The shifting VC landscape: doubling down on diligence (part 2)

Written by Charlie Renzoni. Survey by Charlie Renzoni and McKenzie Foley.

For the first time since the pandemic, both founders and VCs have once again been asking “Are VCs really open for business?”. In part 1, we explored what has changed, and what hasn’t, in the VC ecosystem since the end of the zero interest rate policy (ZIRP) era:

• Habits formed in the COVID era around remote deals are not going away, so we are likely to see habits formed in 2023 to remain as well
• VCs have changed how they spend their time twice as much as when the pandemic hit
• The slowdown in venture deals is not due to dealflow, but changes in diligence practices

In part 2, we are getting into the weeds of how and why VCs are doubling down on diligence. The key points:

• 9 categories of diligence are seeing a >30% increase in focus from VCs, specifically in quantitative diligence, founder and investor analysis, as well as customer diligence
• Most VCs have slowed their diligence timelines, with over a third of VCs spending more than 5 weeks on any given new deal
• ESG diligence has still not gained traction in the market, despite LP and market pressure

The current venture capital environment is experiencing an estimated 31% decline in deals (61% drop in value) since the peak in 2021 according to Pitchbook, even in an environment where 38% of VCs are seeing a >25% increase in deal flow. As a result, we are seeing record number of startup shutdowns, something we don’t expect to slow down in 2024. Have technology companies’ performance dwindled in 2023? Or has the bar for diligence risen since 2021? Our data points to the latter: VCs have drastically changed how they evaluate companies.

Overall, 9 categories of diligence have seen over a 30% increase in focus by the >80 VCs we surveyed in Q3. There are many reasons as to why these categories in particular are under scrutiny, and we explore many of these reasons in this post. One global reason, and an important factor to note, is that startups aren’t the only ones facing a difficult fundraising environment. VCs raising funds are facing an environment that is at least 2x harder than in recent years. According to the Venture Capital Journal, H1 2023 LP funding of VCs is down over 40%, with the number of funds receiving funding down 70%. LPs are simply less willing to take on the risk of venture capital when high yields can be found with less risk in other asset classes. Moreover, the denominator effect has caused many asset managers to be over-allocated to private markets overall.

56% of VCs have an increased focus on financial analysis in 2023 vs 2021.

While this will be no surprise to any founder who has fundraised this year, financial diligence has increased in priority for VCs of all stages in the current market. This can include everything from evaluating the P&L, testing the unit economics, deconstructing the company budget, and a lot more. But VCs don’t just care about past company performance, they seek out pragmatic forward-looking forecasts — use of funds analysis was reported to be an increased focus for 37% of VCs. In the wider category of quantitative diligence, exit analysis and comparable analysis have also seen respective changes of +33% and +31%.

Why is quantitative diligence an even greater focus in 2023? The public markets illustrate it well, where software companies have dropped below historic average valuation multiples as a result of record-high interest rates and record-low growth rates. Further, the benchmark for a public software business now has the highest free cash flow margin of the last 8 years, reaching 12% in Q3 from a long-term average of 6% and a 2022 low of just over 2%. With the changes to interest rates, this was a welcome but expected outcome given the resultant increased discounting on future earnings and increased value of cash flow today.

Despite these significant changes, investors like Jamin Ball still believe that valuations, growth and profitability considered, are still above historic norms. Many investors are realizing that the market for exits at 80x NTM revenue will very likely not exist again this decade. As Jamin Ball stated, “The reality is the vast vast majority of private investments will exit for <10x NTM revenue (most won’t exit)”. These public market phenomena impacted growth equity first, drastically reducing the amount of late-stage growth capital available for startups, particularly for those who have historically prioritized growth over the underlying economics. VC investors have reacted by prioritizing financial and quantitative due diligence. This is explained well by Martin Escobari of General Atlantic, “Rationality comes back to the industry and things are priced at more reasonable levels as growth at any cost is replaced by a respect for capital efficiency and profitability. This is a moment where strong companies becomes stronger, which weeds out the unprepared.”

The changes aren’t limited to quantitative analysis. Founder and management team evaluation has seen an increased focus with 44% of VCs.

The 2nd largest bucket of changes to diligence is around the people. Founders are under the microscope, but this isn’t a new thing. Founder evaluation has historically always been the top priority for venture investors. But evaluation of the people around the deal is not just focused on founders — 33% of VCs are also spending more time analyzing the investor syndicate around a deal.

