TL;DR:
Assessing an Investment Opportunity is not a purely rational activity, and it does not have to be. Rather the reverse!

Our brain provides us with more than just rationality, and according to the founder of Analytical Psychology C.G. Jung, there is even a completely separate entity inside our mind that can be hired for the job.

In this article we explore some cognitive concepts borrowed ruthlessly from science and bent into a shape that allows us to dig deeper into Soft Due Diligence. No psychologists have been harmed during the writing of this text.

Soft Due Diligence is the process of gathering and assessing information about the non-financial and non-legal aspects of an investment opportunity. Researchers are clear about the importance of doing so, the evaluation of “soft data” in Venture Capital (VC) and Mergers & Acquisitions (M&A) is clearly a factor for success and helps limiting the chances of failure of a deal.

The relevance of Soft Due Diligence is obvious in situations where little tangible data is available, e.g. early-stage Venture Capital investments or capital allocations to First-Time Funds without a track record. Even later stage VC investments or M&A deals, typically involving more mature companies, benefit from increased attention to soft factors.

M&A deal teams who evaluate soft factors intentionally, systematically and with a structured approach increase the chances of post-deal synergies in a significant way (1) and a study by the University of Chicago (2) found that VCs who focus on soft factors are also more likely to make successful investments.

But how does that work? Is it an entirely rational process, like financial and legal due diligence?

The answer is: yes and no. Soft Due Diligence clearly benefits from that intentional, systematic, and structured approach: knowing where to look is important, and trying to get a complete picture by planning ahead helps. Also, Soft Due Diligence should contribute to organisational learning and growth, and understanding in depth how to perform it helps making the process reproductible and the results comparable, and to a certain degree quantifiable or measurable.

But not everything in Soft Due Diligence is rational, and that’s ok.

It is even more than ok: non-rational approaches are rather an asset for success in this field than an obstacle to effectiveness. Becoming aware of how our mind works in these situations can improve our ability to collect data and take decisions, and also to better understand how other people take their decisions.

In a number driven world with a tendency to believe that everything can be expressed and understood through quantifiable data, using one’s full cognitive capacity helps to see also the data that is not necessarily quantifiable, but none the less relevant.

Venture Capitalist’s Magical Powers.

Let’s take Venture Capitalists as an example: very proud of their professional capabilities, they almost define themselves through their ability to hunt down the next good deal. Most of them, however, do not have a clue about how they are doing it: according to research (3), most VCs do not understand their own decision-making process (and they are perfectly fine with that).

“Gut Feeling” is the most cited resource when it comes to explaining how to distinguish a good deal from a bad one. It sounds like a mythical, magical capability, that escapes rationality and logical explanation. It provides an additional aura of “you just got to have it” to the bearer, and the luxury of not having to explain anything. No surprise here because research (4) also found that VCs are notoriously bad at introspecting.

But research also comes to rescue when trying to understand what this “Gut Feeling” really is: Laura Huang, after examining investor’s decision making (5), finds that it is a complex process that involves both emotions and cognition. More than pure magic and divine inspiration, “Gut Feeling” actually combines investor’s accumulated treasure trove of experience combined with their creative ability to recognise patterns and draw conclusions from them.

Our Brain runs on two Systems.

Nobel prize winner Daniel Kahneman’s research gives us another model that provides insights into the cognitive mechanics at work here. In his book “Thinking fast and slow” (6) he explains that our mind is split into two systems: System 1 and System 2. System 1 is a collection of stored and pre-configured routines that we use regularly and often. Nobody has to stretch her or his mathematical skills to find the solution to the equation “1+1=?”. The answer is instantaneous, given without hesitation and few people feel they have to think hard in order to find it.

Asked to solve “178.262/512=?”, however, most of us will fall silent, our lateral vision narrows, our iris focusses, blood is diverted into the brain, amid many other physical manifestations that happens when we concentrate.

This is System 2 kicking in.

System 2 is there to solve problems that are not pre-configured in System 1, and that need bespoke thinking. System 2 is doing proper hard work, and it feels like that: when we solve complex problems with our System 2, we feel the strain and it drains our energy. When we’re done with System 2 thinking, we sit back and sigh deeply, in dire need to replenish our batteries.

When we use System 2 often enough for one particular type of task, our brain considers that it is worth creating a shortcut to the solution. The experience gathered from using System 2 on this task is packaged for use in System 1 and from now on available for quick, effortless deployment when necessary.

The Limitations of thinking fast.

This is part of learning; however, it is also part of how biases are formed. By creating a shortcut, our brain allows us to go faster when triggered by something we know. But how closely related is the actual situation that triggers this fast response to the one we think we know? There is a margin of similarity that allows us to use System 1 in situations that resemble the ones we experienced and that made our brain create that shortcut in the first place.

Using System 1 is comfortable and saves energy: it is doing what we are used to do. Following a routine and acting according to our habits feels safe. We have a tendency to match the unknown with the known, and that can give us the false impression that we are actually dealing with something we know. It’s all about saving energy and keeping that saved energy for moments where System 2 is required to do the hard work.

And we make mistakes doing that: “I have seen this 1000 times, I know what to do” means that we use our experience to solve a problem, but it can also mean that we look at a problem in a way that allows us to solve it with the tools we have. Paraphrasing Abraham Maslov’s “law of instrument”: if all you have is a hammer, everything looks like a nail.

Cognitive Dissonance to the Rescue.

But how does our mind recognise that something needs the big guns of System 2? One possible explanation is the concept of “cognitive dissonance” developed by Leon Festinger (7): our mind usually cruises along, keeping all vital systems going while saving energy by relying mostly on the efficiency of System 1. As long as everything going on around us “makes sense” we stay in this state of “running on autopilot”, effortlessly navigating our reality.

That is what happens for example when driving a car on the motorway. Most of the time, we are not actively and consciously checking what is going on around us, and sometimes we “wake up” and ask ourselves what happened during the last 20km and how we managed not to crash the car while apparently driving unconsciously at high speed.

In reality, we were totally capable of keeping our vehicle under control, our System 1 taking care of most of the driving.

Novices would not be able to relate to this, as they will have to drive mostly using System 2 because every situation is quite new to them. Driving as a novice is exhausting and requires a lot of energy. Things that would not even catch a confirmed driver’s conscious attention are a trigger for novice drivers, keeping them in a state of constant alert.

This “catching the attention” is what cognitive dissonance is about. According to Festinger, cognitive dissonance happens when “inconsistency among beliefs or behaviours causes an uncomfortable psychological tension”.

Staying in our motorway scenario, as long as nothing unusual (i.e. anything that System 1 cannot deal with) happens, we continue cruising. As soon as something happens that does not fit the expected scenario, we enter a more or less intense state of alert, and we fire up System 2 to assess, understand and react to the unexpected event. The intensity depends on the difference between the scenario we were expecting, and what we are observing in reality. A car slowly changing lanes will trigger us less than one that zig-zags uncontrollably in front of us.

It looks like there is part of our mind constantly monitoring the reality that we perceive through our various senses, and that checks it against a dynamic reality that we expect. Cognitive Dissonance happens when these two do not match.

Our two selves.

What is this part of the mind, that is doing such a great job – without us even noticing – until our conscious intervention is needed?

Well, it seems a completely distinct and autonomous personality lives inside us. Early 20^th century psychologist C.G. Jung found that we have at least two personalities, our conscience, and our subconscious. Some of us might have more than one conscious personality, one for private use and one for professional use for example, but C.G. Jung draws the line at two. If you have more than two, go and consult the psychotherapist of your choice, he advises.

C.G. Jung describes the subconscious as an actor distinct from our conscious mind. For him, the subconscious draws from an individual’s personal life experience, but also from intergenerational and collective experience. Basically, our subconscious links us to our lineage of ancestors and at the same time to humanity as a whole.

This theory unsurprisingly raised some controversy, and research in psychology in the past 100+ years certainly had something to say about Jung’s propositions. But for us it comes as a useful model to understand decision-making in Soft Due Diligence. Perhaps our subconscious is this part of Laura Huang’s “Gut Feeling” that is informed by our personal experience, and according to Jung, also by the experience of our forefathers and foremothers, and humanity or society at large.

Based on Jung’s developments, our subconscious might also be the “monitoring instance” mentioned before, capable to alert us in case cognitive dissonance happens. This instance, sort of background process of our mind, seems to come from the dawn of our species, mediating between the necessity to save energy and the need to ensure survival.

Palaeolithic example: from the edge of our vision, we perceive a rustle in the leaves of a bush, and the subconscious nudges us to watch this area a bit closer, in case there is a sabre-tooth tiger waiting for us to become his lunch. At that moment, probably just a little more adrenaline in the bloodstream, and a feeling of slight unease. Perhaps not even consciously noticing where this is coming from, just like what Festinger calls psychological tension.

But once the sabre-tooth tiger jumps out of the bush, all our systems are powering up, and we go into fight, flight, or (not recommended) freeze mode.

Restoring Consonance.

What does all this have to do with a Venture Capitalist assessing an investment opportunity?

Everything.

When evaluating a new venture, we have a certain idea of what we are looking for. We want a scalable business model, a product with a “huge” market, and a capable team to bring all this to life. We see presentations, perform due diligence, talk to people, and we try to find out if this particular venture corresponds to our criteria for an investment with potential.

But when the facts don’t add up, we experience cognitive dissonance: these financial projections do not make any sense considering the roadmap the team is presenting to us. We were expecting something different. Why is that so? Let’s go and find out!

Cognitive Dissonance leads us to pay attention to this inconsistency in our perception that served as a trigger. Festinger describes what happens then: we try to reduce the dissonance by changing enough of the inconsistent elements that triggered us in the first place. Here, changing can mean for example that we try to rationalise the situation in order to understand what happens and what the potential consequences are.

The rustle in the leaves was just a furry peaceful mammal, and the startup founders have a very convincing rationale explaining why the financial projections and the roadmap actually correspond. Alert is over.

Festinger explains that cognitive dissonance prompts us to become active, and either reduce the dissonance or add consonant elements to restore consonance.

Harnessing the Power of the Subconscious.

In the above example, cognitive dissonance was triggered by a rational assessment: what is the rational link between the roadmap and the financial model? Based on my experience, I can estimate the financial needs for this venture’s go-to-market strategy, and if this is inferior to the budget they put aside for that purpose, I see a problem.

In Soft Due Diligence, however, we rarely deal with hard, quantifiable data. Rather squishy, fuzzy information that allows multiple interpretations. It is not objective data, and any interpretation will always be subjective by nature.

Terrible news for our analytical conscious mind looking for rationality, but the good news is: we are not alone. There is a second personality inside us that deals very well with these less rational aspects.

We feel that something is not right with the story that we are being told. Something does not add up. In French we say “Je ne le sens pas, ce truc …”, I don’t feel this thing, literally. We can’t say why, but we just know that something is wrong here.

That feeling is located somewhere in our body, very often in our belly, right? Here we are: “Gut Feeling”!

Instrumentalising Cognitive Dissonance.

Now how can we instrumentalise this? How can we use all this in our professional (even personal) life? How does this potentially improve our assessments , and helps us make better investment decisions?

First of all: we need to listen.

