Raphaëlle d’Ornano is the Managing Partner + Founder at D’Ornano+Co., a pioneer in Hybrid Growth Diligence.
The full details of the FTX disaster won’t emerge for years. But in a court filing, the new CEO of FTX said he had never seen “such a complete failure of corporate control.” How could investors not know what was going on? The answer is simple: In my opinion, the traditional way of conducting due diligence for early-stage investments made primarily by venture capitalists continued to be used by the “non-traditional investors” (NTIs) who have come to dominate massive late-stage funding rounds in recent years.
The participation of these NTIs has been one of the defining aspects of the recent tech funding boom, sending valuations soaring. NTIs are used to investing in public companies and apply a similar skill set when looking at pre-IPO companies. But in the case of FTX, despite the amount at stake (according to Pitchbook data it had a $32 billion valuation in January 2022), the company was nowhere close to an IPO, where they’d encounter rigorous controls to meet security regulations. Instead, they resembled more of an early-stage startup.
In the case of early-stage investments, traditional venture capitalists (VCs) are looking at subjective factors such as product-market fit, and the absence of any deal breakers.
It’s a whole different game for late-stage investments—or at least it should be. Diligence questions should include the quality of execution, the governance, whether the financials indicate a clear path to profitability and whether the right processes and controls are in place to produce quality financial information. This is especially true in the presence of NTIs who do not ask for board seats, enabling greater insights into operations. But in the recent period, both NTIs and late-stage VCs have not conducted such “hard diligence” as the fear of missing out took hold.
Adapting to late-stage investing starts with avoiding “factor-driven” investments that are based solely on markets or trends. Instead, investors should use diligence to cherry-pick the winners by rigorously analyzing the unit economics of the business model in the context of the company’s vertical and market to understand the robustness of the economic engine. At late-stage, efficiency and scalability are what investors are looking for.
Solid due diligence should look for obvious warning signs that the company is not efficiently using its cash, with a focus on understanding the efficiency of the sales and marketing engine—or in some cases, its mere inefficiency. Earlier this year, we advised a US investor not to participate in a mega-round for a similar reason. In such cases, late-stage investors need the discipline to walk away.
Even if the frameworks and metrics are still evolving, good governance is paramount. There may not be explicit rules and regulations, but it is possible to know whether a company has in place the proper controls. We’ve already learned that in the FTX case, there was not a robust process for risk management, there were slippery business ethics and no controls on conflicts of interests along with confusion about the relationship between FTX and Alameda Research. Going forward, I expect diligence to increasingly focus on governance issues.
In all cases, fraud is against the rules.
To capture the relevant issues of high-growth and disruptive companies, a holistic framework is needed. Assessing risks and opportunities on these targets is all about connecting the dots between financial, legal and ESG issues, and asking: In a given case, what could be the true deal breakers?
Furthermore, due diligence must be continuous and not just conducted at the investment stage. It’s unthinkable for investors not to inspect the company each quarter—at least with a light touch—in advance of the board meeting using the right frameworks. For hyper-growth companies, everything is in fast-forward mode: A quarter is a year. A month is a quarter. Beyond the business progress, it is likely that the legal and regulatory landscape is evolving rapidly, and course corrections will be needed.
If there is some good news for investors in all of this, the reset in tech valuations (download required) means the pendulum is swinging back from founders to investors, giving them more time to dig into the truth. More fundamentally, this new form of due diligence can rebuild trust in these assets and avoid the kind of failures that can undermine the reputation of the entire startup funding ecosystem.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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