This is the first in a series exploring the differences in conducting due diligence for venture capital, private equity, and growth equity clients.
When buying or investing in a new business, it is imperative that you conduct due diligence (DD) to make sure your investment is evaluated for any potential issues that may cause expensive losses in the future. Often, due diligence is conducted by an experienced consulting firm that investigates the company in question commercially (CDD), legally, financially, while also assessing their technological capabilities (IT DD).
At Penser, we have worked together with major companies across a variety of investment & expansion opportunities. Our extensive expertise in conducting due diligence allows us to understand the nuances in working for venture capital, growth equity, and private equity investments and to guide our clients to a profitable result.
Venture Capital (VC)
Venture Capital refers to investments made by external investors into a startup. Often, the company is in its early stages and has displayed impressive growth potential. Venture capital investments are high-risk, but when invested correctly, the payoff can be immense. For instance, Facebook’s acquisition of WhatsApp in 2014 for $22 billion remains the largest private acquisition of a VC-backed company. At the time, WhatsApp’s only venture investor was Sequoia Capital which managed to turn its $60m investment into $3 billion.
Another example of a venture capital investor gaining back their investment many times over is Morningside Ventures, who invested in Chinese smartphone manufacturer Xiaomi. During Xiaomi’s IPO in 2018, Morningside Ventures made 40 times their initial investment, making it their most successful investment. Their backing helped Xiaomi become the third most popular smartphone maker in the world. Early VC investors have the advantage of gaining a larger share of their target company, leading to a higher profit down the line.
Venture Capital Due Diligence
Due Diligence is an integral factor of venture capital investments. As VCs invest large sums of money into startups, they need to gauge their potential return, from simply recouping their investment to reaping big profits. For instance, while Sequoia Capital had a successful investment with WhatsApp, their investment in eToys did not go the same way. The total funding amount for eToys remains undisclosed but the company raised $166.4M at its IPO before it closed down in 2009.
At Penser, we have an extensive checklist we work with for commercial due diligence (CDD) and technical due diligence (IT DD) for fintech venture capital investments. Here are some of the most significant aspects to consider:
Market Drivers
Due diligence must be done to explore the influence of market drivers, such as changing technology trends, regulatory environments, shifting customer needs, the dynamics of the industry etc. on the product or service in question. The product or service should be capable of attracting & maintaining enough interest to turn a profit, while adhering to compliance regulations. Earlier this year, Tink Labs, one of HK’s first unicorns, shut down after facing monetary and labour issues. Valued at $1.5 billion at the peak of its time, Tink Labs boasted of an array of investors including SoftBank Group, FIH Mobile (Foxconn subsidiary), Sinovation Ventures, and others who raised $125 million in funding. FT noted that the flow of capital into China’s tech sector was declining, and due diligence on prospective investments had increased significantly due to potential risks. Thus, it’s important to consider the various market drivers that can have an impact on an investment — both in the current & future market climate.
VC investments into fintech must take into account the dynamic nature of the industry, the introduction of new regulations such as the PSD2 and the Open Banking mandate and the capability of the company to adapt & thrive in this dynamic environment.
Product Value Proposition & Business Plan
Along with external factors that can influence the product/service, the investment should also consider if the startup has a roadmap for the future that meets customer needs. A due diligence report should also explore the impact of competitors, the current product suite, test assumptions of top-line growth, operating margins and costs, and benchmark the same against industry averages. Path, a social-network considered a competitor to Facebook, gained $66.25M in VC investment, before being bought by Korean tech company Daum Kakao for an undisclosed amount. However, it couldn’t make its mark on the social media market and closed down in October 2018.
Tech Assessment
When it comes to technical due diligence, it is important to assess the technological architecture and test platform scalability & resilience. But during a venture capital investment, it is just as necessary to assess the intellectual property to make sure the company has built something that is truly differentiated. Ensuing that the platform has the capability to withstand any potential security breaches, handle spike in user growth, a viable disaster recovery plan etc. is also important during a VC due diligence consultation. Here are the most important questions to ask during a tech due diligence consultation.
Venture capital investments look for high-value propositions, products with an innovative and enduring appeal, and those that will offer profits in the long run. These investments can be extremely risky, but doing thorough due diligence of the target company will significantly mitigate this risk.
At Penser, we specialize in fintech and have successfully guided the investment decisions of private equity and venture capital investors, as well as corporations, in payments, digital banking, wealth management and lending.
Request a sample due diligence report & contact us here to find out how we can help guide your investments by conducting commercial and technical due diligence.