At least in our “western” societies we are so focussed on rationalising everything, that emotions are totally underrated in terms of producing valuable insights. Everything has to be demonstrated by hard data, if there is not a number or a hard fact supporting something, it did not happen.

By taking our emotions and feelings into account, we add another, equally rich layer of information to our assessments. Remember, C.G. Jung told us there is a whole second personality in our brain that we can recruit to assist, and to provide us with a totally different point of view. As with anybody else’s opinion, we can take it or leave it, but it might be worth listening, and giving it a thought.

In order to take advantage of this additional source of data, we must learn how to access it. Sometimes the emotion is obvious and manifests itself loud and clear. At times, however, querying our emotional state requires to take time, to take a break, to step back and ask ourselves: “how do I feel about this?”. We need to pause to engage in a conversation with this other instance in our mind to be able to draw from its particular insights.

Then follow your “Gut Feeling”, but consciously.

Try to figure out where the “psychological tension” came from. Is it linked to something that you read or that somebody said? Have a critical look at the situation, the people, their behaviour, and also at what has been said, then try to understand what made you feel like that. Sometimes it is obvious, but in other cases it might be an emotion that you cannot clearly associate with anything tangible, yet.

Let your mind wander: for example, retrace your steps and replay that conversation in your head to see if you can link that emotion to a particular part of it. Often, this works best in situations where you are not sitting at your desk, straining your mind to concentrate on something. Take a walk, have a coffee, stand in front of the window, and let your mind freewheel, while staying attentive to where your thoughts are going.

This is not very different from the creative processes employed by artists and designers. You might be surprised where your “Gut Feeling” takes you when you let it take the lead, and how many surprising, yet valuable insights will come out of it.

Make it Intentional!

In Soft Due Diligence, we want to develop a holistic understanding of an investment opportunity. We want to use all the data we can access and draw conclusions from an assessment that validates the coherence of what we see. To develop a truly holistic view, we need to use all the means at our disposal, and we have seen that there are more than what we systematically use.

We live in a world that privileges rational thinking, and our socialisation, education and schooling has trained us to approach anything we do from that angle. But we can learn to harness the other resources we have available, just as much as people can learn and embrace creative approaches, that combine cognitive and emotional faculties of our mind.

The clue, in our opinion, is in the intentionality. It is not about flipping the whole thing upside down, and discard rational, analytical thinking. It is not about some new-age hippie thing. It is about benefiting from the best of both worlds. Considering where we come from culturally, it is not a surprise that taking into account the non-rational faculties of our mind does not come naturally. We need to train ourselves to use them systematically and intentionally.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

(1) Warter, L., & Warter, I. (2015). Cultural Due Diligence as Advantage in Cross-Border Mergers and Acquisitions. Bulletin of the Polytechnic Institute of Iasi, Romania, 59-71.

(2) Soft Factors Matter: The Role of Human Capital in Venture Capital Success by Brad Feld, Ethan Mollick, and Michael Pratt. Journal of Business Venturing, 2011, 26(4), 439-451.

(3) Shepherd, D. A. (1999). Venture capitalists' assessment of new venture survival. Management science, 45(5), 621-632.

(4) Zacharakis, A. L., & Meyer, G. D. (1998). A lack of insight: do venture capitalists really understand their own decision process?. Journal of business venturing, 13(1), 57-76.

(5) Huang, L., & Pearce, J. L. (2015). Managing the unknowable: The effectiveness of early-stage investor gut feel in entrepreneurial investment decisions. Administrative Science Quarterly, 60(4), 634-670.

(6) Kahneman, D. (2011). Thinking, fast and slow. Farrar, Straus and Giroux.

(7) Festinger, L. (1957) A theory of Cognitive Dissonance, Stanford University Press, Stanford, CA

TL;DR

Soft Due Diligence is an extremely valuable approach for tech startup investors, going beyond traditional quantitative metrics like financial statements to assess intangible yet crucial aspects of a startup. This includes evaluating the team's capabilities, market fit, adaptability, resilience, and the founder's vision. Soft Due Diligence serves to mitigate risks in early-stage investing, provides a more holistic view of the startup, and allows for a strategically and culturally coherent partnership between venture capitalists and founders.

Traditionally, due diligence processes have focused largely on quantitative metrics: balance sheets, profit and loss statements, growth rates, and so forth. While these hard metrics are undoubtedly important, it's increasingly crucial to consider the less tangible but equally significant factors that can make or break a startup's trajectory. This is particularly true in the rapidly changing and evolving tech landscape, where product cycles are swift and market dynamics are subject to rapid change.

In the dynamic and competitive context of venture capital, the ability to make successful investments extends beyond mere financial metrics. It is about recognizing the potential of a startup, going beyond the numbers. To fully appreciate the nuances of Soft Due Diligence, a diverse experience across the startup ecosystem can be an invaluable asset. 

Building Fraunhofer's deep tech accelerator AHEAD, serving as a venture partner at early-stage VC firm EWOR, and working at and with UnternehmerTUM, Europe’s largest entrepreneurship center, gave me a multi-faceted vision of startup evaluation. My experience extends into the healthcare sector as an executive at Sigma Squared Society, which unites the world’s most ambitious founders under 26. In addition, I have been navigating the entrepreneurial waters myself. My last three years as a founder offered me a well-rounded view of the challenges and opportunities that tech startups face. This multidimensional experience from strategic and theoretical work, as well as my hands-on experience enable me to offer a robust framework for examining the non-quantifiable aspects, so critical in early-stage investing. 

So let's delve deeper into the intricacies of Soft Due Diligence  for tech startups, a subject that often serves as the tipping point in making or breaking an investment.

In this article, we will embark on a deeper exploration of Soft Due Diligence for tech startups – a topic of huge importance in the realm of early-stage investing.

You might be asking, "Why should I care about Soft Due Diligence?". The answer is simple. Founders, especially in tech, can pivot business models, rewrite codes, or rebrand products overnight. What remains consistent, however, is the team's ability to execute, their vision, and the culture they instill in the organization. These factors don't just fit neatly into spreadsheets but have a far-reaching impact on the startup’s long-term viability.

Defining Soft Due Diligence for Tech Startups

Soft Due Diligence, often considered the art behind the science of investing, revolves around assessing the intangible aspects that can significantly influence the trajectory of a tech startup. It delves into the qualitative elements of a business, evaluating factors such as the team's capabilities, market fit, and the overall potential that extends far beyond the balance sheet. It is, without a doubt, an indispensable component of early-stage investing.

Why Soft Due Diligence is Crucial in Early-Stage Investing

1. Risk Mitigation: Early-stage investments are inherently risky. Startups may lack a solid financial track record, and their market viability may still be unproven. Soft Due Diligence helps mitigate these risks by focusing on qualitative factors that can contribute to a startup's success.

2. Team Assessment: A startup's team is often its most valuable asset. Soft Due Diligence allows investors to delve into the backgrounds, experience, and dynamics of the founding team. It helps in assessing whether the team possesses the necessary skills, cohesion, and adaptability to navigate the challenges that lie ahead.

3. Market Fit Beyond Metrics: While hard metrics are essential, they only provide part of the story. Soft Due Diligence delves into whether the startup's product or service truly resonates with the market. It involves evaluating customer feedback, market trends, and the startup's ability to pivot if necessary.

4. Traction and Momentum: Early-stage startups may not have substantial revenue streams yet, but they should exhibit traction and momentum. Investors should assess whether the startup is gaining users or customers and showing signs of scalability. A growing user base or increasing revenues are positive indicators.

5. Founder's Vision: The founder's vision and passion can greatly impact a startup's journey. Investors should consider whether the founder's vision aligns with market needs and whether they possess the perseverance to overcome challenges.

6. External Validation: Soft Due Diligence involves seeking external validation. This entails talking to customers, partners, and industry experts to gauge the startup's reputation and potential. Positive endorsements from credible sources can bolster confidence.

7. Adaptability and Resilience: Startups often face unforeseen challenges. Investors should assess a startup's adaptability and resilience in the face of adversity. It involves evaluating how the team responds to setbacks and iterates on their strategies.

The Pivotal Role of Adaptability and Resilience in Soft Due Diligence

Adaptability and resilience are linchpin qualities in the realm of Soft Due Diligence. In the context of early-stage investing, these qualities take on even greater significance.

1. Navigating Uncertainty: Early-stage startups often operate in uncharted waters. Market dynamics can change rapidly, and unforeseen challenges are par for the course. Investors must assess whether the startup and its team can navigate uncertainty with a sense of adaptability and resilience.

2. Iterative Improvement: Startups frequently need to pivot or adjust their strategies based on real-world feedback. An ability to embrace change and iterate on business models or product offerings is a testament to a startup's adaptability.

3. Perseverance: Building a successful startup is a long and arduous journey filled with ups and downs. Resilience becomes paramount during challenging times. It ensures that the team can withstand setbacks, learn from failures, and emerge stronger.

4. Response to Adversity: Soft Due Diligence entails evaluating how the startup's team responds to adversity. Do they view challenges as opportunities for growth, or do they crumble under pressure? A resilient team can weather storms and come out on the other side stronger.

The Role of Soft Due Diligence in Early-Stage Investing

In early-stage investing, Soft Due Diligence is pivotal for several reasons:

1. Information Gap: Early-stage startups often lack a comprehensive financial history, making it challenging to rely solely on quantitative data. Soft Due Diligence helps fill this information gap by providing insights into the less tangible aspects of a business.

2. Long-Term Impact: The decisions made in the early stages of a startup can have a profound and lasting impact on its trajectory. Assessing soft factors early can help avoid costly mistakes and enhance the chances of success.

3. Competitive Advantage: Investors who excel in Soft Due Diligence gain a competitive advantage. They can identify hidden gems that may be overlooked by those who focus solely on financial metrics.

4. Portfolio Diversification: By considering both quantitative and qualitative factors, investors can diversify their portfolios effectively, reducing risk and increasing the potential for high returns.

The VC and Founder relationship

In a startup's journey, the relationship between the venture capitalist and the founders is a cornerstone of long-term success. Key pillars for this enduring partnership include an alignment of expectations toward value creation and exit strategies, mutual trust and transparency, and an understanding of the desired level of engagement. Relationships are where human factors matter most and a topic where a Soft Due Diligence is the tool to understand if it works.

Conclusion

In the fast-paced and rapidly changing landscape of tech startups, the conventional frameworks of Due Diligence may not always suffice. While quantitative metrics like financials and growth rates continue to hold weight, they are merely one piece of the puzzle. Soft Due Diligence, therefore, becomes not just a supplementary strategy but an indispensable core practice. This is especially relevant in the tech sector, where disruptive technologies, ever-changing consumer behaviors, and swiftly shifting competitive landscapes are commonplace.

For tech startups, the pace of change can be staggering. A seemingly fantastic idea today may be outdated tomorrow, overtaken by new innovations or shifts in market demand. This makes the elements assessed through Soft Due Diligence —such as adaptability, resilience, and vision — paramount. Tech startups must not only show promise in their current state, but also the agility to pivot in the face of unforeseen technological shifts or market disruptions.

