Friday, July 30, 2010

Perpetual Motion Machine Due Diligence Documentation

I'm not a VC, and nor do I play one on TV. Nor do I even pretend on the internet.

However, I've been backed by enough of them (or just had meaningful conversations which didn't lead to funding decisions) to be part of the network of people brought in to do initial due diligence on technology-heavy startups. And I'm getting increasingly annoyed by what I call the Perpetual Motion Machine Due Diligence Document.

How Unseasoned Entrepreneurs View Funders

Let's start with a simple premise: you're seeking funding for a technology-heavy startup. This doesn't apply to a company which has already launched (and thus should have technical credibility already established), and it doesn't apply to consumer-focused startups (where the technology better not be part of the pitch anyway).

You're doing something Really Hard. Often, you're doing something that's against conventional wisdom, to the point where many people in the market might not even attempt it. That's great! That's the type of technology-heavy startup that a lot of VCs might like to back.

But first you have to get past investors. These investors may have come from a technology background, but these days they work in senior management (if they're angels), or are retired, or are VCs and don't play with much outside of Outlook and the iPads. You've given them your slide pitch, and now they've asked for additional documentation on your Really Hard Technology. You know they won't understand it (it's Really Hard! It's against conventional wisdom! Paradigm Shift!), so what do you do?

Easy! You just dumb it down to the most outrageous claims that you possibly can. "Faster-than-light travel impossible? Those guys don't know what we know!" "Infinite compression impossible? We found a way to eliminate data entropy!" "Free energy! Fucking magnets, we know how they work!" The Perpetual Motion Machine Due Diligence Document thus emerges.

What Actually Happens

The naive entrepreneur assumes that his document is going to be read by the investors, and has to be strong enough in its claims to justify an investment, but simple enough to be understood by a general audience. So every one of these documents seems to follow a general pattern:

  • This commonly accepted wisdom/theorem is actually wrong.
  • We're the only ones who have figured that out.
  • Our technology thus solves all problems to all people.

Here's the problem: The Technical Due Diligence Document Is Never Read By The Investor.

Savvy investors know they're out of the state of the art (if they ever were; most skilled VCs were operators more than just raw techies). They know they don't have the background to determine whether your Really Hard Technology is actually good or doable.

So what they do is get a technical due diligence document from the founder, find someone in their network who is skilled with the state-of-the-art in that area, and send them the document for review.

And that's how the document that was only ever going to be read by an investor ends up in my email inbox.

Over-Inflated Claims Destroy Credibility

So now I'm reviewing a document which appears to be written to target a child, and is so laughable in its claims that it amounts to promising perpetual motion. What do I do?

If you think "Even if that's the case, surely the technical reviewer is going to be so blowed away that he'll seek out clarification directly from me, the entrepreneur" you fail at a technical startup. Why would I expose myself to the entrepreneur? What do I get out of that? Nothing good can possibly come of that.

  • VC/Angel passes on investing. Entrepreneur blames it on me and smears me in the industry. Whether the entrepreneur ultimately succeeds or fails makes no difference: no upside to me.
  • Entrepreneur turns into a complete time waster. I have a limited amount of time that I can devote to doing due diligence, and VCs are aware of that. If they want me to do direct face-to-face due diligence, they'll ask me specifically to do that.
  • Link between investor and me gets exposed. Many times both sides don't necessarily want that exposed to the world, particularly if it's a speculative investment possibility.

So what I do is send an email or have a 15-minute phone call explaining that the claims are completely overblown, the document has no technical detail, and there's a very low chance that their claims are actually going to stand up in production.

My word isn't the kiss of death, far from it. A good investor will collect initial opinions from several people he trusts, and determine whether to go farther. If they do, they'll ask for a smaller set of people to do in-person deep-dive due diligence, and use that to further the decision-making process.

But here's the thing: if I'm asked to be one of those people, if I had to say "the initial document is completely overblown in its claims and I doubt it's possible" in the initial review, I almost always decline to be part of the deep-dive due diligence process. Because I no longer trust anything the entrepreneur is going to say.

It's even worse if you're doing the rounds, and I get asked my opinion (by a potential customer, partner, or another investor) having seen that Perpetual Motion Machine Due Diligence Document. I instantly respond that I think it's probably snake-oil and the potential customer/partner/investor should stay away. When they ask me to do another review, again, I decline. I don't have time to do a gratis technology review for someone where I've already lost all trust in the entrepreneur and his claims.

Don't Be That Guy

It's very simple to avoid this.

  • Write your technical due diligence documents assuming several experts in your field are going to review it, and the investor is never even going to open the PDF file.
  • The more outrageous your claims, the less believable you're going to appear.
  • Don't assume a clever engineering workaround, providing a practical solution to a theoretic problem that's good-enough for most use cases, is a bad thing. It's not. It's been the foundation of numerous successful technology ventures.
  • Make me, as a reviewer, want to find out more, either out of personal interest, or as a potential customer or partner of yours.

But don't ever make me feel like I've just been handed Yet Another Perpetual Motion Due Diligence Document.

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