How to Approach Diligence in Sweat Deals

No More Picking Winners

Diligence in venture deals can range from high-profile legal and financial reviews for late-stage, large-scale funding, to basic meet & greets or product demos in early stage deals. Low quality diligence is at least partly responsible for the low efficiency of early-stage venture, but more than that the idea of picking winners at an early stage is probably suspect to begin with. Diligence as a business function is most useful for late-stage deals, and almost meaningless for early-stage deals—that is, if you have the idea that if you just ask a founder the right questions or if their projections meet certain benchmarks then they are investable.

‍

Sweat investing is about making winners, not picking them. The unique advantage of sweat investing to “diligence” is that the “investor” will work within the organization. They will likely be instrumental to the success.

‍

In a sweat deal, diligence is about determining if there is a foundation for a fruitful partnership—not about a founder jumping through hoops to get cash and then not speak to the investor until they need more. So here at Lynx, we recommend both founders and service providers consider sweat diligence a combination of fundamental venture diligence and service diligence.

Venture Diligence

Venture diligence is about the basics of a venture investor-investment relationship. This is the same evaluation of an investment that any angel investor would make.

For service providers making an investment of sweat equity, consider these basic venture questions:

‍

• Does the team have strong investor collateral, including a deck, model or projections and product demo?
• Is there a large and growing market opportunity?
• Does the investment fit a broader thesis about the direction of the market?
• Can the team detail a reasonable budget of internal and external expenditures?
• Do the founders have credible experience for the venture?
• Have they raised capital to date, or booked revenue?
• Do they show progress toward problem-solution or product-market fit and wherewithal to achieve it?
• Are the fundraising terms reasonable for the stage of the company and market size? Is the valuation (cap) and round size sensible?
• Do business projections allow for sufficient runway to succeed?
• Can the founders detail a plan to overcome competitive threats?
• Are there exit opportunities?

For founders taking on a new investor, consider the questions in reverse:

‍

• Does this investor demonstrate vertical-specific knowledge? Do their background and references support their credentials?
• Does the investment suit their broader venture thesis?
• Is the investor well-enough capitalized to make the investment?
• Do they show patience with your projections, and understand the business model?

‍

Service Diligence

Subject matter expert diligence performed by service providers is the true advantage of sweat investing. While angel investors make only the cursory evaluation above, talent working within an organization have the unique mandate of evaluating the potential of their own work.

‍

We encourage service providers evaluating an opportunity to consider this fundamental question: Will the investment of my firm’s time have a greater than a dollar-for-dollar impact on future valuation? In other words, do you rate the investment of your service as good or better than investing an equivalent amount of cash?

‍

Not all organizations are responsive to the investment of all kinds of sweat, and still they won’t be responsive at every point in their lifecycle. This type of evaluation is different for the investment of each type of service. For example, an advertising agency that specializes in rapidly scaling digital advertising and user growth will might have the greatest impact on valuation immediately after an organization achieves product-market fit. This diligence might involve reviewing product analytics to determine sessions per day, session length, user retention, user referral rate, Net Promoter Score, or other metrics that indicate that investing user acquisition (instead of cash) will have the highest expected value.

‍

Conversely, a product design studio that specializes in rapid design sprints to solve a business problem and achieve problem-solution fit may have the greatest impact when investing their service in an organization with only a prototype. In conducting service diligence, the advertising agency and the product studio might evaluate each opportunity differently based on the stage of the company.

‍

Besides lifecycle stage or progress toward PMF, the sector or vertical may imply an organization’s responsiveness to a service. The advertising agency above, even if their rubric of product analytics is met, may be a sub-optimal investment for a product that sells into government, where digital ads are not right scale lever. The investment of an intellectual property lawyer however may have very high return.

‍

The lesson for service providers is to develop your own checklist for evaluating an investment to determine if your unique service offering and expertise will have a positive ROI and increase the valuation of the target organization in the next round.

‍

For founders evaluating a service provider, even if a deal is equity based instead of cash fees, shop the service like you would run any procurement—compare rates, case studies, and references—but also evaluate the provider as a partner.

In Conclusion

When evaluating a sweat deal from either side, look for sound fundamentals of a venture, but also look for a uniquely good match. Consider each other as partners, and it should feel like a win-win, like an inevitable conclusion.  

‍