Moreover, tech startups often have to navigate complex regulatory landscapes, deal with high rates of obsolescence, and strive for breakthrough innovations rather than incremental improvements. In such a setting, the founder's vision and the team's collective skill set aren't just additives; they are essential ingredients to foster long-term success. Soft Due Diligence helps investors delve into these complex dimensions, offering a more holistic view that goes beyond spreadsheets and quarterly reports.

The relationship between venture capitalists and tech startup founders further underscores the importance of Soft Due Diligence. Given that tech startups often aim for disruptive change, the alignment of visions, expectations, and values between both parties becomes more critical than ever. Soft Due Diligence ensures that this partnership isn't just financially sound but also strategically and culturally coherent.

Soft Due Diligence is not just an option; it is a necessity in the realm of early-stage investing. It allows venture capital investors to assess the multidimensional aspects of a startup, reducing risks, and increasing the likelihood of successful investments. By evaluating the team, market fit, traction, founder's vision, external validation, and adaptability, investors can position themselves as experts with a profound understanding of the nuances of entrepreneurship.

To quote my Mentor “Where traditional Due Diligence answers the “What?” question, Soft Due Diligence more often attempts to give sense where we ask ourselves “How?” or “Why?”.” And to also quote Simon Sinek, “start with why”.

Here are some questions you could ask yourself when evaluating an investment opportunity from a more Soft Due Diligence perspective:

Risk Mitigation

1. How does the startup prioritize and manage risks, especially those not reflected in financial statements?

2. Are there contingency plans or strategies in place to mitigate identified risks?

Team Assessment

1. What specific skills and backgrounds do the team members bring, and how do these align with the startup’s goals?

2. Is there evidence of effective team collaboration and conflict resolution?

3. What kind of emotional intelligence does the founding team display, and how could that impact the startup's success?

4. Are there existing relationships or previous collaborations among the founding team that could either benefit or hinder the startup's growth?

Market Fit Beyond Metrics

1. How does the startup gather and use customer feedback to validate market fit?

2. What differentiators make this startup stand out in the market niche it targets?

Traction and Momentum

1. Beyond user numbers or revenues, what qualitative indicators suggest the startup has genuine traction?

2. How has the startup's growth been sustained over time?

Founder's Vision

1. How well articulated and compelling is the founder's vision for the startup's future?

2. Does the founder display the perseverance and commitment required to realize that vision?

3. What level of emotional investment do the founders have in the startup, and how might that impact decision-making and long-term growth?

External Validation

1. What kinds of partnerships or endorsements has the startup secured?

2. Are there testimonials or case studies that confirm the startup’s value proposition?

Adaptability and Resilience

1. How has the startup pivoted or adapted in response to past challenges?

2. Is there a culture of learning and iterating based on market feedback and internal metrics?

3. How can I effectively assess a startup's adaptability and resilience? Are there any signs that indicate a startup is capable of overcoming adversity?

Information Gap

1. What unique insights does the startup offer that aren't apparent from quantitative data alone?

2. How does the startup plan to acquire or generate the data needed to fill the existing information gaps?

Long-Term Impact

1. Are there early decisions that could significantly affect the startup’s long-term trajectory?

2. How are long-term goals balanced against short-term operational needs?

Competitive Advantage

1. What unique strategies or resources does the startup employ to outmaneuver competitors?

2. How does the startup plan to sustain its competitive advantage as it scales?

VC and Founder Relationship

1. How aligned are the startup's exit strategies and value creation expectations with yours?

2. What level of engagement is expected between the venture capitalist and the startup’s founding team?

3. Is the startup open to mentorship and guidance, and how will that impact its scalability and adaptability?

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

In this issue, we take a break from the Emerging and First-Time Manager series to venture into innovation in the Venture Capital industry. As a big supporter of the idea that there is opportunity in crisis, we think that we are at a moment where our industry has the chance to step back, take a breather and have a critical look at how we can adapt to changing times ourselves.

TLDR:

Hybrid Venture Capital funds break with the traditional model of the closed-ended fund to provide more flexibility to Limited Partners and Portfolio Ventures alike. Liberated from the constraints of the 10 year time horizon, some VCs prioritise a long term vision, explore flexible asset allocation options and give themselves the possibility to stay committed to their portfolio ventures in the long run.

In the dynamic world of Venture Capital, change is not just a constant; it's a catalyst for innovation. For us optimists, the current climate of funding morosity provides an opportunity for innovation to shine, and innovation loves nothing more than the turmoil of a crisis to come up with disruptive concepts. No better time to explore new ways how Venture Capital can serve its clients better, on both sides of the value chain.

Traditional venture capital funds have long been synonymous with their closed-ended structure and rigid 10-year time horizon. However, the emergence of hybrid venture capital funds is challenging this status quo, revolutionising the industry and reshaping the way we perceive investment strategies. In this article, we dive into the rationale behind the rise of hybrid VC funds, explore their distinctions from traditional counterparts, and shed light on the potential advantages and challenges they bring. As we navigate this evolving landscape, the lens of Soft Due Diligence remains crucial, ensuring that innovation and long term value creation continue to be at the forefront of these strategic shifts.

The Genesis of Hybrid Venture Capital Funds

The advent of hybrid venture capital funds can be attributed to several factors that reflect the changing dynamics of the investment landscape. One of the primary drivers is the recognition of the limitations imposed by the traditional closed-ended structure and lengthy investment horizons.

According to Sequoia Capital, who already redesigned their entire strategic concept around the principle of a hybrid fund in 2021, the traditional 10 year closed-ended structure does not match the ambition of their portfolio companies anymore, nor does it match their own. Successful portfolio companies might take longer than 10 years to mature in a sustainable way, and in their role as an investor, VCs see value in prolonging their relationship with certain portfolio companies beyond an exit or even want to continue holding shares after an IPO.

With their restructured “Sequoia Capital Fund”, Sequoia Capital bets on a liquid portfolio interlacing public positions in portfolio companies with investments in underlying closed-end sub-funds that return capital and benefit to the mother fund. In addition to classic Venture Capital investments, the new fund will not shy away from other asset classes, such as cryptocurrencies for example.

Sequoia aims to cement their engagement with portfolio companies, while at the same time offering better value to their Limited Partners. The new fund strategy obviously increases diversification and limits exposure to risks. But the most impactful feature for Limited Partners is to benefit simultaneously from long-term ambition and increased liquidity.

Hybrid funds introduce a more flexible structure, allowing investors to access capital and realize returns at various stages of the fund's lifecycle. This adaptability aligns with the ever-changing pace of the technology and startup ecosystem, where agility and speed are key drivers of success.

Distinguishing Features and Potential Advantages

Hybrid VC funds deviate from tradition by offering more fluidity in terms of fund structure, exit strategies, and investor engagement.

Unlike traditional VC funds, which often lock up investors' capital for the entire duration of the fund, hybrid funds enable periodic liquidity events, allowing investors to exit or enter at different intervals. This innovation not only caters to the preferences of modern investors seeking more control over their investments but also fosters a sense of partnership between fund managers and Limited Partners. By embracing this flexible approach, hybrid VC funds can potentially attract a wider range of investors, thereby expanding their network and access to capital.

This flexibility comes with a price and hybrid funds face specific challenges: a rolling fund structure with capital calls and distributions happening at all times, multiplying investments in different asset classes and increased engagement with portfolio companies all produce operational complexity. Managers must treat Limited Partners fairly and hybrid funds add an additional layer to calculating fees and determining capital redemptions. There are numerous strategic and operational challenges in managing multiple sub-funds and maintaining a coherent, focussed investment thesis across them.

Soft Due Diligence in the Era of Innovation

The rise of hybrid VC funds underscores the relevance of Soft Due Diligence more than ever. As investors consider these new investment vehicles, the focus on assessing the capabilities of fund managers becomes paramount. Soft Due Diligence, in this context, involves evaluating the manager's adaptability to changing market dynamics, agility in adjusting investment strategies, and their ability to navigate liquidity events effectively.

As Limited Partners seeking to make informed investment decisions, understanding how fund managers navigate the nuances of a hybrid structure, engage with investors, and maintain transparency throughout becomes crucial. The traditional 10 year partnership used to be compared to a marriage and both the VC-LP and VC-Venture relationships are often subject to a couple analogy. In a hybrid VC fund, this relationship gets an interesting new dimension: beneficial and designed for the long-term, but - depending on the fund structure - with a lot more flexibility and a potential way out if things turn sour.

The innovation introduced by hybrid venture capital funds symbolizes the evolution of the industry and its commitment to adaptability. These funds not only challenge the conventional closed-ended model, blurring the lines between asset classes, but also emphasise the importance of catering to the preferences of modern investors.

Venture Capitalists must understand their customers – on both sides of the value chain – more than ever, customising their offer to the needs of their ventures and investor base.

As the venture capital landscape continues to transform, the principles of Soft Due Diligence remain steadfast in guiding investors, fund managers, and limited partners towards long-term partnerships that not only embrace innovation but also ensure alignment, transparency, and a shared vision for success.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

(Photo by Noelle Otto, Pexels)

This is the third article in a series discussing the topic of investments in young venture funds, raised and run by Emerging Fund Managers.

Here are the other articles in the series so far:
1. Embracing the Potential of Emerging Fund Managers
2. The Rise of Emerging Managers in Numbers

TLDR:

Emerging VC Funds are a high-risk, high-return investment. To mitigate this risk, Limited Partners must evaluate the fund and its manager(s); due to its “emerging” nature however, there is not a lot of tangible data on which to base an assessment. Drawing from an analogy with VC funds evaluating new ventures, in this article we explain how to use Soft Due Diligence principles to find out if emerging fund managers can deliver on their promise.

Emerging and First-Time Venture Capital (VC) Funds have the potential to be a valuable addition to your investment portfolio. Their razor-sharp investment thesis, extremely committed managers, combined with an uncompromising focus on generating profitable returns are all good arguments to consider them in a balanced, risk-mitigated portfolio construction strategy.

Managing a high-risk, high-return Situation

Not only are these budding funds an exciting opportunity to access an asset class with potentially outstanding returns, the numbers seem to prove that Emerging and First-Time Funds’ success is not necessarily down to beginner’s luck: Emerging Funds have been consistently present in Venture Capital’s top-5 performers over a period of 17 years1 and First Time Funds almost systematically outperform funds of established managers.2

High returns, however, do not come without high risk. This is true in Venture Capital in general, and even more so when VC funds invest in early-stage ventures. Only a few startup companies in a VC’s portfolio will generate the value needed to allow General Partners (GPs) to return capital and substantial profit to their Limited Partners (LPs).

When LPs invest in Emerging Funds, there is an added layer of risk involved: Emerging and First-Time Funds most of the time invest in risky pre-seed or seed stage ventures, but on top of that they are considered risky businesses themselves, because of their lack of maturity and track-record.

Emerging Funds are just Startups

From an entrepreneurial point of view, Emerging and even more so First-Time Funds are nothing but startup businesses themselves.

A fund is a business implementing a two-sided business model, with LPs as one kind of client on one side and Startup Ventures as another kind of client on the other.

Prosaically speaking, VCs are intermediaries facilitating investments from said LPs into said Startup Ventures, adding value through their ability to select and manage relationships and provide a risk-mitigation mechanism through their fund structure.

