Tally up the screening scores
This is a multi-part series on Venture Capital Due Diligence. Throughout this series we cover the basics of deal flow screening, management due diligence, and financial analysis.
To wrap up the screening process, let’s take a look at our due diligence scorecard, which we’ll continue to fill in with sections as we move through due diligence.
Let’s take a look at a real-life example of a venture backed investment and how the venture fund may have assessed the opportunity given the VC screening process using Greylock’s investment in LinkedIn. David Sze, managing partner with Greylock, discussed the firms’ decision to invest in the social networking company in 2004 and provides many clues into the screening process and subsequent continued due diligence performed by the partners.
Sze, as noted in a similar post-mortem on their investment in Facebook, notes the value of being a contrarian, which at the time LinkedIn fit the mold: they were not the first social media company, they had a barely functioning UI, and had no revenues. If there were ever a time to be a contrarian as a VC, this was it — and that fits the Greylock philosophy.
“Greylock Partners backs entrepreneurs who are building disruptive, market-transforming consumer and enterprise software companies. We invest in companies that define new markets…” — Greylock’s website
Greylock’s scope clearly focuses on consumer and enterprise software companies. LinkedIn? Check. Not only does this fit the vertical, but the further interest in companies that are defining new markets certainly characterized social media companies in the early 2000’s.
Greylock goes so far as to define two verticals specifically: Consumer Internet and Enterprise IT. While these are broad categories to be certain, they can aptly filter out enough investment opportunities to allow Greylock to more carefully consider those that do fit.
In terms of stage, Greylock specifies on their website they are stage agnostic: from seed to growth. This not only affords Greylock the ability to find ideas across the growth curve, but it also removes any barriers from the firm investing in subsequent rounds of portfolio companies.
With offices in Silicon Valley, San Francisco, and in Wellesley, MA, and investments in software companies that serve customers across the globe, the firm is agnostic to region. Reid Hoffman, LinkedIn’s co-founder and CEO, was a known entity in Silicon Valley, previously having worked at eWorld (acquired by AOL), founding SocialNet.com, and moved into the COO role at PayPal after a stint on the Board of Directors — checking the boxes for initial business associates/network and likely referral. Sze notes as much when he says, “I believe these are our kind of people. Bright, talented, aggressive/competitive, analytical, committed to excellence, hard-working, intellectually honest, and risk-taking.”
In terms of market size, Sze discusses the early stages at which social media companies Facebook, Friendster, MySpace, and others currently operated in, but a takeaway is the momentum in the space, evidenced not just by metrics such as daily active users, but by the number of companies popping up. As Sze notes, “In those days, Linkedin was one of a bunch of early business-networking startups such as Plaxo, Spoke, Ryze, Zero Degrees, etc. All of these companies were relatively small, though a number were larger than Linkedin.” This is a good start when considering if there is an investable market and it’s potential size.
“One of the hardest/riskiest parts of this type of business is getting scale on building a large, high-quality user base at reasonable cost — and this is almost fully behind them already.” — Sze
This note to his partners denotes confidence in the size of the market and LinkedIn’s ability, as already shown, to capture a significant enough portion to warrant venture money. A good start to market size and sector.
Here again is our scorecard now:
Pretty good, huh? Obviously these scorecards will be unique to the firm. In most cases, a fund such as Greylock may eliminate Stage and Geography screens given they’re agnostic to those classifications.
Now that we’ve come up with an initial screening process, stay tuned as we dive into the next steps: Management and Business due diligence.
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