Introduction

In the world of start-up investing, the depth of due diligence remains a contentious topic. Those who conduct extensive due diligence often face criticism from founders and fellow investors alike, with the latter group arguing that the noise-to-signal ratio in early-stage start-ups is too large for due diligence to be meaningful. I understand both perspectives. However, for deep tech start-ups in particular, extensive due diligence isn’t just beneficial—it’s essential. I will share my views on what good deep tech due diligence looks like.

Unmet Needs and the Problem that Matters

Owing to the nature of deep tech, many startups in this category can seem like solutions looking for problems as they aim to commercialise their research. These commercial implications might not have been a priority during the founding team’s academic pursuits, so it’s not rare to find deep tech start-ups employing sophisticated technologies to address minor issues. For instance, I recall an old chemistry professor who spent over a decade arguing that the surface of water wasn’t neutral but was charged. And this was in the 2010s, not the 1910s. In a more extreme start-up example, a renowned biotech entrepreneur relayed a tale from one of my medicine classes. He had been attempting to commercialise a drug molecule but only considered producing a TPP (target product profile) and consulting with the drug regulator TGA quite late in the process. Ultimately, the TGA equated the drug’s commercial value to that of paracetamol. Despite clinical successes, the initiative was promptly terminated.

While most deep tech startup concepts aren’t this drastic, derivative solutions are all too frequent. For pharmaceutical propositions, if a drug isn’t first in class (innovative treatment), best in class (highly specific), or cost-effective to produce (like orphan drugs), its commercial viability is somewhat predetermined before any attempt at commercialisation. It’s rare for research commercialisations to experience the kind of market expansion typical of software start-ups.

Science and Technology

Conducting due diligence on the science and technology behind deep tech may seem daunting, especially for generalist investors. In special situation investing, the capability to execute high-quality due diligence on deep tech start-ups might be the primary reason an investor is involved in a deal. Many investors either avoid deep tech altogether or skip due diligence, thereby inadvertently attracting scams.

Context is crucial when assessing the science. For instance, if pitched a therapeutic IgG3 antibody venture, would you invest? Knowing that the hinge region of human IgG3 is longer, susceptible to proteolysis, possesses a short in-vivo half-life, and has few clinical success, do you know better at what you are looking at? At a minimum, understanding the context helps frame the right questions.

The other aspect is the interview with the creator(s) of the deep tech. Those individuals tend to be extremely resourceful and could possess invaluable knowledge that might remain hidden unless directly engaged. Some might be retired, not actively involved in the start-up and have a vision they wish realised, whereas others might have deep partnership and operational level involvements and deep insights about where the breakthrough is happening in their field. Grasping what differentiates their technology and assessing their skin in the game could be very helpful. In addition, sometimes they hold options and it could be a strong vote of confidence if they choose to exercise their options at the current round.

Intellectual Property

In the world of software, startup = growth. This analogy doesn’t translate to deep tech, where a more fitting equation might be deep tech = IP.

The most common exits for deep tech start-ups are trade sales or licensing deals with large incumbents. When they buy out the deep tech start-ups, they are not buying the customers, infrastructures or even the employees, they are just buying the IBD asset - IP.

Without IP, a deep tech startup is virtually uninvestable—a mistake many budding researchers commit.

Navigating IP issues in deep tech is so complex that our investment team even includes a dedicated IP attorney to advise on IP aspects during the due diligence process. One often overlooked issue is the founder’s academic success. A prolific academic record could mean an extensive list of publications. Unless patents were filed before these publications, these works would be considered prior knowledge, rendering related patent applications non-novel. It’s also worth noting that natural chemicals or organisms can’t be patented, potentially reclassifying some deep tech concepts from pharmaceuticals to complementary medicines, which have distinctly different business models and upside potentials.

When founders seek external investments, many merely just lodged their patent applications and the assumption that those patents would be approved in full is largely unsubstantiated. When the claim of IP is forced to be narrow, the value of the investments will drop substantially.

Sales and Marketing

Sales and marketing activities might be minimal or even non-existent for deep tech start-ups. In this context, such terms are used loosely.

Deep tech start-ups typically have clear milestones, with each stage offering a potential exit point with its corresponding returns. Important considerations include managing conflicts of interest, negotiating licensing terms, aligning with major players, and establishing valuations.

It’s not rare to encounter serial entrepreneurs juggling multiple related ventures, including in deep tech. Such founders might have vested interests in partners contributing to the deep tech’s evolution. Recognising these affiliations isn’t necessarily a dealbreaker provided appropriate governance structures are in place to protect the investment. Again, this is not a generalist’s game - it takes experience and insights to do it properly.

Licensing terms, especially those from prestigious universities or research institutions, can sometimes hamper a deep tech start-up’s prospects. All parties involved in deep tech development are essentially partners, and an abundance mindset rather than a zero-sum mindset is more conducive to success. I’ve witnessed situations where savvy investors have assisted start-ups in renegotiating favorable terms with research entities and benefited all partners involved.

Engaging major players is crucial, but their interests may not align with the start-up’s offerings. Effective negotiations often involve major entities with strategic interests corresponding to the start-up’s focus, as opposed to those not aligned strategically.

Valuing deep tech start-ups might be among the most systematic appraisals in the start-up investment realm. Clear exit scenarios exist, and recent comparable acquisitions provide both a benchmark for potential returns and a probability model. In my experience, valuation of deep tech start-ups causes fewer disputes among investors, between investors and founders, than in the software start-up sphere.

Conclusion

Deep tech start-ups occupy a unique and challenging space in the world of investment. Unlike their software counterparts, the intricacies of science, technology, and intellectual property play a more dominant role in their potential success. As a result, investors must adopt a refined approach to due diligence, delving deeply into the science, IP, and the minds behind the innovations. By understanding the distinct aspects of deep tech – from the significance of patents to the importance of aligning with key players in the industry – investors can mitigate risks and identify true potential. In the rapidly evolving landscape of technology, those equipped with thorough due diligence strategies will be best positioned to capitalise on the transformative opportunities that deep tech start-ups offer.