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The VC Due Diligence Process

In my continued trend of reading out-of-print books about venture capital checked out from the Ford Library at Fuqua, I'm in the process of reading a book titled Venture Capital: The Complete Guide for Investors by A. David Silver printed in 1985. David Silver is a venture capitalist and investment banker with Santa Fe Capital in Santa Fe, New Mexico. As I discovered recently, Silver's success as a venture capitalist is debatable. Nonetheless, I'm finding the book to be succinct yet extremely insightful and it's not surprising why Silver has written over 30 books on entrepreneurship and finance.

The book is divided into six sections: 1) Formation of a Venture Capital Fund, 2) Generating a Deal Flow, 3) The Due Diligence Process, 4) Valuation, Terms, and Conditions, 5) Monitoring and Adding Value, and 6) Selling, Liquidifying, and Portfolio Management. The vast majority of the book is spent on section 3) The Due Diligence Process and I'm going to be summarizing highlights from that section in a series of posts, beginning with this one which will link to others as I write them. Keep in mind the book is over 250 pages, so I'll just be covering highlights. The book is definitely worth a read if you can get your hands on a copy.

The Deal Log
The due diligence process starts with a screening process, usually completed by associates or interns. The screening process is meant to scan and summarize the most important elements of incoming business plans so that partners can quickly decide which to turn-down and which to pursue further. It saves both the VC and entrpreneur time. The key facts the intern is looking for are the following (pg 80):
  1. At what stage is the company?
  2. What problem is the company attempting to solve?
  3. Is its solution proprietary or conveyed to the problem in a unique way?
  4. Is the entrepreneurial team experienced and competent to manage a rapidly emerging company?
  5. Has the company, its product or solution or its management team, been endorsed by a responsible and highly regarded customer or investor?
  6. How much capital is required?
Deals from the deal log are reviewed on a regular basis (usually weekly) by the partners. Turndowns are provided promptly (and likely should be followed-up on by the entrepreneurs for more information).

The 3 Laws of Venture Capital
Before diving into the specific due diligence activities, Silver outlines a framework for how VC's should be disciplined about considering their investments. The framework is outlined as Silver's "3 Laws of Venture Capital" and form the basis for the due diligence activities. The laws are as follows:
  1. Accept no more than two risks per investment
  2. P x S x E = V (where P = problem size, S = solution elegance, E = entrepreneurial team, and V = valuation)
  3. Law of the Big-P
See my follow-up post The 3 Laws of Venture Capital where I expand on this list.

The 5 Audits
Based on the above disciplined approach to considering investment decisions, Silver then goes on to outline the five audits that a VC should do to ensure that they have fully vetted the deal and are not undertaking undue risk in the investment. The five audits are as follows (in order):
  1. The Audit of P (see follow-up post The Audit of P and S)
  2. The Audit of S (see follow-up post The Audit of P and S)
  3. The Audit of E (see follow-up post The Audit of E)
  4. Financial Statement Audit
  5. Legal Audit
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