In recent years, the failure of high-profile startups has drawn renewed attention to a persistent question in the venture capital (VC) world: How much diligence is enough when speed of investment is at a premium? Collapses at the likes of FTX reflect a broad pattern of governance failures in fast-moving markets.

In a new paper, we focus on a systemic incentive problem: In competitive environments, investors are rewarded for speed and access, not verification. This gives rise to a collective action problem in which no single fund has an incentive to conduct comprehensive diligence, because each fund assumes that others have already done it. While individually rational, this strategy amplifies risk across the system when no one verifies what everyone assumes.

Venture capitalists are described in the literature as “risk-reduction engineers” who reduce information asymmetries by conducting thorough due diligence, identifying governance risks, and certifying quality before deploying capital.[1] This role carries downstream consequences: Startup employees, customers, and follow-on investors may take VC involvement as a proxy for verification. But in practice, this ideal is frequently unmet.

In hot markets, when capital is abundant and deal flow accelerates, traditional safeguards such as reference checks, founder background reviews, and legal and financial due diligence are often abbreviated or skipped entirely. VCs may rely on external cues, like a respected lead investor, rather than conducting their own review. Bill Gurley, a veteran investor and longtime general partner at Benchmark, has described this behavior as “proxy due diligence:” relying on the reputational cues of co-investors in place of independent scrutiny.  This pattern is not simply the result of haste or neglect, but a rational response to market incentives.

Formal liability rules do little to deter shortcut diligence. Within a fund, limited partnership agreements frequently wave fiduciary duties and include exculpation provisions that limit general partner liability to cases of gross negligence or willful misconduct. These contractual terms are enforceable under Delaware’s permissive alternative entity regime, provided they are clearly drafted and negotiated by sophisticated parties. Outside the fund, third-party plaintiffs face even higher hurdles: Prevailing legal doctrines require either a special advisory relationship or clear evidence of actual knowledge or deliberate indifference – barriers that routine diligence failures rarely overcome. As a result, even when glaring red flags are missed, there is usually no legal repercussion absent intentional deception.

This creates a moral hazard: Because VC funds’ downside is limited to the amount of their committed capital, and they benefit from diversification across portfolio companies, they can tolerate individual diligence failures so long as aggregate fund returns remain strong. General partners have an incentive to chase outsized winners that can compensate for multiple losses.

Consequently, regulators have increasingly relied on selective enforcement and informal guidance to encourage due diligence. In the wake of FTX’s collapse, the Securities and Exchange Commission (SEC) requested information from FTX’s investors about whether they had established due diligence procedures and adhered to them. The SEC subsequently included due diligence practices in its 2024 Examination Priorities for private fund advisers.[2] The Federal Trade Commission (FTC( has focused its enforcement on startup founders, including a 2024 initiative targeting deceptive AI claims.[3] Furthermore, in a 2024 speech, a senior Department of Justice official stated that the agency “will not hesitate” to pursue investors, such as VC or private equity firms, who ignore red flags in sectors like healthcare.[4] Still, these efforts remain selective and come largely after the fact. The policy environment is also uncertain, both because regulatory priorities may shift under the current administration and because the Supreme Court’s 2024 decision in Loper Bright v. Raimondo eliminated Chevron deference, which may now limit agencies’ confidence in imposing new diligence standards.

We propose a three-part agenda for aligning speed with responsibility in the VC world. First, the SEC should issue non-binding guidance on what constitutes “reasonable” due diligence, calibrated to sector and systemic risks. A principles-based VC Due Diligence Code, potentially developed with industry participation (in collaboration with the National Venture Capital Association), could clarify baseline expectations without mandating a rigid checklist. Second, regulators should pursue targeted enforcement in egregious cases involving fraud or gross negligence. Third, technological tools can help reduce the speed-scrutiny tradeoff, enabling independent verification through RegTech solutions. These proposals aim to elevate standards without stifling flexibility. They reflect our view that VC firms are often best positioned to detect early red flags, and that soft-law instruments, information infrastructure, and reputational incentives may be more effective than mandatory rules.

We recognize that not all harms can be prevented, and that overregulation risks deterring the kind of high-risk ventures the innovation economy depends on. Still, by enhancing the credibility of gatekeeping before capital is deployed, the industry can mitigate the broader costs of proxy due diligence.

ENDNOTES

[1] Ilya Strebulaev & Alex Dang, The Venture Mindset: How to Make Smarter Bets and Achieve Extraordinary Growth 101 (2024), https://www.amazon.com/Venture-Mindset-Smarter-Achieve-Extraordinary/dp/0593714237.

[2] SEC Div. of Examinations, 2024 Examination Priorities 11 (2024) https://www.sec.gov/files/2024-exam-priorities.pdf

[3] FTC Announces Crackdown on Deceptive AI Claims and Schemes, Fed. Trade Comm’n (Sept. 25, 2024), https://www.ftc.gov/news-events/news/press-releases/2024/09/ftc-announces-crackdown-deceptive-ai-claims-schemes

[4] Jaime L.M. Jones, Brenna E. Jenny & Lauren McBride, DOJ Ramps Up Scrutiny of Health Care Investors, Reuters (June 14, 2024, 8:47 PM), https://www.reuters.com/legal/legalindustry/doj-ramps-up-scrutiny-health-care-investors-2024-06-14/

This post comes to us from professors Yifat Aran at the University of Haifa and Nizan Geslevich Packin at CUNY’s Baruch College and the University of Haifa. It is based on their recent article “Due Diligence Dilemma,” forthcoming in the University of Illinois Law Review and available here.