The Role of Diligence
Evaluate and confirm, but don't confuse the two.
I once had a mentor tell me that the sole purpose of due diligence is to either: kill an investment you don't want to make anyway -or- to merely mentally justify an investment decision which you’re going to follow regardless. So why even do the work if it’s in vain? The intent behind his observation was somewhere between cynical and tongue-in-cheek, and true enough his approach to diligence was admittedly quite a bit on the laissez-faire side.
However, like with all humor, it contains fundamental truth. What I would posit is that much of the due diligence early stage venture investors conduct is indeed in vain because most VCs don't make the important distinction between "confirmatory diligence" and "evaluative diligence," and when/what each is appropriate for.
Confirmatory diligence is a process of confirming facts and assumptions about a given opportunity that have already been assessed. Trust, but verify. While in contrast, evaluative diligence is the strategic attempt to objectively assess the merits of the investment opportunity to decide whether it's worth pursuing.
I personally believe that the process of an investment decision should be a truth-seeking mission. Evaluative diligence matters. But it need not be unnecessarily laborious. The key is to proactively seek the true risk-points in the investment fact-pattern and push on them to see what results.
Typically it only takes a couple diligence phone calls to address the fundamental issue at hand. Instead of calling numerous existing customers (confirmatory), pitch the value prop to the prospective customers (evaluative) and ask them what they think. Rather than asking the founder for references (confirmatory), find a former direct colleague of her on LinkedIn and reach out to ask what their experience working with her was like (evaluative).
Search for an industry expert who is going to be a natural skeptic to hear their point of view -- don't take it at face value, but rather truly listen to see if you agree with their assumptions. Chat with employees at a competitive incumbent who naturally is going to be challenging of a new startup in the space to see if it sways your perspective.
It's the one or two hard conversations which confront your assumptions about an investment idea which are going to be the most productive. Seek the truth when evaluating.
A couple of anecdotes of truth-seeking evaluations. Once we were considering a startup investment founded by two people spinning out of a company where the CEO was notorious about giving bad references on nearly everyone. I sought out a conversation with this CEO anyway. And he indeed gave a perfectly ho-hum lukewarm reference, which I knew was in reality an overwhelming positive given the context! On a relative scale, that's the best he was going to give. That company has now since exited for north of a billion dollars. In another case, I proactively found a non-competitive but adjacent CEO in the space who was going to be a natural skeptic. He initially was very honest about the challenges that the company was going to face and we invested eyes wide open to his cited risks. Interestingly, that diligence CEO has become increasingly intrigued over time as I pushed him and is now actually an advisor to the company. The theme here is to proactively find those who are going to challenge an investment thesis and then interpret those results through your own lens.
When I was first starting out in venture, there was a new venture firm which promoted (especially to LPs) that they had a fundamental edge in winning by doing more diligence than any other firm. My junior investor peer friend there would share horror stories to me about the pages upon pages of diligence packets which they'd produce for every investment... on early stage companies with limited operating history. Needless to say for this example, that strategy didn't yield successful results, and this firm has since faded away. After all, venture is about a search for bold outliers on the upside, not the watered-down average investment that can pass through a thorough hand-wringing. However, the mistake that the principals at that firm made wasn't the relative importance of diligence overall, but rather the understanding evaluative versus confirmatory diligence distinction. The notes from those dozens and dozens of existing customer calls, for example, didn't yield any additional insights about why many not-yet customers in the market weren't going to adopt the product.
All of the above is not to say there is not any merit in the good hygiene of “dotting your i's and crossing your t's” with confirmatory diligence to validate your assumptions once a decision is already made. It is indeed important to validate what a founder saying is indeed true. But completely recognize the purpose of those efforts versus the more important one -- efficiently complete the couple of key evaluative diligence items that can make or break the investment decision first and then verify assumed facts from there.