ExtraVallis Expert Interview: Due Diligence with Eli Velasquez of VentureWell
We had the honor and pleasure to catch up with Mr. Eli Velasquez, Head of Venture Development, VentureWell, on the topic of due diligence. This interview and its topic, incidentally, reflects the startup investment scene in this pandemic time.
Key Takeaways
In a founders market or an investors market, who has more negotiating power?
In a matter of weeks, due to the pandemic, we went from a founders market to an investors market. Investors are taking on more rights into the companies: more board rights, more liquidation preferences. There are a lot more terms that have now shifted in favor of the investor. And because of that, it's making it a little bit harder for startups to have strong negotiating power.
What is the tedious work necessary to best assess the risk of a company?
Eli wants to encourage a lot more one-on-one engagement between the investor and the founder. It's tedious work, but it's necessary to help assess the risk of a company.
How to quickly reach a state of mutual understanding between investor and founder?
In order to quickly reach a state of mutual understanding between investor and founder, there should be a forthright conversation in the beginning to agree on a common goal of moving the company towards success.
Founders should not neglect this part of their company
Founders should not neglect the “back office” of their company, like corporate and legal matters. Back offices should be orderly and operated correctly.
How and when should founders make information available to investors?
All templates, agreements, procedures, policies – all of that has to be in place and well looked at by attorneys and accountants and professionals – must be in order. And then once it's put together, then founders should make it available to investors in a secure, cloud-shared folder.
Under what circumstances should you be going into opportunistic buying at this time?
For investors who want to be opportunistic during this time, unless you intimately know the industry that you want to invest, or you are completely skilled and an expert, and you have a strong network in a particular industry, you should not be going into opportunistic buying unless you have that wherewithal.
Edited Transcription (edited for readability):
Interviewee: Mr. Eli Velasquez, Head of Venture Development, VentureWell, a non-profit organization on a mission to cultivate an ecosystem of innovators, inventors, and entrepreneurs through training, mentoring, and funding. VentureWell is the global implementer of the United States government Department of State program entitled Global Innovation in Science and Technology.
Interviewer: Mr. Aaron Everhart, Head of Asia Territory and CMO of ExtraVallis. Aaron is also the founder of HATCH! Ventures, a startup ecosystem builder in Southeast Asia and local implementer of GIST activities in Ho Chi Minh City, Danang, and Hanoi, Vietnam.
Aaron, host: First question: what would you say is the current state of due diligence in the world of early stage startup investing?
Eli: So I'm glad you asked that question, Aaron. I've been doing a lot of interviews with other angel investors and venture capitalists and the responses are mixed.On one hand, you have the camp of investors who’re saying, let's just wait, let's maintain our liquidity, let's maintain our cash. And let's not make any investments now, or, take on the risk of making investments. And thereby, not do any due diligence, obviously, if you're not investing in deals.
And then on the other hand, are more of venture investors or angel investors with a lot more experience saying this is the time to invest and this is the time to start looking at new deals and they continue to explore new opportunities and thereby continue to follow the process of doing due diligence. So it really is a mixed approach. And I think it comes down to the risk threshold that the investors have chosen to take on. So I can't say it's either one or the other.
Aaron: So there’s no indicator in the market whether it’s full steam ahead for all parties? It’s kind of a personal thing?Eli: It is, and I would say in some cases. I was on a webinar last week with a couple of private equity investors. One invests in the cannabis industry, and they are going full steam ahead. They're saying we're going to keep making investments, keep looking at deal flow. And then the other private equity firm is investing in healthcare. So of course, you can kind of see the correlation there. Yeah. So when you look at cannabis, and then healthcare, it's kind of interesting to look at the relationship and to see how they are budgeting.
Aaron: So can you tell me a little bit more about those? So you mentioned that some are being a little bit more and some are being a little bit less conservative. What are the things that might be influencing them? I'm just throwing out one prompt, say, industry?
Eli: So the individuals who consider this is the time to get in on opportunity are predominantly those that are looking for how their industry or new industries will emerge as part of and post pandemic. For example, one individual who has expanded from simple healthcare devices, and healthcare diagnostics into generally health care services, so they are now exploring software, education and supply chain in healthcare. So they have expanded out their investment thesis to start looking at how industries are going to be changing as part of this pandemic. So I would consider them some of those like opportunistic or futuristic looking investors who think about where these new industries and markets will emerge, then go ahead and put some money down into those areas and see where it goes.
Aaron: So could you characterize or discuss a little bit about how some investors might be taking advantage of lower valuations?