This being the fundamentals of their value proposition, VCs also have to distinguish themselves from their peers in order to attract LP’s investments. This has never been more relevant in the last decade than today in 2023, where LP’s commitments to VC funds are historically low.

Mature VC firms have a history and track-record to give their investors some assurance over their ability to manage the capitals entrusted to them, and they can demonstrate a level of returns from past funds that LPs will expect à minima to receive from the money that they are about to commit to a fund.

But even mature VCs need an “edge” that makes LPs choose them over their competition.

Going back to entrepreneurial terminology, VCs need to have a focussed Value Proposition, a holistic and consistent concept that involves a deep understanding of clients’ needs on the one hand, and a product and service as an exact response on the other, solving the problem generating the need in an effective and unique way (see Alexander Osterwalder’s work here for example).

Building on Osterwalder’s work, Ash Maurya (Leanstack) adds the concept of “secret sauce” to the recipe: for a business model to be successful, there must be something in the mix that enhances its uniqueness, and makes it hard to copy. This can be either linked to the product or service (e.g. a patent, or a skill or technique that is hard to reproduce) or to the entrepreneurial team (e.g. proprietary knowledge or an exceptional network).

When evaluating an Emerging Venture, i.e. a Startup Company, which by definition has no track-record and financial history to offer, VCs need to deploy a multi-faceted Due Diligence strategy in order to assess the chances of success of such a precocious business model and the likelihood of a team to execute on it.

Emerging Fund Due Diligence

Looking at Emerging and First-Time Funds through the lens of this Startup analogy allows us to draw from established Due Diligence strategies and processes in order to evaluate the likelihood of an Emerging Manager to execute her or his business model.

To be a little more precise on the analogy, we would look at Emerging and First-Time Funds in the same way as VCs would look at a Startup Venture at pre-seed/seed stage, meaning there should be a consistent business model hypothesis, problem/solution fit and a validated technology or product/service concept.

At this stage, tangible information is scarce, and traditional Due Diligence strategies and processes (e.g. financial, operational, organisational) are often of little help when there is almost nothing to evaluate yet.

This is where the power of Soft Due Diligence resides: instead of trying to come to a seemingly rational investment decision by extrapolating from the few facts a venture can provide at that stage, Soft Due Diligence focusses on the ability and capability of the protagonists (i.e. founders) to enact a yet mostly unwritten story (i.e. business model). Soft Due Diligence is not that much about asking “What?”, but rather “How?” or “Why?”.

Two Kinds of Success

In our academic research on Soft Due Diligence, we found that VCs evaluate an Investment Opportunity according to a twofold conception of success: Business Success and Investment Success.

For a VC investment to succeed, the portfolio company has to be successful, sell to customers, generate income, cover its costs and engender a profit. This is only possible if the founding team is capable of implementing and executing their proposed business model, generating value for the company’s shareholders on the way. This is Business Success.

Business Success alone is not enough for an Opportunity to be a successful one: VCs need to be able to return a substantial profit to their investors, on top of the initial capital. For this to happen, a portfolio venture has to mature in a way that makes it attractive for a future investor or buyer, in order to allow the VC Fund to “exit” through a liquidity event, for example by selling the shares detained by the fund with a profit.

VC funds are generally close-ended, most of the time limited to a 10 year period between the first investment and the mandatory restitution of capital and profits to the investors. Investments must happen relatively quickly at the beginning of this period, over 3 to 4 years, to give portfolio ventures the time to grow and allow for a timely divestment and liquidation of the fund.

Ten years may seem a long time, but the process from evaluating, investing, managing, and exiting a portfolio venture is far from a long quiet river.

During that period VCs and founders must be able to work together to grow the Startup Venture into a (more) mature business. They do not need to be friends, but they need to be able to establish a collaborative atmosphere based on mutual respect and transparency that can endure difficult times and last for years.

To succeed in going full circle with all the ventures in the fund, founders and VCs need to have total alignment on their objectives: not all founders are ready to manage their business in a way that prioritises fast growth, and many of them experience reticence to step aside if needed, and let a professional manager guide the business towards a timely exit.

Business Success and Investment Success both have to happen for an Investment Opportunity to result in a substantial return. When the target is an early-stage venture, most of the underlying factors for success or failure are of a “soft” nature, related to the capabilities and attitudes of the people involved with the business.

Searching for Success in the LP-GP Partnership

The Business/Investment Success model is very much transferable to the relationship between Limited Partners and the General Partners and the Venture Capital Firm. Limited Partners need the VC firm to achieve Business Success - find and execute profitable deals - while at the same time ensuring Investment Success - building and maintaining an alignment of values and objectives over the long time of the investment period.

In the following paragraphs we are going to give an overview over the main topics that are relevant to evaluate this partnership from both success perspectives:

A. LP-GP Hard Fit (Business Success)

To make sure an allocation of capital in a VC fund fits your strategic goals and investment objectives as a Limited Partner, a certain number of tangible factors must align. However tangible these might be in theory, there will always be a soft factor to them, in particular when considering an investment in an Emerging Fund.

1. Investment Terms

The first thing you are obviously going to check, and the easiest information to get hold of, are the fund’s investment terms and conditions. Very often fund and fee structures as well as fund governance principles are part of a first filter to ensure the basic parameters of the fund fit your investment strategy.

While certain restrictions and limitations will put a hard end to the evaluation, keep an open mind when it comes to fund characteristics where you are able to give yourself some room for flexibility. An unfavourable fee structure might be putting you off, but there could be other “softer” elements (see discussion below) that might justify it.

Questions to ask yourself:

• Do the fund terms and conditions match our investment goals and objectives?

• Are the terms and conditions compatible with restrictions and limitations we are subject to?

• What are the elements that raise concern, but could be outweighed by other factors?

2. Investment Thesis

The second element that should be very clearly communicated to you is the fund’s investment hypothesis. This must be at least a unique combination of industry focus, venture type and geography, together with an explanation of the thought process that allows the fund manager to argue that this is what is going to lead the fund to produce a substantial return for you as a Limited Partner.

Emerging Funds have the luxury - and in our opinion the obligation - to have a very sharp focus when it comes to their investment thesis. They are nimble, with a small team and hopefully loads of ambition and a healthy motivation to succeed. Far from being an obstacle for success, their small size allows them to be very radical in their decisions what to invest in and what not, and then stick to it.

Their strength is to be able to develop a very deep understanding of the kind of ventures they plan to invest in. Often, Emerging Managers bring with them some special industry knowledge, or they are very familiar with a particular region of the world or a demographic that provides a unique angle to their investment thesis. Many Emerging Funds also target emerging geographies, often closely related to the fund managers own origin. Them stemming from an underserved culture in terms of products and services might also give them privileged access to their community, to the benefit of the ventures they invest in.

For your further evaluation, keep the investment thesis in mind as the big picture into which the whole rest has to fit. Ask yourself if the thesis itself is coherent, unique and ambitious, and above all if it presents a very, very clear focus. Then, when you consider the other aspects of the investment opportunity, always check them against the big picture to understand if all the pieces of the puzzle fit together.

Questions to ask yourself:

• Does the investment thesis make sense? Is it comprehensive and coherent?

• Is it focussed enough to allow the fund to execute it with limited resources?

• Is it clear what falls in the scope of the thesis, and even clearer what not?

• Does the thesis have an “edge”, a character of uniqueness that distinguishes it from what we have seen elsewhere?

3. Fund Manager

Emerging Managers and even more so managers rising a First-Time Fund do not have the luxury of a solid track record showing the performance of their prior investments and the pertinence of their past investment decisions. But there are other ways to look at a prospective fund manager’s professional history to evaluate their ability to execute the investment thesis on the table.

Many Emerging Managers split off of more mature VC firms, and a look at the track record of their activity in a former position can provide good insights. Just as VCs do it with the founders of their prospective portfolio companies, you can ask them for references, and check them with a quick call.

Others might have built some relevant experience by other means, either by investing as Angel Investors themselves, or by participating in or by building Angel syndicates. Looking at how they went about that will give you some insights into their ability to build relationships with ventures and partnerships with other investors, both crucial skills for successful fund management. Their own investment portfolio can give you a “preview” of what their future investments might look like.

But there are other, not directly investment related experiences that should help them give a favourable impression: engagement in other startup related contexts, like Incubators, Startup Studios and Accelerators in various roles allowed many Emerging Managers to hone their evaluation skills and gain a deep understanding for early-stage entrepreneurship. As an added benefit, the continued relationship with the startup ecosystem provides them with good access to new ventures and ensures a steady deal flow.

But professional history and experience is not everything, and even previous failure and lack of performance must not be a decisive criterion. After all, professional life is not necessarily a straight line. Many other “soft” factors can give you an indication about an Emerging Manager’s ability to raise and run a successful fund.

Questions to ask yourself:

• Where does the fund manager come from? What are professional (or even extra-professional) experiences and activities that enrich her or his profile?

• Keep an open mind: creating high quality deal-flow needs people who know how to create and maintain a network, and who are comfortable building constructive relationships. What are the elements in the fund manager’s profile that prefigure that?

• This is rarely a one person business, and even “single” fund managers need a support network around them to pick up where their knowledge and abilities end. What does the professional network of this particular fund manager look like?

• By whom is he supported? Who is on his team (close or extended) and what does his ecosystem look like?

4. Fund Team and Ecosystem

Venture Capital is a very gregarious industry where relationships matter. Be it inside a firm, amongst VCs, or with prospective or acquired venture founders. Everybody talks to everybody, few VCs expect (or can afford) to go alone, in particular emerging or first-time funds rarely take the lead.

As an LP, it is of extreme importance for you to understand how an Emerging Manager is surrounded, as the quality of the ecosystem and his engagement with it constitutes an essential asset.

Using the onion-skin model as an analogy, and starting from the inside, there is (hopefully) a team. VCs are notoriously victims of a wide range of biases, and working closely with a peer, being able to have a critical look on one’s basis for decision making and running decisions by a colleague before committing helps fighting those. For your evaluation, it is important to see the team as a whole, and to understand how the members of the team complement each other, across all stages of the Venture Capital Investment cycle.

Questions to ask yourself:

• Who is in charge of what?

• Is everybody doing what they know best? (i.e. fundraising, deal-flow, financial management, value-adding, …)

• Is this a team that has worked together previously? How did that go?

• Are there any competences missing from the team?

• How does the team composition fit the investment thesis?

• How do you feel about this team being able to execute on the investment thesis?

Continuing with the onion-skin model, look at the extended team of the firm. Non-permanent team members might play an important role in filling gaps in an Emerging Fund’s setup. Venture Partners, Advisors and even Mentors, former colleagues from a previous job in a VC firm or privileged relationships with high-quality industry experts or scientists might provide the experience that the core team of the fund lacks.

Questions to ask yourself:

• What does the fund’s ecosystem look like? Do the managers have access to experienced peers, to high-level industry experts?

• How does/do the fund manager(s) benefit from their network, and how do they integrate external expertise in their evaluation/decision-making/management activities?

• How does the fund’s ecosystem match the fund manager’s combined characteristics? How does it fit and to which degree does it support the investment thesis?

The outermost onion-skin layer would be the fund’s non-operational relationships, such as peers, organisations and other networks the fund managers have privileged access to.

Questions to ask yourself:

• Are the fund managers an active part of their larger ecosystem?

