The next round should have been a tear-down-and-replace, but there's now someone who has a misaligned objective inside the business, without an innovation mindset, who now no longer has the time to learn and who's now managing the narrative upwards to the board.”
Grubert says INEVITABLE, whose due diligence services focus particularly on A.I. and machine learning, has seen a few businesses fail in this way.
“They end up with something that just won't scale, and they don’t know why it's not scaling. And [the CTO] will fight like mad in order to not bring tech consultants in, because the problem’s already too bad.”
Cap table concerns
Dealmaker David Levine says a common problem that comes up in due diligence is the cap table.
‘Dead equity’–people with shares in the company who shouldn’t really have them–can be a red flag for investors. Those shares could be better reserved for future investors or as an option pool for early employees. Dead equity limits a startup’s growth potential.
Often, Levine explains, this happens when an initial co-founder checks out of the startup early on.
“At the beginning of the marriage everyone thinks everyone's going to be happy and hunky-dory forever and ever and ever, and there are people who are going to be doing lots of cool stuff. And then they don't because life happens. They can't get paid so they go and find a job, so they're not involved anymore.
“Sometimes ex-founders or employees leave in a very messy fashion and that mess has not been tidied up.”
Levine adds that when you get to a seed round, earlier investors, angels, or universities (in the case of spin-outs) might have taken too much off the table early on, or claimed preference shares (AKA ‘preferred stock’) that gives them an outsized say over the company’s future.
Serious seed or series A investors are unlikely to want to touch a startup where a hands-off, minor angel can influence its future.
Investors: watch your timeline
Due diligence is a fact of life. Investors usually have their own investors (‘limited partners’, in VC speak) who want to be sure their money is being deployed responsibly. And no-one wants to end up backing the next Theranos.
But as Rupert Wingate-Saul, who has been involved in venture capital for over a decade and now runs Founder Funding Groups to help support founders in raising their rounds, says this process can take too long, to the detriment of startups.
“Even in a tougher, more investor friendly market, where they have probably a greater amount of control in the deal, I still think it is beholden on the investor to exercise good manners and be transparent about where they're up to in the process.”
Wingate-Saul says investors should be transparent about the likelihood of them doing the deal, any issues that could block the process, and what they require in order to get the deal over the line.
“Unfortunately, what happens in this market is investors know they're in the driving seat and they think they can hang on, hang on, hang on, and then choose whether they want to do the deal or not.
“That kills startups. It doesn't hit the investor, because if they say they don't want to do the deal and they walk away, they still have the capital to deploy elsewhere.
“But if that startup has taken a lot of time, a lot of focus, working on that deal, and then just to be told it's not happening, that really hurts. And that behaviour can can damage the early-stage ecosystem without necessarily damaging the individual investor.”
Wingate-Saul’s point leads to a good way to end this article. Don’t forget that due diligence goes both ways. Founders should always do some checks on potential investors. Landscape is a good place to start.
More next week
Our series of special editions focused on different aspects of the early-stage UK startup landscape continues next week with a look at whether investors are taking advantage of startups in the current, challenging climate… or are they just being more careful?
If you have any thoughts or insights about how pre-seed deals and investor attitudes in the UK have changed over the past year, drop me a line.
PreSeed Now will be back to publishing twice-weekly profiles of early-stage B2B and deep tech startups from the beginning of September.