Due diligence in investor syndicates: Balancing risk and reward

Due diligence is about verifying an investment, challenging assumptions, and thoroughly assessing the risks and rewards. 

The goal is to ground investments in reality rather than getting swept up in assumptions, hype, or wishful thinking.

However, the due diligence process takes on new dimensions when you're investing as part of a syndicate – a group of investors who pool their resources to invest in startups collectively.

While the syndicate’s lead investor bears most of the responsibility for due diligence, it’s still down to the follow-on investors to do their own homework. 

This article unpacks the ins and outs of syndicate due diligence, including the lead investor's role and how to use the group’s collective knowledge as an advantage.

Alignment starts with partner selection

The foundation of effective syndicate due diligence is laid long before any specific deal is considered. It starts with the selection of your syndicate partners.

Syndicates have exploded in popularity in recent years, leading to a surge in lower-quality syndicates that don’t always engage in rigorous research.

Phil Nadel, the founder of Forefront Venture Partners, explains the predicament:

“There has been a rapid increase in the number of syndicates available on AngelList, and I characterize many of these as “high volume, low quality.

"They conduct very little substantive due diligence on the companies they syndicate and may never have even spoken with anyone at the company.

"They are given allocations in deals by VCs or other investors, often without the knowledge or approval of the startup they are investing in.”

As such, due diligence really begins when you’re looking to join the syndicate. Nadel points out some red flags to look out for:

“I advise extreme caution and serious inquiry into the syndicate general partner’s track record, cadence of deals, and rigor of due diligence.” 

Seek out partners whose investment philosophies align with your own. Look for individuals with complementary skills and proven domain expertise rather than those who just want to get stuck in as many deals as possible. 

The role of the lead investor in due diligence

Typical syndicates are spearheaded by a lead investor, usually an experienced angel investor or a venture capital (VC) firm with a track record in the sector.

The lead investor is responsible for the heavy lifting in due diligence. They'll investigate the company's financials, market position, and growth potential. They'll also handle key tasks like negotiating the terms of the investment.

Plus, they’ll often use their expertise to influence and improve the target company post-deal.

Thus, the lead’s commitment to due diligence is not merely academic. It’s very much tied to their reputation, cash, and the incentives of being the lead.

Also, don’t forget that the lead has to commit their own capital, so they have skin in the game too. 

The syndicate due diligence process

While the exact due diligence process can vary between syndicates, the syndicate’s follow-on investors (who decide whether or not to join the lead’s deals) should have access to the due diligence materials compiled by the lead investor. 

These include the company's pitch deck, financial projections, market research, and other figures and complementary information you might find in a data room.

As a follow-on, you can review these materials and assess the opportunity yourself. If you have specific questions or concerns, you can raise them with the lead investor. 

It’s often quite a collaborative process with in-person meetups or conference calls held by the lead. 

In the case of larger or more established syndicates or a VC firm who’s syndicating the deal, they’ll typically have a ‘VC standard’ approach to due diligence that leverages internal experience and advice from external experts. 

Remember: the decision to invest remains with the follow-on investors. So, while you can lean on the lead investor's expertise, it’s ultimately your cash and your decision.

Fortune favours the wise

In many syndicates, especially smaller, more engaged ones, the follow-on investors often contribute through active collaboration. 

However, research shows that the lead’s personal conviction can greatly influence the investment, as their confidence builds trust and signals potential to the group.

Dustin Dungelow, GP at VC firm Maiden Lane, explains:

“There is evidence that there is another approach that can at least perform as well, and in many cases outperform consensus-based investing [typical in normal VC investing], and that’s when an individual has an insane amount of conviction in some combination of product, team, and space and you have enough trust with them to let them pursue that conviction and take a bet.”

This comes from a paper published in the National Bureau of National Research, called Is a VC Partnership Greater than the Sum of its Partners?

The essence of the point is that follow-on investors might simply want to take a punt on the lead’s skills. This can generate higher returns than selecting deals after lengthy back-and-forth.

After all, investing is about risk tolerance. Follow-on investors might have a different risk appetite, so they’re free to conduct their own research and trust the lead’s instincts or not.

With all of this said, we must emphasise again: it depends on the syndicate! Most leads (especially VC firms with more rigid practices) will establish clear communication within the syndicate. 

Balancing structure and adaptability

While each investment opportunity is unique, many lead investors (particularly if they’re syndicating deals as a VC firm) will have a structured due diligence framework to ensure consistency and thoroughness.

It will contain checks like:

• Financial review
• Market analysis
• Product assessment
• Team evaluation
• Legal review
• Customer validation

However, true to the spirit of angel investing, it's equally important to remain adaptable.

Based on the deal's specifics, the lead will be prepared to explore deeper into certain areas, bring in additional expertise if needed, and adjust the deal timeline if issues arise. 

Balancing speed and thoroughness

Due diligence means balancing two competing imperatives: the need for thoroughness and the need for speed.

On one hand, a syndicate's pooled resources can allow for a deeper, more comprehensive diligence process than an individual investor could conduct on their own.

On the other hand, startups often operate on tight timelines. An overly drawn-out diligence process can strain the relationship and potentially cause the deal to fall through.

Negotiating the speed and timing of the investment are pertinent skills for the lead investor. Nadel gives an excellent example of why:

"Just yesterday, we were at the tail end of our due diligence on a deal we were excited about. But I had a nagging sense that something wasn't right. So, I kept pushing.

"The company claimed to have just signed a deal with a major restaurant chain for $20M. I asked them to connect me with the restaurant chain so I could verify this... We had caught the startup in an outright lie."

These are exactly the instincts that will make someone a great lead investor, and the very insights that follow-on investors stand to benefit from.

Syndicates: it’s all a balancing act

Managing due diligence in a syndicate is a balancing act, but it doesn't have to be a juggling act.

As an investor, your most valuable asset isn't your capital – it's your judgment.

As a follow-on, you're not bound to invest in deals you're unsure about, and you can leverage the syndicate's collective expertise to make informed decisions.

As for the technical aspects of managing syndicates, this is where Special Purpose Vehicles (SPVs) come into play.

SPVs are investment entities designed to pool capital from multiple investors into a single vehicle, which then invests in the target company.

They offer several advantages for syndicate investing:

• Simplified cap table: Instead of having numerous individual investors on the startup's cap table, there's just one entry for the SPV.
• Streamlined communication: The startup deals primarily with the lead investor, reducing administrative burden.
• Easier follow-on rounds: Future funding rounds are simplified as the SPV acts as a single entity.
• Flexibility for investors: SPVs can accommodate different investment amounts and terms for syndicate members.

By offering the means to set up and manage SPVs directly (and crucially, digitally) Vestd makes collaborative investing smoother and more efficient.

To learn more, book a call with our team to discover how Vestd can help with the setting up of SPVs and support syndicate investing.

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Please note: The Syndicate and Pledge Fund products are intended for Sophisticated Investors and High Net Worth Individuals, under the relevant legislation. Vestd acts only as the Platform Operator and Nominee Provider, and does not act as a Fund Manager in this arrangement. Vestd Ltd is authorised and regulated by the Financial Conduct Authority (685992).