• How closely do they interact with peer VC funds? How good is their access to participate in investment rounds led by firms in their network?

• Do the fund managers engage with their own or adjacent professional organisations (i.e. VC networks, Angel Investors and Syndicates) and are they an active part in them?

• How about their engagement in the industry specific networks of the companies targeted by their investment thesis?

• Do they participate in startup-related events and engage with the wider startup ecosystem (i.e. incubators, accelerators, educational programmes)?

5. The Fund and Firm as an Organisation

Before, we said that Emerging Funds are nimble. By necessity first, probably, as the funds are relative small and management fees often not abundant. But Emerging Fund Managers know how to do more with less and make management fees go further. Just like startup founders, Emerging Managers must deploy creativity in maximising the impact of the money they can spend. Emerging Funds even more so than more mature funds have to be designed for performance.

For you as a Limited Partner, this is good news, because it looks like you are getting more for the fees you are paying: lean organisational structures and a focus on what is essential to achieve success should be aligned with what you expect.

But don’t take it for granted. Pay close attention to how the fund is set up, and how it intends to spend (or spends) the funds available for fund management and value-adding activities. And this goes in both directions: too much money for the wrong things, and not enough money for the right ones.

Venture Capital (surprisingly still) has an aura of “big bucks” and lavish “Wolf of Wall Street” lifestyle, which also attracts some of the wrong people amongst many honest people with the right ambitions. Give a six-figure sum every year to someone who feels that being a VC gives him a right to drive something like Jordan Belfort’s Lamborghini Countach, and you might realise after a while that your management fees are not adding value to whom you might have expected.

Humour aside, and this is very likely an exception, but you should still be well informed about the cost structure and financial roadmap of the VC firm you are going to work with for up to 10 or even 12 years.

More often than the cinematographic example cited above, you might encounter Emerging Fund Managers with a lot of good will and intentions, wanting to do a maximum for their portfolio companies, but lacking the organisational or financial means to do so. Also, with all the best of ambitions, keeping the motivation high over a decade or more without proper remuneration for themselves will prove difficult.

When looking at the fund’s organisational structure, keep in mind the investment thesis, value-adding ambitions and - of course - the fund’s expected number of investments.

Questions to ask yourself:

• Does the fund’s organisational setup match their ambitions? How “lean” is it?

• Does the fund’s cost structure (remuneration, travel, etc…) seem appropriate?

• How many portfolio companies will be assigned to each fund manager?

• How do the planned value-adding activities add up, and how is their organisation and implementation distributed among the fund managers?

• If not performed by the fund managers themselves, what does the platform support system look like? Who is part of it, what are the associated costs?

• Taken the direct and indirect cost structure of the fund into account, what does the remuneration of the fund managers look like? Is it fair, are incentives attractive enough to keep them motivated in the long term?

6. Fund Strategy

After closing the fund (ideally and more frequently already before) the fund managers run deal sourcing activities, fill the fund’s pipeline and evaluate prospective ventures before taking investment decisions. After the investment, portfolio companies benefit from VC’s networks and value-adding activities, helping them to grow, reach their milestones and generate value for their shareholders on the way.

For the fund’s success it is crucial to have a structured approach to managing the Venture Capital cycle. This starts with a position on how deals are sourced, how they are evaluated, how investment decisions are made, what portfolio companies can expect from their investor, how future funding rounds are managed and what the exit expectations should be.

All this should be a well defined, sound and consistent framework, capable of implementing the Investment Thesis through a series of strategic guidelines. It should be clear where the red lines are, and which aspects of the overall strategy allow for space and flexibility.

When it comes to Emerging Funds, these guidelines are most of the time nothing but a bunch of good intentions. However, as a consequence of the strong focus that Emerging Funds (should) have, the outline must be very clear and help you understand how the fund managers will implement this strong focus, and where they are willing to give themselves some slack.

Questions to ask yourself:

• What are the strategic guidelines at each stage of the Venture Capital Investment cycle? I.e. how are prospective ventures evaluated? What are the most important hard and soft criteria?

• Does the firm have a “playbook”? To which degree are these rules formalised?

• Does the firm implement an “agile” approach in their processes, e.g. are rules intentionally and systematically reviewed, in the light of successes and failure? Is there a process of organisational learning?

• What about agile retrospectives? Is there an ambition to systematically improve ways of working by examining what works well and what does not?

• Again: how well do the strategic guidelines fit with the overall investment hypothesis?

7. VC - Founder Relationship

The relationship between fund managers and the founders of their portfolio companies is bound to last many years. During that time, these founders have the task to work towards and ultimately reach the agreed milestones, a journey not exempt of difficulties.

For them, it is important to have the right investor at their side, where the “right” might take on a variety of shapes: more or less involvement, more or less support, more or less control. What matters to founders is to find resonance in their relationship with investors.

For this resonance to happen in a VC - founder relationship, expectations have to be clear and aligned: the venture has to prosper, value has to be created for shareholders, and returned to the investors through a liquidity event, an exit. Basing this relationship on transparency and trust, a constructive attitude and mutual respect from the onset is key.

The benefits of the right mix of hands-on/hands-off involvement and the right attitude towards the founders is manyfold: the fund is more attractive, especially to founders who know what they want and need, and this is the kind of founder you want in a fund. Negotiations between parties that work at eye-level tend to have a more sustainable outcome, and create the foundation for long lasting relationships. Getting used to hearing each-other out early on increases the chance of navigating choppy waters in this long working relationship where difficult times are bound to happen.

As a Limited Partner, you want to allocate your money to a fund that does everything to maximise the chances of a substantial return. Exploring the fund manager’s attitude towards relationships with their founders will give you a good picture of how well this attitude fits with them.

Let’s go back to our startup analogy: every startup business has to have extensive knowledge about their customers in order to serve their needs adequately and comprehensively. An emerging fund is no exception to this rule: founders are one of the two customer groups they serve, and knowing their founders, i.e. their particular customer segment, is key.

Here again, Emerging Managers should excel. Deep industry knowledge and proximity with founders either through their own entrepreneurial experience or their activity in the startup ecosystem often gives them the necessary empathy to know what is needed and how much of it is the right amount.

Questions to ask yourself:

• How would you describe the fund manager’s attitude towards founders, the quality of their interaction? Could it be qualified through attributes like trust, respect, transparency?

• How well do you think the fund managers understand the founder’s needs? Do they show empathy with the founders?

• How much importance do the fund managers place on the alignment with founders, in particular in regards to post-investment topics like management replacements, speed of execution, milestones and KPIs, nature and timing of potential exit opportunities?

• Does the nature and degree of fund manager’s involvement fit with a) their own investment thesis and strategy and b) with the founder’s needs (given the stage of the ventures, the industry, the geography, …)

B. LP-GP Soft Fit (Investment Success)

So far we have been examining aspects of the “hard” fit between LPs and GPs, relevant for the Emerging Fund Managers to achieve their Business Success. This involved anything that allows to assess the likelihood of a successful cycle of selecting, investing, managing, and exiting ventures in a way that returns a multiple of the allocated capital to the Limited Partners of the fund.

But for the Investment Opportunity to achieve overall success for Limited Partners, the LP - GP dyad is dependent on Investment Success, i.e. the construction and maintenance of a decades long relationship based on an alignment of objectives and values.

1. Purpose

Traditionally, Emerging Funds receive most of their funding from High Net Worth Individuals (HNWIs), Angel Investors or Family Offices. Much rarer are asset allocations by Institutional Investors (Banks, Insurance Companies, Pension Funds, Sovereign Wealth Funds) because of the high-risk profile and small ticket sizes inherent to Emerging Funds.

Investors in Emerging Funds frequently choose a fund because there is something in their own history or profile that resonates: for example former startup founders close to the industry the fund invests in or HNWIs from cultures that the fund targets with investments.

This emphasis on purpose is perhaps even stronger with Family Offices, whose objective is to preserve intergenerational wealth, and to create an instrument to care for future generations of the family. Many Family Offices originate from wealth generated in a family business, and an affinity to entrepreneurship is deeply ingrained in their investment activity.

Investing in Emerging Funds can be for many of those investors a way to reconnect with the roots of the wealth that they manage: Angel Investors giving back by providing funding but also support or Family Offices reconnecting with their entrepreneurial origins.

Emerging funds often focus on purposeful investments that have the capacity to resonate with the core values of their (potential) Limited Partners. They frequently occupy niches by financing ventures from underrepresented geographies and cater to underserved demographies. Their need to develop a strong focus, and to stand out amongst more mature or mainstream VC firms almost naturally takes them into territories where investments create environmental or social impact while demonstrating high standards in terms of governance (ESG).

For Limited Partners, Emerging Funds have the capacity to simultaneously respond to the intention or obligation to invest mindfully, while satisfying many ESG related requirements or constraints.

Questions to ask yourself:

• What are the fund’s (or the fund manager’s) core values and how do they express in the fund’s investment thesis? How do they relate to the values we stand for?

• What is the core purpose of the fund’s investment thesis? To which degree does it overlap with the way we want to allocate our capital?

• Which ESG related constraints and objectives will be fulfilled or impacted by an investment in this fund? How high is the quality of the reporting, and how easy will it be for us to process it?

2. Fund Manager(s)

This is perhaps the topic where Soft Due Diligence gains the most importance: investing in an Emerging Fund comes down to investing in an Emerging Manager (or a small team of Emerging Managers). Cue the startup analogy: investing in an early stage venture comes down to investing in a Founder (or a small team of founders). The situation is the same: very little tangible information and almost no historical data available for conducting an evaluation.

Just as VCs with founders, as a Limited Partner we can ask ourselves: Why in earth does this Emerging Manager want to raise a fund? What is his motivation for trading the option of a cushy corporate job (they could get without problems based on their experience) against long and tiresome hours of research for funding, dealing with stubborn founders and the agonising pressure of exiting everybody before the fund is supposed to be wound up?

The central question is “Why does she/he want to raise a fund?”.

And this is not about the Investment Thesis or the opportunity to generate value for their Limited Partners and themselves. It is about what it means for them to be raising a fund and then to be the person managing it. What is the deeper, intrinsic motivation?

The clue might be in the previous section, some fund managers want to make a difference, make the VC industry evolve, drive a particular type of innovation, restore some justice in capital allocations or generate environmental impact.

When evaluating this Emerging Manager, we have to examine this quest for purpose in the light of the investment thesis and the other elements influencing the Business Success of our investment. And then, confront that story with her/his higher purpose. Does this fit? Is there coherence between the role of the fund as a an investment vehicle and the role the fund plays in the life of the fund manager(s)?

A strong intrinsic motivation that is aligned with the fund’s purpose and Limited Partners’ interests is indeed a powerful combination. These fund managers are able to formulate and express a vision for what they are doing, and capable of generating the enthusiasm and momentum necessary to launch the fund lifecycle.

Questions to ask yourself:

• What is the purpose of this fund manager? Why is she/he doing this? A good question to ask in this context would also be “What else would you do, if you were not raising a fund? (or what would you do if you failed to raise this fund?)”

• What is the fund manager’s vision? Does she/he generate enthusiasm? How likely is it that they might motivate other investors to join the fund?

