Venture Debt: The Critical Role of Operational Due Diligence (ODD)
In part seven of his series on venture debt, Zack Ellison from Applied Real Intelligence delves into the critical role of operational due diligence in mitigating the risks of lending to venture-backed startups.
While financial assessments often take the limelight in venture debt, operational due diligence (ODD) plays a decisive role in determining a startup’s long-term viability. Unlike investment due diligence, which scrutinizes a startup’s financial health, ODD ventures deep into the operational heart of prospective borrowers, evaluating not just their visionary prowess but their operational acumen and readiness to execute their ambitious plans.
This investigative endeavor holds particular significance for early-stage companies characterized by rapid evolution and adaptation. These enterprises are tasked not only with innovation, but also with demonstrating operational excellence, resilience, and the capacity to scale operations – effectively laying down tracks while the train is already moving.
ODD aims to identify key operational risks inherent to a specific business, assessing their likelihood of materialization, and determining the potential damage if they do occur. It is imperative to ascertain whether these key risk factors can be adequately mitigated before extending the loan. Moreover, the deal structure should be tailored to the individual borrower to mitigate risks for the lender.
Following are some of the key elements of ODD that venture lenders must dig into.
Management and Leadership Evaluation
At the core of operational due diligence lies the leadership team’s assessment. Their ability to foresee, adapt, and navigate challenges provide lenders with assurance. Evaluating a leadership team extends beyond CVs and accolades; it entails in-depth exploration through interviews, personality assessments, and scrutiny of past performance. Background checks, reference verifications, and understanding compensation structures are not mere formalities, but also necessities in gauging the leadership team’s alignment with the venture’s long-term success.
“For early-stage companies, it’s crucial to contextualize past experiences within the present situation,” said Richard Roscelli, an investment advisor and portfolio management specialist at Cardea Capital Group. “Given the absence of an immediate ‘sell button’ in private loans, lenders must be confident in their ability to collaborate with the leadership team indefinitely and ensure effective communication, especially during challenging periods.”
Culture and Team Dynamics
Evaluating a start-up’s culture and team dynamics is crucial. This process focuses on understanding how the leadership’s goals effectively flow through to the team, checking for cohesion, values alignment, and the integration of core values into the company’s daily operations. A strong culture fosters innovation, effective problem-solving, and strategic execution, creating a base for sustainable growth.
Key aspects include assessing communication practices, risk-taking attitudes, learning and development support, and the overall health of team relationships, evidenced by key departures, turnover rates, and employee satisfaction metrics.
Incentive structures need to be aligned to ensure that the team operates cohesively, driven by a shared commitment towards serving customers and investors over the long haul rather than short-term individual achievements.
Operational Systems and Technology Infrastructure
A startup’s technological backbone – including IT infrastructure, cybersecurity policies, and CRM systems – serves as its operational nerve center. Assessing the robustness and scalability of these systems is vital, as they underpin the company’s growth trajectory.
Additionally, evaluating the startup’s adoption of new technologies and its innovation pipeline is essential. Understanding how the start-up utilizes technology for operational efficiency and product development provides valuable insights into its long-term growth potential.
Business Continuity and Disaster Recovery
It’s imperative for start-ups to establish robust business continuity and disaster recovery plans. These plans serve as a proactive strategy to mitigate risks posed by unforeseen events such as pandemics, wars, cyberattacks, and natural disasters.
These plans should outline clear protocols for responding to various scenarios, including remote work procedures, data backup and recovery strategies, communication channels, and contingency plans for critical operations. Given the significant value attributed to the leadership team and key personnel, securing key person insurance is a prudent measure. Regular monitoring and testing of these plans are essential, enabling timely interventions and adjustments to reduce risk.
Supply Chain Resilience
The pandemic underscored the criticality of supply chain resilience. Analyzing a start-up’s supply chain for vulnerabilities and mitigation strategies becomes a lens through which lenders view potential operational disruptions.
“Understanding the strength of supply chain partners is very important as these are necessary for the company to succeed yet somewhat out of their control,” said Jane Leung, who previously served as CEO and head of iShares, Asia Pacific, for BlackRock.
Internal Controls
“The goal of the ODD review is to conclude that a borrower has implemented a solid internal control environment that gives the lender comfort that they can trust the borrower,” said Desmond Low-Kum, managing partner of Diligent Controls and previously director of operational risk management and compliance at Stanford Management Company.
Rigorous internal controls over cash management, expense allocations, and financial reporting demonstrate a borrower’s operational maturity and readiness for unforeseen adversities.
Regulatory Compliance
Borrowers need to implement a comprehensive compliance program, while managing potential liabilities, including litigation, safety, and environmental concerns. Strategies for success include a systematic approach with continuous monitoring of regulatory changes and integrating compliance into business strategy.
Furthermore, educating stakeholders and employing technology to streamline compliance processes are critical measures. These efforts not only help borrowers meet current regulatory requirements but also prepare them for future demands.
Challenges and the Future
The role of operational due diligence in successfully lending to startups cannot be overstated. It’s the backbone of risk mitigation, a critical evaluator of a startup’s ability to execute its vision. As the venture debt ecosystem matures, the methodologies and importance of ODD will only deepen, ensuring that lenders can confidently invest in the next generation of innovators, knowing their operational foundations are as strong as their visions.
Coming Up
Future columns will dive into the nuances of investment analysis and the art of building and managing a successful venture debt portfolio.
Zack Ellison is the founder and managing partner of Applied Real Intelligence and CIO of the A.R.I. Senior Secured Growth Credit Fund. Send comments or questions to zellison@arivc.com and visit A.R.I.’s website at www.arivc.com.