Eli: Yeah, again, it's been interesting, because one investor that I spoke to said, in a matter of a few days or weeks, we went from a founders’ market to an investor's market, meaning there was a lot more capital in the system: founders could pick and choose where they could get their investment from, so investors were clamoring for attention from founders. Now the situation has sort of switched, there's less capital, people have pulled back and in many cases, and founders are now having to hunt around for the right investor. And because of that, investors are more inclined to take on more rights in the company. So they're pushing valuations down, in some cases, as much as half or more.
They're taking on more rights into the company: I want more board rights, I want more liquidation preferences, which means I get more of my money out in the event of an exit or more money back. So there are a lot more terms that have now shifted in favor of the investor. And because of that, it's making it a little bit harder for startups to have strong negotiating power.
Aaron: So is there anything else you want to say about the state of due diligence?
Eli: If you're an active investor, or you're going to be making investments, you still need to engage within the same due diligence that you would normally do. Be as thorough as you possibly can, I would say, maybe more thorough in the process, because there's so many uncertainties. Really test the startup around the kind of risks that they'll be adopting, or mitigating as part of addressing the pandemic, like where will you be hiring teams? How will you get customers? How will you manage your supply chain? Be extremely diligent as part of your due diligence.
Aaron: I’d like to get into the how of that in a little bit. But first this question: what is your biggest concern [as it relates to due diligence]?
Eli: Typical to other investment opportunities, not really thinking long term, about the impact that the economics is going to have on startups. And if an investor is not aware of, or really being thoughtful about their approach, it could actually come back and bite them later. Because not only you as the investor, adopting a little bit more risk by investing now, and then not taking the time to do that little bit extra due diligence could be a double hit, if you don't make that right decision doing due diligence.
Aaron: So if you could change one thing about how due diligence is done. What would it be?
Eli: I would definitely encourage a lot more one on one engagement between the investor and the founder. And a lot of times investors don't want to do the due diligence, sometimes don’t even read the due diligence info that’s been prepared. I shared 13, 15, or 20 pages of due diligence memos with other investors then came to find out that they didn't really read it. So if you're getting into this, you have to work very closely with either the founder or with a team of investors to actually take part of the due diligence. It's tedious work, but it's necessary to help you to assess the risk of the company.
Aaron: If you can think of an analogy in any other realm, sometimes that helps people get their mind about things and understand them clearly. Can you think of an analogy?
Eli: Sure. If you're gonna make a major purchase this year, to buy a house or a car, if you want to obviously learn as much about the property: who owned it before, how it was treated, what kind of damage it has, what are the secret pockets of the house, does it have any holes or plumbing issues? So you’d get inspectors to go in. They’d “research” the house inside and out. And you’d walk in there too, you’d inspect everything you could. Because you're about to make a significant investment. So you want to understand all the good, the bad, and the ugly that came with that house investment. And that's how I would assess due diligence for startups. It's not enough just to accept the founders’ claim that their company is good. The investor has to get inside the company, dig around. The digging comes through due diligence: looking at paperwork, examining the legal structure, and talking to the team. Investors have to know about the company as good or better than the CEO knows the company.
Aaron: Interesting. Inspector is kind of a third party and indirect thing. But I'm thinking that maybe face to face, due to cultural factors or politeness, not everything gets shared candidly. Do you think that there's any problem with that?
Eli: This is an issue. The founder wants to put the best face forward for the company because the founder wants the money. And, many times, the founder will unnecessarily hide information or not disclose information. They may have issues with a team member and they don't bring those issues to the light. And it becomes an interesting dance between the investor and the founder, until they find a comfort zone of trust. And they say, “look, I only want to help because it is my investment and I want my investment to succeed.” When the two parties come to that same understanding, is when you start to see that flow of information go a little bit smoother.
Aaron: That makes a lot of sense. Can you think of a way for that to happen faster?
Eli: I’ve always put this on the investors for them to say to the founder, “look, if you get my money, you also get me.” So, being forthright about the fact that I'm going to be engaged and I will ask questions, that I'm not doing this to be a mean overlord to take over your company, but that I also want to get my money out someday. I think if this conversation happens very early in the process, it helps both parties to understand that they have a common goal of moving the company towards success.
Aaron: Now I just want to ask you, Eli, if you could give some bullet points on what is your idea of a perfect due diligence process. And I know that that might be kind of hard to do in a short span of time. So perhaps you have a resource where a longer explanation or template for perfect due diligence might be.