• What does this mean for my investment? Do I feel comfortable with the fund manager’s intrinsic motivation, or is it colliding with my objectives or my own investment thesis?

3. Fund Team

In the discussion above, we have seen that managing a fund is rarely a solo activity, whether that means that there is a management team or a strong support network.

The first, and often overlooked, team member is/are the fund manager(s) spouse(s). Unless she or he lives alone and in total independence, it is crucial that fund manager’s obtain the opt-in of their significant other, or even of their families.

Raising and running a VC fund is more than a 9-5 job and requires long hours, travel, worry, despair and a whole other range of strong emotions, some of them even positive ones. Being (or becoming) a GP is a project that impacts not only one’s individual life, but the lives of one’s whole family. A committed spouse is a powerful ally, a spouse kept in the illusion of a strict separation of the professional and private domain makes Darth Vader look like an angry kitten.

When it comes to the core operational team, we saw that its composition is central to providing the fund with the combined skillset to achieve Business Success, but the inner workings of the team will determine the Investment Success part of the Opportunity. And this team must be strong and solid, and capable of weathering the storms of a decades long collaboration.

As with any team, the collaboration of more than one individual invariably raises the question of leadership and management styles and qualities. In an Emerging Fund the team will likely be very small, but deficits in management capabilities and lack of leadership will even more directly impact the quality of their work, and their relationship with you as their Limited Partner.

Understanding the team and management culture, how flat or hierarchic (yes, in a 3-person team!) it is organised, how personal initiative and opinions are valued (or not), what is considered a success and how it is recognised and celebrated (or not), how failure and mistakes are tolerated (or not) and dealt with (or not, you got it), what the reaction to a crisis would look like; all these elements are going to impact the communication and touch-points you are going to have with the fund team.

Emerging Funds are supposed to be very focussed on success and on generating outstanding returns. At the same time they need to be able to take risks and to learn quickly from their mistakes. This can only happen in a work climate and team culture that fosters mutual trust and transparency, and where people feel safe enough to risk making mistakes.

This culture should not only stay contained inside the fund’s core team, but permeate all of the fund team’s relationships with stakeholders involved: the founders and venture teams downstream, and of course the Limited Partners upstream. Again: a sound and coherent way of working and communicating at all levels, internally and externally.

Questions to ask yourself:

• Is the fund manager’s professional and private situation aligned? Can I be sure that he is in it for the long run? Is there anything that could make him capitulate prematurely?

• Do I feel comfortable with the working style and culture of the core fund team? Does their way of working make it easy for me to interact with them?

• Is the fund team harnessing the power of their collective minds and skills? Or is it a one-man show with a couple of assistants?

• Is the team balanced? Where are gaps in the team’s composition and skillset?

• What does the team’s culture and management style mean for my investment? How does it impact communication?

2. The LP - GP Relationship

And high quality communication is central to the relationship that Limited Partners rightfully expect from fund managers.

In particular from Emerging Managers, LPs can expect careful attention to communication quality. Emerging Managers need to compensate their lack of track-record with excellent service, and often spend more time interacting with their LPs than managers of more mature funds.

Lack of experience and absence of routine might impact the communication in a negative way, but you want your Emerging Manager to be ready to admit mistakes and learn from them to avoid them in the future. This might seem a high price to pay, but in return - in addition to potentially outstanding returns - you might also get to work with people who are extremely proactive and eager to serve.

After all, an Emerging Manager’s goal is to graduate from the “emerging” status, and she or he can only achieve this by building a network of committed LPs ready to invest in fund n+1 and n+2. For you, this is an additional investment that might pay well later: Emerging Managers of today are the unicorn hunters of tomorrow who invested at seed stage. And you might just get the best seat at their highly coveted table.

When evaluating an Emerging Manager, pay attention to not only the content of the documentation and the reporting, but also to different aspects of quality. The information should be presented in a pleasant way and easy to consume. Producing attractive documents is in everyone’s reach these days, and you are entitled to a reading experience on par with the level of management fees you pay.

But even more important is the selection of information the fund managers provide: this should not be a mandatory chore to get rid of every quarter, but the fruit of a real ambition to inform you about what happens with the capital you committed to their fund. VCs expect prospective ventures to know their customer, and you can expect your Emerging VCs to know theirs.

Questions to ask yourself:

• Do I feel that these fund managers have empathy with Limited Partners? Do I have the impression that they understand my needs (and worries, concerns)? Is there resonance in the way we interact?

• How does the quality (in visual and content terms) of the documents I am provided fit with the perception I have of the fund?

• How is the quality of interaction between the fund and myself? Do I feel like a partner in a collaborative environment?

• Do I really want to commit interacting with this fund (manager) for the next 10 years?

How to go about the evaluation?

After this admittedly very long list of considerations, questions and reflexions on evaluating Emerging Managers and their funds, we would like to end with some recommendations on the evaluation process itself.

Evaluating an Emerging Fund is - to make it short - finding the answer to the question “What’s the story here?”. Finding the answer supposes piecing together the story from all kinds of information, gathered from the documentation and the conversations with the fund managers.

Soft Due Diligence - and most of the topics mentioned in this article would fall in this category - is not a process distinct from traditional Due Diligence, but rather an always present way of adding a layer of meaning to the information and facts collected. Where traditional Due Diligence answers the “What?” question, Soft Due Diligence more often attempts to give sense where we ask ourselves “How?” or “Why?”.

With Emerging Managers, there is not a lot of “What?, but loads of “How?” and “Why?”, which makes Soft Due Diligence a powerful and adequate tool for evaluation an Investment Opportunity with their funds.

Soft Due Diligence is performed all the time during the evaluation period, everywhere and at every opportunity. The nice thing with Venture Capital is that it is a highly social industry, and the opportunities to perform Soft Due Diligence are often very pleasant ones: besides official meetings and presentations, lots of business happens while having a drink or enjoying a meal. Do not get me wrong, this is real work and you have to focus to use the dinners, receptions and parties wisely to build the story and to fill the gaps in the narrative.

The best way to do this is to interact as much as possible with the fund manager(s). Ideally you should even find an opportunity to collaborate on something with them, to get a taste of how they behave when working.

Ask a lot of open questions (that make them talk by themselves), respect the 20/80 rule (talk 20% of the time and listen for the rest) and make your conversation partner(s) comfortable by listening actively and giving them space to elaborate on their thoughts. Pay attention to non-verbal clues, the intonation of their voice, the gestures, posture and facial expression while they talk, this might give you more information about what you asked than what they are saying.

This might sound like manipulation, but you are not trying to make them do anything against their free will. Your goal should always be to validate the assumption of a future fruitful and prosperous partnership.

Enjoy the ride, but respect the Emerging Managers. They are putting everything on the line for their fund and for you!

Our next article in the series might switch sides, and summarise best practices for the attention of Emerging Managers getting ready or finding themselves in the thick of the fundraising process.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

In our first article on emerging managers, we were focussing on the qualitative aspects of the risks and opportunities of young venture funds. But while there is undeniably a case for investing in this asset class, how big are the rewards, and how risky is it really?

In this second article, we want to share the various quantitative insights we have collected in our research (see also references below). There is no ambition to be exhaustive, and much of the data is starting to look a bit old, but we think that Venture Capital has a long-term perspective and the general trend is discernable. (Feel free to suggest data that we overlooked or omitted by sending an email to softduediligence@saintclair.ltd).

Who is an Emerging Fund Manager?

Before we dive into numbers, a quick look at the definition of an Emerging Fund Manager itself, which is quite prone to variations across sources. Parameters are generally a combination of years of activity, number of funds raised and fund sizes.

Pitchbook sets the bar at less than four funds raised, and other definitions seen elsewhere include a vague “newly formed” or “relatively small” in their criteria, leaving the spectrum quite open.

There is obviously a big difference in available track-record between VCs raising Fund I and others already benefitting from the experience of having raised one, two or three previous funds. But just considering the case of an experienced spin-off GP from a mature VC firm raising his first solo fund vs. a relatively recent Venture Capitalist raising Fund II or III, we do not find this criterion that meaningful.

So, at the end of the day, who is an Emerging Fund Manager? In our opinion, it comes down to for whom you represent an Emerging Fund Manager. Being “Emerging” or not is not a label, it is a decision criterion for the people you interact with, in particular prospective LPs.

As an LP, you need to have a focussed investment approach and an effective risk-mitigation strategy. Part of it is a set of criteria creating boundaries between funds you are ready to invest in, and the ones you’re not. This set of criteria will certainly (or should) include the ones cited above, but tailored to the individual requirement and objectives of your own investment portfolio.

For ourselves, unsurprisingly, we would retain a definition that comes more from an entrepreneurial point of view, than one based on numerical data. We would probably consider “Emerging” fund managers those whose activity includes an element of exploration, a quest for ways to push the boundaries. Those could be their own boundaries as fund managers (e.g. starting out in the industry) or the boundaries of the industry itself, with an investment thesis sporting an innovative element (e.g. in the industry focus, geography or demographic).

The other “Emerging”

There is another way a fund manager or a fund is considered “Emerging” in the literature, namely by considering aspects of origin or diversity.

The Venture Capital industry has long been dominated by a very homogeneous demographic, to intentionally oversimplify it, by “white western males” all coming from the same cultural and academic backgrounds.

This produces a negative side-effect coming from similarity biases on venture financing in general. In their academic research, Franke et al. found that VCs look more favourably at founders with a similar social and educational background, and Murnieks et al. found proof that VC fund managers prefer founders who think like themselves.12

One striking example is the topic of female-led Venture Capital funds: according to Pioneerspost3, 90% of female-managed funds had to be considered “Emerging” in 2021, based on the criteria of managing their first or second fund sized below $100m. (See also the underlying study “Women in VC”4)

(Source Study “Women in VC”)

Going beyond the scope of Venture Capital, the same Pioneerspost article cites a study5 that finds that only 1.4% of US based financial assets are managed by diverse-owned firms.

(Source: KNIGHT DIVERSITY OF ASSET MANAGERS RESEARCH SERIES: INDUSTRY)

Emerging Fund Performance

This being said, when looking at Emerging Fund’s performance, there is a clear case not to discriminate against them as a LP, as a matter of fact quite the reverse. In our opinion Emerging Managers have a compelling argument in their favour.

PitchBooks Q1 2021 Benchmarks Report finds that First Time Funds (FTF) significantly outperform “higher number” funds while presenting a lower downside risk.

(Source: PitchBook, 20216)

And this seems to be consistently so: a Prequin report from 2016 states that “First-time funds have outperformed funds of established managers in every year except one (2004) over the past 13 years”7 Again, this data is 7 years old at the time of writing this article, but Venture Capital has a long-term horizon where the underlying internal dynamics do not change.

It would be interesting to see this study updated with more recent data to see how the latest macroeconomic developments might have exercised external influence on first-time and emerging funds. A 2023 study by Vauban for example cites a survey from Venture Capital Journal on LPs willingness to invest in first-time managers.8

The picture is a mixed one: while in 2023 there are significantly more LPs declaring it “less likely” that they would invest in first-time managers, there are fewer that exclude it completely. However, the combined proportion of LPs who responded “more likely” or “just as likely” is larger than in previous years.

