The Business Times' Column | Due Diligence: The hard talk that venture capitalists need to have with startups now

This column was first published on The Business Times

By Benedict Tan

AS AN investor, I often hear about the various ways startup founders celebrate after successfully raising investments from venture capitalist (VC) firms. Raising new funds is no easy feat, and definitely a milestone for the founders.

After all, it takes an average of three to four months of intensive investor due diligence ranging from background checks on the founder(s), verifying the business’s technological stack, digging deep into market research and scrutinising go-to-market strategies.

But receiving the cheque from the investor is just the beginning of a long relationship between the founder(s) and their investors. There will be numerous challenging decisions that founders and investors need to make until the company eventually exits. Such tough decisions are now made more difficult in the current environment of cutbacks and lower valuations.

Founder red flags, cutbacks, down rounds

Due diligence can help investors to spot potential issues early, but even the most thorough diligence only gets investors that far. Ongoing monitoring of the portfolio is critical.

In today’s rapidly evolving market, new breakthrough solutions could quickly upend age-old business models, and disrupt product viability and unit economics. A good example is ChatGPT by OpenAI, a new artificial intelligence chatbot with the capability of automating tasks such as drafting essays, writing computer codes, answering enquiries etc. I imagine that certain companies that VC firms invested earlier this year thinking that they were the latest groundbreaking innovation, could be disrupted by the integration of OpenAI tools today.

After investing, the lead investor’s goal is to ensure that the startup founders build a scalable business successfully and exit at a high valuation multiple. Catching red flags along the way is an essential part of the job, and doing it well takes years to hone the required skills and gain experience.

An issue that is common but hard to predict is conflict among the co-founders, or management team. And this issue is typically of high concern for investors.

If left unresolved, this could lead to the sudden departure of one or more parties and even the eventual collapse of the business. In these situations, the board of directors would need to discuss and objectively determine if the departing party is a good or bad leaver, as defined in the Shareholder Agreement (signed at the point of investment), and execute the appropriate share clawback procedures (claiming the equity back from the party who is leaving).

No matter the outcome, this is a nightmare for early-stage VC investors, whose core investment thesis is typically heavily anchored on the founding teams and their execution capabilities. This is not to mention the damage to the remaining team’s morale and visible dent in business growth.

There are also conundrums that place the VCs and founders in a precarious situation where their interests and agendas may diverge. Today, in a recessionary-like market where there is slow funding activity, it is common for VC firms to advise their portfolio companies to reduce their burn rate to tide over the funding winter. And these are often not trivial measures.

Founders would need to reduce expenses such as marketing spend, shut down low-priority initiatives, and possibly roll out firm-wide layoffs. Even if the company survives, cutbacks indirectly impact the VC’s fund performance. The company’s top-line growth will be far behind the original forecast plan for the next few quarters, or worse, go into hibernation mode for the foreseeable future.

The story does not end here. Many startups which previously raised at abnormally high valuations in a frothy capital market environment back in 2021 would likely find themselves in a delicate position. As the capital market has significantly cooled, VCs are no longer willing to pay the same price as the previous round; hence, a huge disconnect opens up between the startup’s reasonable intrinsic value versus their last valuation.

During this period of “funding rightsizing”, raising new funds becomes mountingly difficult. Not only do founders have to convince new investors to invest, but raising at a down-round valuation means founders themselves have to be diluted substantially. They also have to convince their existing investors to mark down their investment below cost to reflect the revised valuation.

This is hard for many VCs to accept, as they are acting fund managers on behalf of their limited partners (LP), and every dip in performance could impair their chances of raising the next fund.

Anticipating derailments, correcting course

How do an investor and founder then navigate through sensitive and complex issues in each situation? One role that the lead investor should play is to help anticipate potential derailers, and provide advice and lend their experience to guide the founders.

From our perspective, lead investors play a crucial role to ensure that problems are surfaced in a timely manner and potential solutions are discussed and executed. The lead investor is also often the primary provider of capital for their portfolio companies and, therefore, holds significant influence in the decision-making process. In most cases, the lead investor is appointed to join the board of directors and is heavily relied on by other investors to monitor the company’s performance post their investment.

Lead investors stay actively involved with the portfolio company throughout the life-cycle of its investment. They provide guidance, monitor progress, and assist in strategic decision-making. This ongoing involvement helps ensure that the investment remains on track, and that steps are taken to correct course early if necessary. In cases where there is misalignment between the founders and other stakeholders, lead investors serve as the middle ground of both sides, and should quickly step in to reorientate the interests of all parties.

The lead investor often treads a fine line navigating between objective yet complex business needs on one hand, while maintaining trust and rapport with the founders. However, this is often easier said than done.

In practice, when it comes down to making difficult decisions, many lead investors, including several experienced regional VCs, may choose the “easy” way out by avoiding confrontation instead of putting their relationship with the founders at risk.

Certain lead investors may choose to react passively, adopting a “yes-man” mentality, not course-correcting early even if they know the business direction is wrong, or in a worse scenario, acting prohibitively and threatening the founders to act in a certain direction (at times even against the founder’s principles).

In some bad-faith situations, some investors actually invest in competing companies.

As with any marriage, there will be matters where priorities might be misaligned. At these crucial times, we are not afraid to offer our stern but fair criticism based on our past experience, judgment and instinct – be it providing a reality check for the founders on outlook, poking holes in their assumptions, and making sure that they understand the rationale behind the recommendations.

Good founders understand this and are appreciative of such constructive disagreement and forthcoming conversations to ensure that they have deeply considered all factors before making decisions.

Some words from one of our portfolio company founders struck me: If your founders are only sharing the good news and not sharing their troubles, then in their mind, you fall into the “other investor” category to them. In general, VCs need to invest the time to build trust and rapport, but founders also have the responsibility to be upfront and proactive in surfacing concerns.

Of course, the VC may not always be right. But this is where regular and frank conversations are critical in equipping VCs with the right information and instincts to engage productively with founders to solve problems. We feel that only through a hands-on model approach can VCs intrinsically understand the problems faced and decide their next course of action, whether it is offering a bridging fund, or brainstorming new ways for the company to pivot their current value proposition.

Being there during bad times

But speaking up is not all it takes; VCs also need to remember the human aspects as well. It is easy for investors to get engrossed in problem-solving when it comes to crunch time, and that they are still dealing with people, who are usually under immense pressure.

Founders should not bear this alone. Beyond tangible financial and business support, the VC can serve as an important emotional pillar for their founders, especially when the chips are down.

The litmus test of a great investor is how they manage their portfolio company when the odds are turned against the founders. Will they roll up their sleeves and push through with you? Or will they turn out to be fair-weather investors – passively praying for things to get better?

A good lead investor brings a tremendous amount of expertise, industry knowledge, and experience to the table, which is valuable in guiding the company’s strategic direction, especially for a fresh-faced founder. While investors and founders have the same north star for the business to grow, what truly separates great investors from ordinary investors is the appetite for hard conversations with their portfolio founders, especially when it matters the most.

Benedict Tan is an investment associate with Vertex Ventures South-east Asia and India

We publish monthly on The Business Times "Due Diligence" column and we invite you to read our previous articles here.

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