**Venture Capitalists Analyze the Failure of IRL: A Lesson in Due Diligence**
Last week, Fortune reported on the downfall of IRL, a social app startup that, despite reaching a valuation of over $1 billion a few years ago, recently announced its closure due to the discovery that 95% of its users were fake. This unfortunate turn of events has prompted venture capitalists to reflect on the mistakes made by investors. In this article, we will delve into their insights and discuss the importance of conducting thorough due diligence in the world of venture capital.
**IRL’s Rise and Fall: The Warning Signs**
IRL entered the exclusive group of unicorns, companies with valuations exceeding $1 billion, after securing $170 million in a Series C funding round led by SoftBank Vision Fund 2. With additional investments from Goodwater Capital, Founders Fund, and Floodgate, IRL had raised a total of over $200 million. However, suspicions about the authenticity of IRL’s user base arose when CEO Abraham Shafi stepped down following allegations from employees regarding inflated user numbers.
**Insufficient Due Diligence: A Critical Error**
During a discussion on the All-In podcast, venture capitalists shed light on the lack of due diligence that should have revealed IRL’s inflated user numbers. Angel investor Jason Calacanis emphasized the importance of asking uncomfortable questions and conducting uncomfortable diligence. While trust in the founders is essential, it is crucial to verify the accuracy of the data provided.
David Sacks, a general partner at Craft Ventures, added that one of the most crucial aspects of due diligence, apart from analyzing metrics, is reaching out to customers independently rather than relying solely on information provided by the company. This off-sheet referencing allows for a more objective assessment of the startup’s performance.
Chamath Palihapitiya, founder of VC firm Social Capital, highlighted the insufficient checks and balances within the industry. Palihapitiya criticized what he described as “deeply inexperienced” venture capitalists who struggle to ask even the most basic questions or lack the courage to challenge startup leaders. He stressed the necessity of conflict within the investment team and between the investors and the startup’s executives.
**The Pitfalls of Large Funds: SoftBank’s Role in IRL’s Downfall**
The venture capitalists also discussed the role played by the SoftBank Vision Fund, particularly its massive size. With over $100 billion in capital, the fund has the potential to magnify the consequences of its mistakes. Sacks explained that while IRL’s failure should have been a $10 million error, the fund’s size compelled it to write substantially larger checks.
Palihapitiya further elaborated on the issue, mentioning that the size of venture capital funds often increases as it leads to higher annual management fees. This financial incentive can potentially compromise the thoroughness of due diligence, reducing it to a perfunctory process with little regard for future outcomes.
**The Future of Due Diligence: Lessons Learned and Applied**
Palihapitiya, known as the “SPAC king,” who has brought numerous high-risk startups to market through special purpose acquisition companies, also cautioned that these problems will likely continue to arise with the proliferation of new artificial intelligence (A.I.) companies. According to him, the venture capital community is currently in a rat race, prioritizing profit over genuine due diligence. As such, he predicts that similar situations to IRL’s downfall are likely to occur again in the A.I. space. However, he believes that the hype cycle surrounding artificial intelligence is just beginning.
**Lessons for Venture Capitalists: Conducting Effective Due Diligence**
The collapse of IRL serves as a powerful reminder of the importance of conducting thorough due diligence before investing in startups. Venture capitalists must take on the role of asking uncomfortable questions, independently verifying data, and challenging startup leaders to ensure the accuracy and authenticity of their claims. Moreover, the size of funds should not overshadow the need for diligent scrutiny.
As the venture capital landscape continues to evolve, it is crucial that the industry learns from the IRL debacle and applies these lessons to future investments. By prioritizing diligent due diligence and fostering an environment of constructive conflict, venture capitalists can mitigate risks and increase their chances of success in the ever-changing startup ecosystem.
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