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Avoiding Mistakes: How Due Diligence Can Save Your VC Investment

05/30/2023

There can be a lot of power in an idea, if you also have the ability to capture it, harness it, and bring it to fruition. However, from an investor’s view, a truly great idea is only as good as its ability to be commercialized and subsequently seeded, scaled, and managed. Even the simplest concepts can pave the way for innovation, propelling our economy forward and creating opportunities for all. However, an idea is rarely monetized on its own. There must be the right combination of vision, grit, execution, and that “it” factor.

Early-stage companies often have the most innovative ideas, highest growth potential, and a unique market position. However, these opportunities are associated with several risks, including, lack of market traction, lack of funds available, and ultimately potential failure. This is why we emphasize extensive due diligence as a way of de-risking (as much as possible) the investment.

Due diligence is the process of analyzing a prospective investment before investing. This helps investors to identify risks, evaluate potential opportunities, and make informed investment decisions. The basic purpose of due diligence is to answer financial, operational, cultural, and legal queries related to the company’s history, background, prospects, business plan, and goals. It is also conducted to ensure that the information and materials provided by the company are an accurate representation of the business. The greater the time dedicated to due diligence, the better the understanding of the business and the clearer the risk/reward profile the investment opportunity becomes.

DCA Asset Management’s diligence process focuses on three core pillars:

1) Vertical and market size assessment – what is the total market opportunity?
2) Thorough review of the financials, founder(s) team, and product
3) The terms of the deal, governance, and returns

DCA’s Stringent Due Diligence Process

We begin the due diligence process by researching the business vertical in which the company competes. This allows us to gain a better understanding of market size and what the true total addressable market (TAM) is, market trends, key competitors, and opportunities for growth. We also evaluate the company’s competitive advantages and its unique value proposition to identify where each company fits within the relative landscape.

We then dig into the company’s background, its founder base, and team. This includes reviewing the company’s founding history, future roadmap, and the experience and qualifications of the management team. It’s important to have confidence in the management team’s ability to execute on the company’s vision. The team’s track record, industry experience, and commitment to the company’s mission are carefully factored into our assessment.

The next step is to review the company’s business model and potential for growth. This involves understanding the revenue streams, cost structure, and ability to scale. We carefully evaluate the company’s intellectual property (patents, trademarks and other forms of IP) and its ability to protect its competitive advantages. As part of this process, we also scrutinize the company’s marketing and sales strategy, to better understand the customer acquisition process and growth potential.

In our diligence process, we typically ask that a product demonstration be done live with the CEO. On top of this we closely review the product features to find product moats and areas of improvement. If necessary, we follow up with the CTO, to get a firm understanding of any technology involved. In conjunction with these demos, we also take a deep dive into the product roadmap to understand the future trajectory of the companies offering and weigh the likely costs and hurdles to achieve the milestones on their roadmap.

Rounding out our analysis of a company’s potential is a review of their go-to-market (GTM) strategy, or their plan for bringing a product or service to customers. We scrutinize the company’s current channels, as well as the overall processes they have in place and whether they have successfully executed on their strategy. We also typically assess the company’s positioning to implement future GTM strategies to broaden their product offering.

Also included in our review of the company’s potential are customer and industry expert checks. We gather feedback from existing customers and outside industry experts to validate our assumptions regarding the team, business model, product, and go-to-market strategy. We gain rich insights through customer and expert evaluations of a company’s product or service. We also typically speak to existing investors in the company to understand their reasons for investing as well as their foreseen risks.

While the components of due diligence for early-stage companies can be similar to those for more established companies, there are some unique considerations that investors must keep in mind. This includes analyzing financial statements, creating a financial model and forecast, and evaluating the company’s cash flow and burn rate. We also evaluate the company’s funding needs and potential sources of financing, including an evaluation of the company’s financial projections and its ability to execute on key performance indicators (KPIs).

We also place a great deal of time evaluating potential risks, such as regulatory or legal issues, as well as the motivations of stakeholders. We look at potential returns and exit strategies for each investment and assess the company’s valuation and potential for an eventual initial public offering (IPO) or acquisition.

Before making an investment decision, we assess the deal itself. Multiple factors outside of the company are considered in the investment decisions. This stage in the process likely includes (but is not limited to) final calls with the deal lead, analysis of similar transactions, type of round (preferred equity, convertible note, etc.), cap table, size of the deal, valuation, and more.

Above all, a good investment should produce a strong return. To sell a stake in a private company, or “exit,” the company typically has a liquidity event. A liquidity event comes in a few different forms; the most common are acquisitions or public offerings. We analyze the potential liquidity events, estimate a time frame, and use various valuation methods to forecast a prospective exit value. Together this can produce an estimate for the foreseen return to shareholders.

Making The Investment Decision

Our final step in the due diligence is to weigh the pros and cons, risk and reward profile, then make our final decision. DCA takes its due diligence incredibly seriously, heavily relying on our analyses to form the bases of our investment decisions. Only by thoroughly evaluating a company’s management team, business model, financial performance, risks, and potential returns, can we make informed investment decisions and generate meaningful returns for DCA and our partners.

*One of DCA’s guiding principles is that we will communicate with our investors and prospective investors as candidly as possible because we believe investors and prospective investors benefit from understanding our investment philosophy and approach. Our views and opinions regarding the prospects of investments and/or the economy are forward looking statements as defined under the U.S. federal securities laws, which may or may not be accurate and may be materially different over future periods. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will,” “may,” “should,” “plan,” or the negative of such terms and similar expressions identify forward looking statements. Forward looking statements are subject to certain risks and uncertainties that could cause actual results to materially differ from an investor’s historical experience and current expectations or projections indicated in any forward looking statements. These risks include, but are not limited to, equity securities risk, corporate bonds risk, credit risk, interest rate risk, leverage and borrowing risk, additional risks of certain investments, management risk, and other risks. We disclaim any obligation to update or alter any forward looking statements, whether as a result of new information, future events, or otherwise. You should not place undue reliance on forward looking statements, which speak only as of the date they are made.

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