Due Diligence Dilemma

This Article examines venture capital (“VC”) due diligence practices in the wake of FTX’s collapse and a broader rise in startup fraud. It introduces the “due diligence dilemma”: a core tension between the imperative to invest rapidly and the widespread, yet often unfulfilled, expectation that VC firms serve as effective gatekeepers through independent diligence. The Article argues that this dilemma is exacerbated by cyclical market conditions, which give rise to a collective action problem. Individual VC firms are incentivized to expedite investments and rely on others’ diligence efforts in order to maintain a founder-friendly reputation. The result is “proxy due diligence”—a practice of inferring trustworthiness from the presence of other reputable investors rather than conducting independent verification. While this approach may be rational for VC firms and their limited partners—who can hedge against failure through portfolio diversification—it can result in real harms to employees, customers, and other stakeholders who treat VC investment as a proxy for reliability. The Article suggests that the current legal framework, which primarily depends on private ordering between sophisticated private parties, may not adequately address these wider implications.

The Article explores potential legal and regulatory responses, ranging enforcement actions to more prescriptive due diligence requirements, and concludes by addressing the fundamental question underlying this discussion: are the potential impacts on uninvolved parties simply an unavoidable trade-off for innovation-driven economic growth, or might carefully designed policy interventions encourage venture capital firms to consider the wider social implications of their investment and oversight decisions?