This statement by Axios confirms that the dynamics of asset allocations are less favourable to emerging funds: 62% of the capital has gone to 6% of funds, and in Q3 alone, 86.7% of the money was committed to just 66 funds.9

The evolution of global economics in the last 12-24 months, and in particular the rise of the risk-free rate, got the Venture Capital industry into choppy waters. We will dedicate one or our upcoming articles to the particular challenges of being an Emerging Manager in the present times.

The Contribution of Emerging Managers

Looking at how Emerging Managers contribute to the industry as a whole, it appears that they are far from playing a negligible role. According to Cambridge Associates,10 Emerging Managers account for 72 percent of the top returning firms between 2004 and 2016, while receiving a share of allocated capital inferior to more mature funds.

Cambridge Associates situates first-time and emerging funds consistently in the 10 top performers between 2004 and 2016, just like in the Vauban study cited above, where they rank among the 5 top-performers for vintages from 2004 to 2020.

In terms of deal value created, Axios uses Pitchbook data to confirm that emerging Venture Capital firms contribute significantly to the value created by the industry, representing consistently at least 25% over the 10 years leading up to 2022, and up to almost 50% in the peak year of 2017.

Emerging Manager’s future?

Statistical data seems to confirm the case we were making for the benefits of investing in Emerging Managers, our selection of information and sources for this article certainly being prone to a range of biases. However, it looks like we are not alone in thinking that Emerging Managers are to play an important role in the risk-reward game of investing in Venture Capital.

Becoming an Emerging Manager and appearing a credible and trustworthy target for asset allocation is certainly not easy, but at least with the data at hand there is a way to debunk the idea that only the solid track-record and experience of mature VC firms can promise value for LPs.

LPs themselves might want to look more favourably at Emerging Managers and at the potentially outstanding returns they seem to be able to generate. In particular in current times, where allocation of capitals in VC funds are penalised by more compelling alternatives and a low risk-free rate, investing in an emerging fund might be worth considering.

Also, let’s not forget that Emerging Managers are not going to be emerging for ever, an Emerging Manager’s goal is to graduate out of this category and build a successful track-record. For LPs, building a portfolio of Emerging Managers is also creating a pipeline of future - and one day potentially access-restricted - high performing VC funds.

As Rainer Braun, Professor for Entrepreneurial Finance in my Alma Mater TU Munich and Co-Founder of fund of VC funds Equation states: the successful unicorn hunters are the ones that invested at seed stage.

In our next article, we are going to shed some light on the criteria and best practices LPs use to evaluate emerging fund manager and the role and importance of Soft Due Diligence in the process.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

Building a strong venture capital portfolio requires a careful balance between established managers and emerging managers. While established managers offer stability and proven track records, it is the emerging managers who bring the potential for extreme outlier performance and the opportunity to participate in the future landscape of Venture Capital.

In this article, we delve into the significance of incorporating emerging managers into a portfolio, despite the inherent challenges. By understanding the potential payoffs and adopting a diligent approach to identifying the right emerging managers, limited partners (LPs) can unlock exceptional returns and establish a pipeline of future industry leaders.

Any industry has its incumbents and new entrants and Venture Capital (VC) is no exception. As a relatively new sector however, most of the VC firms active today have been “emerging” in the last 15 to 20 years. Emerging managers can stem from a large variety of origins, from the inside of the industry, i.e. GPs creating a split-off fund, or often from adjacent territories like tech-founders turned investors, operators from successful startups or professionals active in the wider startup context, e.g. incubators or accelerators.

The LP-GP relationship is one based on values like trust and consistency. Where Limited Partners typically expect some form of track record to support these values, emerging managers have to overcome the lack of history inherent to their condition as newcomers. In particular institutional investors usually require some proof of experience and a history of consistent returns. More often, consequently, budding fund managers raise their first fund from high net worth individuals and family offices or foundations in their own network, where a trusted relationship already exists and softens the lack of track record.

Emerging managers, however, have a lot to offer that investors might not be able to find in more mature funds.

The parallel with the role and characteristics of start-ups as industry newcomers is helpful to understand how new fund managers are driven by an exceptionally high and intrinsic motivation to succeed, and pack a set of advantageous characteristics not available to mature funds.

New fund managers need to impress if they want a life beyond (or even before) “Fund I”. No emerging manager wants be considered emerging longer than necessary. Therefore, they will be extremely focussed on return maximisation rather than playing it safe. Across the board, their performance might be more volatile than that of longer standing funds, but their potential for outsized rewards is also much higher. It is a risk-reward game after all.

At the same time, emerging funds are structurally very simple, even rudimentary businesses, with all the advantages coming along with it: they are very nimble and agile and know how to operate with extremely limited resources.

This reduced complexity makes them more likely to show a laser sharp focus in their investment activity and proportionally less time spent on administrative overhead. They know how to do more with less, and can make your management fees go a long way.

This agility also reflects in their investments. Most emerging funds are small and target pre-seed to seed stages with smaller ticket sizes allowing for faster fund deployment. As a positive side-effect, many emerging funds welcome co-investments alongside the fund’s involvement in a venture, allowing you as an LP, to gain increased exposure to an asset, but with lower fees.

This agility also provides very early access to ventures dedicated to potentially disruptive new technology or exploring innovative new customer needs in yet inexistent markets. As an investor, besides the high potential for outstanding returns, this also allows you to take a front seat and help drive groundbreaking innovation.

Many emerging funds also target new emerging markets niches, often because of the fund managers familiarity with the domain, or his own previous involvement with the industry as an entrepreneur or researcher. This is also where diversity plays an important role, when emerging managers use their privileged access to yet underserved populations or geographies, or their specific knowledge of unsolved problems and customer needs.

As a LP, you might also value this very personal link between emerging fund manager and investment thesis, even fund “purpose”, when it reflects your own values and helps you fulfil your investment goals or impact objectives.

Finally, these emerging managers might not be emerging for long, and those who will give you outlier performance will probably soon be amongst the most coveted funds. The most sought after funds have severe access constraints, and by getting a seat at the table early, you will certainly benefit from the privileges reserved for early supporters. As you position yourself to benefit from the growth and success of these managers in the future, you build a strong pipeline of established fund managers for your portfolio.

Balancing Risk and Reward

Incorporating emerging managers into a venture capital portfolio brings the potential for extraordinary performance and the opportunity to establish connections with future industry leaders. Despite the challenges and the inherent risk associated with emerging managers, the payoffs can be significant. By striking a balance between established managers and emerging talent, LPs can capture the benefits of outlier performance, build a pipeline of established managers, and create a diversified portfolio that embraces the potential for groundbreaking innovation and exceptional returns.

While it is true that investing in emerging managers comes with increased risk, it is essential to recognize that a diversified venture capital portfolio should encompass a mix of risk profiles. The potential payoffs of exceptional returns and the opportunity to shape the future of venture capital justify the effort required to identify the right emerging managers and build a well-rounded portfolio. By carefully managing the risk exposure through diversification and conducting thorough due diligence, LPs can mitigate potential downsides.

In our next article, we are going to look at quantitative insights on Emerging Manager’s performance and their contribution to the VC industry at large.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

Recognizing Biases

The first step in overcoming biases is to identify them. Common biases encountered during Soft Due Diligence include confirmation bias, where individuals seek information that supports their preconceived notions, and availability bias, where recent or easily accessible information carries undue weight. Anchoring bias, on the other hand, occurs when individuals rely heavily on the first piece of information encountered. By being aware of these biases, professionals can actively work towards minimizing their impact on the decision-making process.

Mitigating Biases

To overcome biases, it is crucial to employ strategies that promote objectivity. One effective approach is to gather diverse perspectives from multiple team members or experts. Encouraging constructive debate and challenging assumptions can help counteract confirmation bias and ensure a more comprehensive evaluation. Additionally, establishing clear evaluation criteria and metrics beforehand helps prevent biases from clouding judgment and ensures a consistent and objective assessment across different opportunities.

Establishing an Unbiased Decision-Making Process

Creating an unbiased decision-making process requires a structured approach. Begin by defining the evaluation criteria based on the specific requirements and objectives of the partnership. Develop a systematic process that includes multiple checkpoints, such as independent reviews or external audits, to validate findings and reduce individual biases. Furthermore, documenting the decision-making process and rationale behind each assessment provides transparency and accountability, reducing the influence of biases and enhancing the overall integrity of the evaluation.

Overcoming biases in Soft Due Diligence is essential for making objective and informed decisions. By recognizing biases, implementing strategies to mitigate them, and establishing an unbiased decision-making process, professionals can navigate the path to successful partnerships. By prioritizing objectivity and thorough evaluation, businesses can unlock the full potential of Soft Due Diligence, fostering collaborations based on merit, compatibility, and shared values.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

Cultural fit refers to the alignment of values, beliefs, behaviours, and attitudes between individuals or organizations. It encompasses the shared norms, goals, and expectations that shape the working environment. Evaluating cultural fit during Soft Due Diligence enables businesses to gauge whether potential partners possess a compatible organizational culture, facilitating effective communication, and collaboration.

The assessment of cultural fit is important whenever two organisations have to interact or collaborate more or less closely. This can range from temporary partnerships on one end of the spectrum to Mergers and Acquisitions on the other. The tighter the relationship between the two organisations will be, the more critical cultural fit becomes, and consequently Soft Due Diligence as a means to assess it.

First, understanding the core values and mission of each party involved is essential to evaluate cultural compatibility. Aligning on fundamental principles ensures a shared sense of purpose and direction. Evaluating differences in organizational structure, communication channels, and decision-making processes allow businesses to identify compatibility in terms of hierarchy, transparency, and responsiveness. At the team level, assessing work culture entails evaluating factors such as teamwork, work-life balance, risk appetite, and innovation. Compatibility in these areas can promote a positive and productive work environment. Last but certainly not least, evaluating the approach to diversity and inclusion provides insights into an organization's commitment to creating an inclusive and equitable workplace. Assessing whether values and practices align can help avoid potential clashes.

Strong cultural fit between two organisations yields many benefits. A strong cultural fit fosters seamless collaboration, as team members are more likely to share similar working styles, communication preferences, and problem-solving approaches. This synergy can lead to improved productivity and efficiency.  When partners possess shared values and perspectives, decision-making processes become more streamlined. A cohesive understanding of goals and priorities enables quicker and more effective resolutions. Cultural fit establishes a solid foundation for long-term partnership success. It fosters mutual trust, respect, and commitment, which are crucial for navigating challenges and achieving shared objectives.

Neglecting cultural fit during the due diligence process, on the other hand, can have detrimental consequences, both internally and externally.

Incompatible communication styles, decision-making processes, or work practices can result in misunderstandings, delays, and frustration among team members, hampering collaboration. Incompatible work cultures can lead to low employee morale, dissatisfaction, and increased turnover. The resulting instability can disrupt ongoing projects and hinder progress.

Without a shared understanding of goals and expectations, partnerships can quickly unravel, leading to conflicts and decreased performance.  A failed partnership due to cultural clashes can have lasting reputational implications. Clients, stakeholders, and the wider industry may perceive an organization as incapable of forming successful collaborations.