Why is there more scrutiny on the people, both founders and co-investors? High profile cases like Theranos and FTX have contributed to this, where frenzied or competitive deal processes led to gaps in board-level governance and diligent founder evaluation prior to investment. VCs serve as professional fiduciaries, in fact they are ‘dual fiduciaries’, in that they owe fiduciary duties to both their fund LPs and the common shareholders of their portfolio companies in which they hold board director seats (more on that here). Decisions and events put fiduciary duties to the test are now commonplace: down rounds, fire sales, recapitalizations, major headcount reductions, company pivots, etc. The market is only getting more challenging. Investors have started to see cracks in their founders’ or fellow board members’ capabilities and occasionally even in their understanding of fiduciary duties. As such, much more scrutiny is being placed both founders and investors in new investments — VCs need the best people around the table that are capable of operating in significantly more challenging times.

Customer diligence has increased priority with 38% of VCs. On top of that, GTM analysis has increased in focus by 33%.

As we discussed above, growth rates for public SaaS companies are at decade lows. Investors have seen both through public data and in their portfolio companies that the key drivers of growth for technology companies are down across the board. For SaaS businesses, Scale Venture Partners is reporting ARR growth rates are down from a median of 72% in Q1 of 2022 to 19% in Q3 of 2023. This is occurring because CFOs are being tasked to cut operating spend — we first saw those cuts driving headcount reductions, and now CFOs are cutting software spend between 10–30%. Net new sales aren’t the only headwind, renewals, a key revenue expansion milestone for most SaaS businesses are also under pressure with CFOs negotiating reductions in contract values by threatening non-renewals. Revenue is only recurring in nature if the customers renew! For free products supported by advertising, a key advertising revenue metric, RPM (revenue per 1000 impressions), is reported to be down between 20–55% YoY. Overall, the VCs are reacting to these market changes by spending more time evaluating the health of their prospect investment’s existing customers, the clarity around ICP (idea customer profile), and the GTM approach to reach and convert that ICP. Founders should expect to open up their customer base for customer interviews during a diligence process. OMERS Ventures Partner, Shawn Chance, writes about this here.

With these major changes to diligence processes, here is the overall new stack-ranking of diligence categories for VCs:

With changes to diligence come changes to timelines. Founders, you can now expect your average diligence timeline process with a VC to last from 3–5 weeks, but with over a third of VCs spending more than 5 weeks on a deal. 53% of VCs are slowing down their diligence timelines in this market.

Here at OMERS Ventures, we asked ourselves if we should lengthen deal processes given the slowing pace of the market. The answer? A consistent “No”. OMERS Ventures fund head, Michael Yang , recently posted about our ways of working — we are structured around thematic investment areas so that we can be better prepared to quickly action investment decision making. This benefits the market in two ways: we are able to prioritize deals more effectively better making use of our small team’s time, and we are able to better respect the time of startup founders by giving them extreme clarity on our diligence process (sometimes this means declining earlier in a process than they might usually expect). We have a portfolio of over 80 companies, and one of the biggest drags on a founder or CEO’s time is fundraising with slow investors, so we do everything we can to shed light on our process and give them decisions at or ahead of the pace of the market.

A disappointing finding in the survey, is that VCs don’t prioritize ESG within their diligence processes. 41% of VCs see environmental diligence as a distraction, and 18% in the case of social diligence/D&I. This is in contrast to a proliferation of data finding that ESG considerations have become a core component in driving value in private equity.

We believe there are a couple of reasons for this. The survey question was asked in the context of evaluating deal dynamics today. Because it was only a single question on the topic it is impossible to draw out nuances. And it is entirely possible that ESG factors would have been considered by respondents to be important, but outside the realm of ‘deal dynamics’. And we certainly know first hand that our major source of funds, OMER, is committed to ESG (and our role in it) in a significant way.

Second, to us this result signals a lack of education around the fact that — especially in the area of diversity — it has a direct correlation to the success of the business. So if diversity is not included as a key indicator in financial-driven diligence, maybe it should be. In our small effort to contribute to learning on this topic, we recommend checking out this research from Credit-Suisse (from 2012!), this research from McKinsey done in 2020 and the stats in this article from 2022 (source data here).

As the fundraising market tightens for venture funds, perhaps LPs writing checks into VC will use their greater influence over venture funds to increase the focus on ESG. Also, some would argue that it has never been easier to monitor ESG data with carbon accounting and D&I platforms on the rise.