How diligent is your due diligence?

Failures like Theranos and FTX put due diligence in the spotlight. Proposed new SEC rules for VC and similar funds will make diligence even more critical.

Spectacular corporate failures tend to be followed by a wave of questions. How did this happen? Why did nobody see this coming? Why wasn’t this caught by due diligence? How do we prevent this from happening again?

The FTX failure is recent example where poor due diligence is being blamed for investor losses of around $2 billion. Some investors did their own diligence but now admit their processes have obvious room for improvement. Some simply assumed they could rely on the diligence of others. That turned out to be an embarrassing and costly mistake.

Adding fuel to this fire is a move by the SEC to tweak the regulation of private fund advisors, making it easier for LP investors to sue VCs and other GPs when they mess up. In a rule that could come into effect this year, VCs would be exposed to investor lawsuits for mere negligence, rather than gross negligence (the status quo for most private funds). This will put pressure on VCs and PE firms to up their game on due diligence, to show they were not negligent in their deployment of investor funds.

The venture capital industry is, not surprisingly, strongly opposed to these regulatory changes, pointing out that it will increase the cost of doing deals and reduce access to capital for many startups and growth companies.

Nonetheless, some big-name VC firms are already signaling plans to overhaul their diligence efforts. Having lost $150 million on FTX, Sequoia reportedly told investors it would improve due diligence on future deals. It seems likely many other VC and PE firms are making similar moves.

On a brighter note, the technology for conducting due diligence continues to improve. In the past, many firms would de-scope contract and document review to a limited set of “material” contracts to reduce the burden of human review. As AI-powered contract analytics improves in accuracy and reliability, it’s possible to lower the cost of reviewing a given set of documents for various risks and issues (sometimes quite dramatically), or to widen the scope of documents reviewed (without increasing costs), making it less likely something important is missed.

Document review won’t catch all red flags, but it does go a long way. If you’re curious about revenue projections, for example, there’s much to be gleaned from looking at all customer contracts. If you’re worried about the strength of a company’s intellectual property (IP), a comprehensive contract review can highlight IP gaps, leakage, and exclusivity complications. To better understand unusual spending commitments or third party compliance risks, look closely at the supplier and vendor agreements. When Theranos claimed to have revenues of $140 million for 2014, it might have been a good idea to say “show me the contracts”. Revenue for that year was actually zero.

Due diligence will probably never be fun. But it is getting faster, cheaper, and more effective thanks to technology.

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