Eli: Perfect due diligence would be ideal in a perfect world. One of the key points of advice that I give companies is that you have to get your team all aligned and make sure that the business model is working and the customers are working. That's the front part of the business. That's what everybody likes to see. But an equal or even greater part of it is the back office.
Have you ever walked into a retail store that looks really pretty in the front, but then you walk in the back and it's a disaster? The founder has to take the time to get all of their corporate and legal matters in order. Here's the tough part: you have to have it done right. You have to do the templates, the agreements, the procedures, the policies, all of that has to be in place and well looked at by attorneys and accountants and professionals. And then once it's put together, then you'd have it available in an online share folder on a secure server.
With this in place, when an investor is interested in your company, all you have to do is to send them a link and say, “here's everything that you want to know.”
Hopefully, you organized it in a clear folder structure; and now, the investor can go through that material at their leisure. Having the material available, now it's beholden on him or her to do the due diligence within a reasonable amount of time. So the investor can say, “let me take a week or so to get this stuff going with the investments; then it’s going to take two weeks with my other investment team. In the meantime, we're going to come back to you with questions.”
So there is an open channel of communication. And then there's a formal closure to say, “we have completed our due diligence, and we are ready to move forward,” or “we’re not ready to move forward, and this is why...”
So it's a very step-by-step mathematical process, that requires a lot of back and forth, and it has to be efficient.
Aaron: Sounds like that having a share folder would make it efficient. Is there a standard term for naming that folder?
Eli: We refer to it as the “Deal Room”, others may just refer to it as a “due diligence packet”.
Aaron: Great. I got one more question, Eli, and this is going to be a fun one. So in the space of due diligence best practice, what leader do you most admire?
Eli: My hero investor is a gentleman named Faz Bashi. The reason I like Faz is because he asks the most thoughtful, critical questions of a founder. And the reason I like the way he approaches due diligence is because he's very open and forthright
Faz always starts with this question when he meets with a new founder, he asks, “Will you give me the name of your corporate attorney, and give me the name of your IP attorney?”
Faz is looking to see if the company, at the beginning, is already thinking about ‘getting their house in order’, from a legal perspective.
And if they say, “well, I'm gonna go get one now,” or “I don't know one,” or they say, “my aunt is a lawyer.”
Then Faz says, “come back to me when you're ready with a formal corporate attorney and informal IP attorney.”
And that's how he starts the process. So now you (the founder) knows that Faz is going to engage with you; to make sure that you can only come to him when you have all of that in order.
Once Faz starts the due diligence process, he is consistent in giving feedback. He reads everything in the Deal Room folders. Then he comes back to you with poignant questions that he wants answered in order to learn more about your business. Faz engages with the founder consistently. So I would say this is the guy that you want to look up to when you're doing due diligence.
Aaron: So let's flip back to that house- (or car-) buying analogy. How would you fit asking for the name of the corporate attorney and IP attorney matter into our analogy?
Eli: You as a seller, can you show me for example, the interest history of your house, whether your house has been adequately insured, show me the maintenance records of your home right now, have you consistently kept up with the paint and the plumbing, have you been keeping up with your mortgage, have there been any issues with the lender, or banks having issues with with your property, have you done a property assessment, is there any bad soil, those kind of things where you have the professional records ready and available because you've taken the time to use professionals in selling your house.
Aaron: Are there any last minute tips you want to share with us or any online resources or entities that you want to point people to?
Eli: There are a lot of investors that may appear to be (or want to be) opportunistic during this time.
One tip is, unless you know the industry that you want to invest in backwards and forwards, you are completely skilled and expert and you have a strong network in a particular industry, you should not be going into that unless you have that wherewithal. It might be tempting to invest in all these different things that you're seeing, and that may be arising as part of the pandemic. But if you don't have expertise in those areas, you know, don't don't swim into unchartered waters.
The other tip is about the program we run with the State Department: GIST. You can use it to create a network of like-minded investors. It enables investors to organize themselves and start to work together to invest in industry sectors that they understand.
Also the Angel Capital Association, also our partner, has areas where global investors can link in with other like-minded investors in the US, like life science, healthcare, energy, or women-owned.
Aaron: Would you like to point people to any websites or books?
Eli: Definitely. Go on our website Venturewell.org for links to the different programs that we offer, both in the US and globally.
Go to the Angel Capital Association website which provides a lot of resources, both free and paid webinars.
I would also point you to the GIST website, gistnetwork.org to learn more about GIST program and how you as an investor can connect into our global network.
ExtraVallis would like to thank Mr. Eli Velasquez for his time.