The majority of early-stage VC deals fall apart in due diligence

Here’s what investors are looking for when writing the first check into a fledgling startup

Covering Five Flute’s fundraising and tearing down the deck the company used to raise its $1.2 million seed round had me wondering: How the hell do investors decide whether to invest in a company at the earliest stages?

VC firm Baukunst led the Five Flute investment, and I sat down with Axel Bichara and Tyler Mincey to learn how they evaluate a potential early-stage deal. They told me that the vast majority of the deals they look at fall apart at the due diligence stage and helped me get a deeper understanding of what that process looks like from the inside.

“The decision to take a second meeting is one of the biggest decisions in venture capital because, from that [moment] onward, you are committing significant time,” Bichara said, explaining that, in his experience, they only invest in one out of every 250 deals or so that they see. Only about 1 in 40 first meetings result in a second meeting. “Everything you do after the first meeting, I consider due diligence. You’re evaluating the founders. At the stage we invest, most of our due diligence focuses on two things: The quality of the founding time and the size/attractiveness of the market opportunity. If you get those two right, everything else will fall into place, almost by definition.”

With the right team and a huge market, everything else can be figured out later, Bichara argued, saying that if you have a great “founder-market fit,” you’re off to the races.

“The right founding team will do the right thing [in that case]. They will execute well, and there will be capital-efficient market opportunities. You enter with a competitive advantage, find a niche and scale from there. If you don’t get a resounding ‘yes’ from those two, you shouldn’t invest,” Bichara explained. “All the due diligence you do is geared toward answering those two questions.”

In the case of Baukunst, the firm’s investment thesis means that for an investment to make sense, the startup needs to at least have the possibility of a $1 billion outcome or more — which means that the market opportunity needs to be big enough to enable that if the founding team executes well.

“You just work backward from there,” Bichara said, “and all the due diligence we do will be in support of that.”