How to perform due diligence on a crypto startup
Due diligence is an investigation, audit, or review performed to confirm facts or details of a matter under consideration.
Performing due diligence drastically reduces the risk of a company running away with your money. And if you haven't done due diligence, you have no idea who you're transferring money to or the legal risk.
What’s the point of DD?
The goal of the due diligence process is to strengthen your conviction.
There are two factors to look at:
- Founding team
- Product + market size + token relevance
Casey Caruso over at Paradigm illustrated it nicely:
Depending on your strategy, you weigh them differently.
Founder-first emphasizes the founding team. The variable part of the equitation is bound to change, and the founders will adapt and overcome.
Company-first emphasizes the market size, revenue model, and current product. Focusing more on explicit revenue models and how they will work.
Founder team checklist
- Do the founder's share history?
founders should share a prehistory before they start a company together — otherwise it’s just rolling dice” — Peter Thiel
2. Is the founder team uniquely equipped to solve this exact problem?
“Above product-market-fit is founder-product-market-fit” — Naval
3. Is the founder team public?
Pseudonyms have and will continue to work. But we can all agree to take a bet on an anonymous team contains more risk.
4. Are the founders able to attract extraordinary talent?
Is there any indication, past or present, that the founders have been able to recruit or bring in extraordinary talent? Having and being able to attract the right people is incredibly important.
- Are users ready to adopt this?
Understand the timing. In terms of attracting market adoption, are the end user ready to adopt the product, and is the timing in the market correct?
2. Does the product have moats?
The most important thing is trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle — Warren Buffett
Moat is the durable ability for a business to increasingly dominate a market without losing profits to competition.
There are five types of moats:
Before you evaluate the market size, you need to understand; whether the project is delivering products and solutions in an existing market or creating a new category.
The two explanations below are excerpts from GoingVC’s article Venture Capital Due Diligence: The Market Test.
Market size for an existing market
If the project is offering a new solution to existing markets, at least one of the following must be true:
- There is real product differentiation: The product is at least 10x better than existing solutions through user experience, total functionality, or something else.
- There is perceived product differentiation: The product benefits from the brand's strength (i.e. Microsoft may have an easier path to launching a new productivity tool than an unknown company).
- There are network effects: There is an added value as more users join and use the product or platform (social media platforms and other two-sided marketplaces such as eBay), and/or user interactions create value.
Market size for a new category
It often requires time, resources, and capital to make this work. And lots of trial and error before the user base adjusts and adopts.
This is known as the Tough Tomato Principal and was stitched together brilliantly by Flo Crivello and shared by Jackie DiMonte of Hyde Park Venture Partners (tweet here)
Simply put, it often requires the project to be able to adjust the entire system, which is no simple feat.
Some questions to help validate this market:
- Are the people within this market easily identified?
- Is the pain they are fixing greater than the cost of adjusting how the market is currently doing it?
- Is it clear whether this is a utility, governance, or security token?
- Does the distribution split after TGE make sense?
- Does the token allocation between founders, employees, investors, and other activities make sense?
Operational due diligence
Operational due diligence must be the final step before committing to an investment. The goal is to ensure the business you are about to invest in is adequately set up. You are making sure there aren't any red flags or anything from a legal standpoint that can jeopardize your investment. You're trying to mitigate the risk. The questions below are a great starting point; you can send them as an attachment to the company.
You will need to request access to several documents:
- Certificate of Incorporation - you need to ensure they have a company set up and registered.
- Corporate entity organizational chart - you need to understand if a parent or subsidiary company exists. Are you investing in one company, but they have multiple branches or subsidiary companies set up? Why do they have that?
- Formal shareholders' register - who owns the shares in the company, and how much do they own? Is the business or any of the shareholders on a sanction list? If so, the worst case is that your investment can be seen as terror financing. That's where doing a KYB (know your business) process comes in.
- Any documents evidencing indebtedness for money borrowed or loaned by the company - does the company currently have debt, and have they taken up a significant loan? You're trying to understand the financial situation and identify significant risks.
- Any correspondence or documents relating to any pending or threatening action, suit, proceeding, or investigation, including without limitation, (i) those involving the Company's employees in connection with their prior or present employment or use of technology and (ii) those being conducted by or before any governmental entity or regulatory agency - this clause is meant to be all covering, and you're asking for information regarding disputes and potential litigation. A pending or active lawsuit significantly increases the risk of the investment.
- Any correspondence or documents relating to allegations of the Company's infringement of the proprietary rights of others - here, you're making sure you cover a potential ongoing infringement of proprietary rights.