In the intricate web of business partnerships, cultural fit emerges as a vital component of Soft Due Diligence. By recognising the significance of cultural alignment, organizations can forge fruitful collaborations built on shared values, effective communication, and mutual understanding. By conducting thorough assessments of cultural fit, organisations can mitigate risks and prepare for better integration between both parties. When evaluating evaluate cultural aspects in a timely manner, organisations can join forces in a much more efficient way. Culturally compatible partnerships dramatically increase the chances to see expected synergies materialise, with a direct impact on shareholder value.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

Soft Due Diligence encompasses the qualitative, non-financial aspects of an M&A deal. It goes beyond the numbers and legalities, focusing on the intangibles that shape the culture, people, and strategic alignment of the entities involved. Soft Due Diligence aims to assess compatibility, identify synergies, and evaluate the potential risks and challenges arising from the blending of organizational cultures, leadership styles, and operational practices.

Evaluating Organizational Culture

Cultural Alignment: Assessing the compatibility of organizational cultures is crucial to ensure a smooth integration post-transaction. Evaluating shared values, leadership philosophies, and communication styles can reveal potential synergies or incompatibilities.

Employee Engagement and Retention: Understanding the workforce's sentiment, morale, and satisfaction levels is vital in assessing the potential impact of the M&A on employees. High employee engagement and retention rates can signify a healthy organizational culture and smooth integration process.

Change Management Capabilities: Evaluating the change management capabilities of the entities involved helps gauge their ability to navigate the transitions and potential resistance. Strong change management processes can mitigate disruption and ensure a successful integration.

Leadership and Management

Leadership Styles and Approaches: Examining the leadership styles of key executives involved in the M&A helps identify compatibility or divergence. Assessing their decision-making processes, strategic vision, and ability to inspire and motivate teams can provide valuable insights.

Talent Management and Succession Planning: Understanding how talent is managed, nurtured, and developed within each entity allows for an evaluation of potential synergies and opportunities for talent retention and growth.

Operational Synergies and Challenges

Supply Chain Integration: Assessing the compatibility of supply chain processes, infrastructure, and distribution channels is crucial for identifying potential operational synergies and integration challenges.

IT and Technological Integration: Evaluating the compatibility of IT systems, data management practices, and cybersecurity protocols ensures a smooth integration and minimizes potential risks and disruptions.

Intellectual Property and Legal Considerations: Investigating intellectual property rights, patent portfolios, and any legal constraints associated with technology, trademarks, or copyrights helps identify potential risks and opportunities for innovation and growth.

Customer and Market Dynamics

Customer Base Overlap: Assessing the overlap and compatibility of customer bases helps determine potential market share expansion and identify potential risks associated with customer retention or attrition.

Market Positioning and Competitive Advantage: Evaluating the market positioning, brand equity, and competitive advantage of each entity allows for a comprehensive understanding of the combined entity's potential strength and market opportunities.

Soft Due Diligence stands as the vital bridge that connects the financial intricacies of M&A with the intangible but crucial elements that define organizational culture, leadership, and operational practices. By incorporating Soft Due Diligence into the M&A process, businesses can unlock hidden value, identify potential risks, and set the stage for successful integration. Embracing the art of Soft Due Diligence enables organizations to navigate the complexities of M&A transactions with strategic insight and precision, ultimately propelling them towards transformative growth and lasting success.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

The Essence of Soft Due Diligence in Venture Capital

Soft Due Diligence takes a holistic approach to evaluating investment opportunities, focusing on factors such as leadership, team dynamics, market insights, and the viability of business models. It acknowledges that success in venture capital is not solely dependent on financial metrics but also on the people behind the venture.

Particularly in early-stage investments, intangible elements related to the founders and the team, but also intellectual property, competitive advantages, and market positioning, contribute significantly to the potential success of a venture. Evaluating these intangibles requires a broad understanding of human behaviour and dynamics as well as a deep understanding of the industry, market trends, and the broader ecosystem.

Distinctions from Soft Due Diligence in Other Domains

Venture capital investments carry inherent risks, often involving early-stage companies or disruptive technologies. Soft Due Diligence in venture capital acknowledges and addresses the unique risks and uncertainties associated with such investments.

Unlike traditional due diligence in other domains, Soft Due Diligence in venture capital places significant emphasis on evaluating a founding team’s ability to execute a proposed business model and to grow the business. Assessing the capacity of the management team to navigate challenges and seize opportunities allows investors to understand if the founders are able to adapt their product or service depending on the market’s response. Or, in an extreme scenario, even successfully pivot towards a different concept without compromising the value of the investment.

Soft Due Diligence at Different Stages of Venture Capital Investment

The inherent difficulty in evaluating early-stage ventures is due to an almost total lack of track record and tangible data. Soft factors related to the founding team and aspects of market validation constitute the most relevant areas of investigation at this stage.

Soft Due Diligence focuses on evaluating the founders' vision, passion, domain expertise, and their ability to build and lead a successful venture. Assessing their entrepreneurial qualities and understanding their motivations are crucial factors. Examining market trends, customer needs, and competitive landscapes help identify the potential for product-market fit and assess the venture's ability to capture market share.

At this stage, however, founders are often new to entrepreneurship, and their products or services attempt to create new markets for yet unserved customer needs. This is where Soft Due Diligence with its holistic approach shines: the evaluation encompasses not only what can be known about the venture proposal and the market, but even more importantly how the founders present their project and its potential. The most important criteria for evaluating early-stage ventures is the quality of the founders’ reasoning, and their ability to evolve with their venture as the business model takes shape.

In growth-stage investments, there is much more information available for an evaluation. Companies have a team of employees and the founders have dealt with management challenges. This is why Soft Due Diligence in growth-stage investments emphasises assessing the management team's capabilities, experience, and track record. This includes evaluating the team's ability to scale operations, manage complexities, and execute growth strategies effectively.

When it comes to late-stage Investments the detailed analysis of financials, revenue projections, and profitability of the venture dominates. An evaluation must also consider potential risks associated with upcoming funding rounds, capital requirements, and exit strategies.

Soft Due Diligence in late-stage investments involves assessing the venture's relationships with strategic partners, suppliers, and customers. Evaluating the stability, reliability, and value of these partnerships is critical in determining the venture's long-term prospects.

Soft Due Diligence in venture capital offers a nuanced and comprehensive approach to assessing investment opportunities beyond the realms of financials and legalities. It recognises the unique risks, growth potential, and intangible value associated with venture capital investments. By focusing on the people, market dynamics, and scalability, Soft Due Diligence provides venture capitalists with a holistic view, enabling them to make more informed investment decisions and support ventures in unlocking their true potential.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.

Soft Due Diligence encompasses a broader and more comprehensive approach to evaluating business partnerships, investments, and collaborations. It goes beyond the numbers and legalities to examine intangible factors that can significantly impact the success or failure of a business deal. This article aims to provide an introduction to Soft Due Diligence, highlighting its importance in today's business landscape, the differences between soft and traditional due diligence, and the benefits of incorporating Soft Due Diligence into your business practices.

Understanding Soft Due Diligence

Soft Due Diligence focuses on assessing the intangible elements of a business, such as culture, relationships, communication styles, leadership qualities, and emotional intelligence. It aims to gain insights into these less quantifiable aspects to determine the compatibility, trustworthiness, and overall suitability of potential business partners or investment opportunities. By delving into these intangibles, Soft Due Diligence provides a holistic view that complements the traditional financial and legal analysis.

Differences between Soft and Traditional Due Diligence

Traditional due diligence primarily revolves around financial audits, legal assessments, and risk analysis. It heavily relies on historical data, financial statements, and contracts to assess the financial health, legal compliance, and potential risks of a company. It aims to ensure that the financial and legal aspects are in order and align with the objectives of the deal.

In contrast, Soft Due Diligence focuses on evaluating the people, culture, and relationships involved in a business. It recognises that successful partnerships extend beyond financial transactions and require alignment of values, vision, and goals. Soft Due Diligence emphasises the importance of cultural fit, effective communication, shared values, and trust between the parties involved. It seeks to identify potential red flags, misalignments, or hidden risks that may not be apparent from the financial and legal assessments alone.

The Benefits of Incorporating Soft Due Diligence

1. Improved Decision-making: By incorporating Soft Due Diligence, decision-makers gain a more comprehensive understanding of the potential partner or investment. It helps identify intangible factors that can greatly influence the success or failure of a business deal. With a deeper insight into the people and culture involved, decision-makers can make more informed choices that align with their long-term goals and vision.

2. Enhanced Compatibility: Soft Due Diligence enables businesses to assess the compatibility between potential partners or collaborators. Cultural fit, shared values, and similar communication styles are crucial for fostering effective collaboration and reducing conflicts in the future. By evaluating these factors early on, businesses can avoid costly and time-consuming disputes that may arise due to a lack of compatibility.

3. Mitigating Risks: Soft Due Diligence helps identify potential risks that may not be immediately evident in financial or legal documents. By assessing the leadership qualities, communication effectiveness, and reputation of the parties involved, businesses can identify warning signs or red flags that may indicate potential problems. This allows for proactive risk mitigation and the avoidance of partnerships or investments that may pose higher risks.

4. Strengthened Relationships: Soft Due Diligence fosters the development of strong and mutually beneficial relationships. By prioritizing the evaluation of relationships and communication styles, businesses can identify potential areas of synergy and alignment. This, in turn, lays the foundation for building trust, open communication, and long-term partnerships that are more likely to thrive.

5. Competitive Advantage: In an increasingly interconnected and relationship-driven business landscape, soft

due diligence provides a competitive edge. By going beyond the surface-level analysis and considering the intangibles, businesses can make better-informed decisions, establish stronger relationships, and seize opportunities that may not be apparent through traditional due diligence alone.

Incorporating Soft Due Diligence in Your Business Practices

To effectively incorporate Soft Due Diligence into your business practices, consider the following steps:

1. Identify Key Soft Factors: Determine the soft factors that are most critical for your business and align with your values and goals. These may include cultural fit, leadership qualities, communication styles, and emotional intelligence.

2. Develop Evaluation Methods: Establish evaluation methods to assess the identified soft factors. This may involve conducting interviews, surveys, reference checks, or engaging third-party experts with expertise in Soft Due Diligence.

3. Assess Cultural Fit: Pay close attention to cultural fit, as it plays a significant role in the success of partnerships. Assess shared values, working styles, and the overall compatibility of organizational cultures to ensure alignment and minimize potential conflicts.

4. Evaluate Leadership and Communication: Evaluate the leadership qualities and communication effectiveness of potential partners or investment opportunities. Look for strong leadership skills, transparent and open communication practices, and an ability to collaborate effectively.

5. Leverage External Expertise: Consider engaging external experts specializing in Soft Due Diligence to augment your evaluation process. These professionals can provide valuable insights, objectivity, and expertise in assessing soft factors and identifying potential risks.

Soft Due Diligence is an integral part of modern business practices. By focusing on the intangible elements of a business deal, such as culture, relationships, and communication styles, businesses can gain a more comprehensive understanding of potential partners or investments. Incorporating Soft Due Diligence enhances decision-making, mitigates risks, strengthens relationships, and provides a competitive advantage in today's relationship-driven business landscape. By embracing Soft Due Diligence, businesses can unlock new opportunities and navigate the complexities of the modern business world with greater confidence and success.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.