advertisement
advertisement
The Fast Company Executive Board is a private, fee-based network of influential leaders, experts, executives, and entrepreneurs who share their insights with our audience.

VCs will need deeper technical due diligence capabilities

Venture capital firms are going to need to develop new skill sets and diligence processes to determine which startups and founders deserve capital.

VCs will need deeper technical due diligence capabilities
[fizkes/Adobe Stock]

In 2011, A16Z cofounder and general partner Marc Andreesen famously said, “Software is eating the world.” He was right; 11 years later, it has completely devoured it. Now, investors are wondering what the next megatrend is going to be that completely changes the way we live. With advances in computing power and global crises accelerating the need for innovative new technologies, startups commercializing scientific breakthroughs in energy, transportation, infrastructure, agriculture, manufacturing, and human augmentation are poised to be the next wave of companies that “eat the world.”

advertisement
advertisement

The earliest venture capital firms in Silicon Valley had very strong technical teams because they were making investments in telecommunications and semiconductors. Basic pattern recognition was not enough to ensure they were making an investment in a technological breakthrough. Unfortunately, that is no longer the case. Most venture capital firms today are not in a position to understand the risks associated with this new generation of breakthrough science startups. They can’t tell if a company has developed a true breakthrough or if it is just a small iteration of existing tech—or pseudoscience that will never work. This is largely the result of two decades of VCs pouring money into startups focused on mobile apps, social media, SaaS, and fintech.

To prepare for this new era, venture capital firms are going to need to develop new skill sets and diligence processes to determine which of these startups and founders deserve capital. The days of writing large checks to startups with just a pitch deck and no product are over. Diving deep to validate founders’ scientific breakthroughs and their applications can be time-consuming, but as the Theranos scandal proved, is critical.

Venture capital firms must fully understand an underlying scientific breakthrough and resulting technology enough to identify the risks and help founders manage those risks. VC firms need to adopt new technical diligence processes driven by a diverse team of scientists and engineers. The MBAs who have traditionally filled the ranks of the top VC firms are going to need the support of PhDs, MDs, and researchers who can look at patents and research to see if the company truly has made a breakthrough.

advertisement
advertisement

First, venture capital firms have to develop better landscaping and pattern recognition capacities across these new industries. They will have to do the same in deep tech as they have in SaaS and fintech. My team and I recently invested in a lithium-sulfur battery developer based on years of research in this industry. VCs have to go out and develop conviction around technology readiness and market readiness for months or even years before making an investment in these sectors. Doing technical diligence from scratch in a totally new vertical is difficult and prohibitively time-consuming.

While looking at cap tables and financials will remain critical, the technical review of the due diligence process is becoming more important than ever. Like most VC firms, my firm conducts in-depth reviews of the company’s leadership team, business, and deal terms. Unfortunately, this is where most firms’ due diligence ends, but it is where it really needs to begin. At Prime Movers Lab, we’ve developed a world-leading technical due diligence process. As part of our technical deep dive, we look for a few core things:

1. VALIDITY

advertisement

We undertake a systematic targeting and diligence process to assess technical risk by looking at specific industries that we think need a breakthrough or are on the verge of one. We don’t invest in significant scientific risk. Many investors have made the mistake of investing in science risk, which by its nature is impossible to underwrite to a particular timeframe or budget. We target companies that have retired as much science risk as possible and have a clear engineering plan. At the end of the day, both scientific and engineering plans have to respect the laws of science.

2. REQUIREMENTS

My team and I also work to make sure that the company clearly understands what needs to be built. During this step, we meet critical members of the technical team to learn about their expertise and experiences because we want to know if there are any technical expertise gaps. Venture capital firms can’t focus on just the physical hardware and whether it works. They also need to look at the strength of the technical team to make sure they have the right people to reach the milestones that they have outlined.

advertisement

3. MATURITY

A startup’s engineering, planning, and manufacturing standards need to be maturing at an appropriate rate. We want to understand if they are ahead of the competition and if the investment amount is appropriate to achieve the next round of technical milestones. Most importantly, the timing needs to be right. Most things that we think of as science fiction will become reality someday, but investors cannot wait forever. Time is a luxury and it is not on the side of most startups.

4. DEFENSIBILITY

advertisement

Firms need to identify the defensible intellectual property that startups possess and how their technology is differentiated from competitors. It needs to be hard for competitors to copy their achievements, IP/trade secrets, and business strategy. Startups should be forthcoming and ready to share technical data.

Venture capital firms owe it to the world to conduct deep technical due diligence. They will need to strategically grow their teams to include people who have a strong understanding of the scientific landscape across multiple industries, and be prepared to walk away from deals when founders are not forthcoming. The problems that society is facing are too important, and capital needs to be appropriately allocated to the startups that are actually going to change the way we live.


Dakin Sloss is the Founder and General Partner of Prime Movers Lab, the world’s leading partner of breakthrough scientific startups.

advertisement
advertisement

Call for Most Innovative Companies entries! Apply now.

500+ winners will be featured on fastcompany.com. Final deadline: 9/23.