80% to 90% of venture-backed companies won’t reach the initial public offering (IPO) stage.
As a general rule, out of every 10 startups, 3 or 4 will fail entirely, 3 or 4 will only return the initial investment, and 1 or 2 will succeed. However, for those few that do go public, the returns can be staggering, that is why most established companies and investors consider taking the risk and investing in early-stage companies.
For this process to be successful, a thorough due diligence is required. It simplifies the process for startups and investors alike.
Venture capital due diligence involves investors and VC firms carefully looking at potential investments in new startups, while thoroughly evaluating potential opportunities and risks.
This guide explains what good due diligence is, why it matters, and what top VC firms look for to find the best opportunities.
What is VC due diligence?
VC due diligence process refers to the comprehensive investigation and evaluation process conducted by venture capitalists before making investment decisions.
Conducting thorough due diligence is crucial for any investment, but it’s especially so in venture capital. Startups at this stage often face unique challenges in assessing their value or potential due to several key characteristics:
- Limited history: Venture-backed companies typically have scant historical data available, making it challenging to make well-informed decisions.
- Volatility in growth: Despite the expectation of rapid growth, startups often experience erratic growth patterns in the short term, complicating projections for long-term success.
- Equity complications: Startups may already have existing claims on their equity, whether from angel investors or founders, further complicating the investment landscape.
- Uncertain demand: Forecasting demand can be particularly tricky, especially for products or services entering uncharted markets or industries.
A big part of venture capitalists’ job is to navigate these challenges to make informed decisions, mitigate key risks, and accurately assess the startup’s true value.
Even with limited data, venture capital investors strive to gather enough information to paint a comprehensive picture of the company and its market. This entails meticulously analyzing available information and applying a mosaic theory approach to investment.
There are various business scenarios that necessitate the application of VC due diligence, including but not limited to:
- Startup investments: Required when evaluating early-stage startups seeking VC funding, ensuring thorough assessment of the startup’s business model, target market, and team capabilities.
- Mergers and acquisitions: Necessary to assess target companies’ strategic fit, financial health, and potential synergies before engaging in acquisition or merger transactions.
- Portfolio management: Ongoing due diligence is essential for monitoring and optimizing the performance of investment portfolios, identifying opportunities for value creation, and managing risks effectively.
- Strategic partnerships: Prior to entering into partnerships, comprehensive due diligence is crucial to assess the alignment of objectives, compatibility, and potential synergies between the parties involved.
- Equity financing rounds: Required before participating in funding rounds, involving assessment of valuation, terms, and potential dilution effects on existing shareholders.
- Intellectual property transactions: Essential for evaluating the value, ownership rights, and potential risks associated with intellectual property assets during transactions such as licensing or acquisition.
- Corporate restructuring: Necessary to evaluate the feasibility, implications, and potential benefits of restructuring initiatives on the company’s operations, finances, and strategic direction.
- International expansion: Required to assess market opportunities, regulatory landscapes, operational risks, and cultural considerations when expanding into new geographical regions or markets.
- Technology licensing agreements: Crucial for evaluating the value, scope, and risks associated with licensing agreements for technology transfer, ensuring alignment with strategic objectives and mitigating potential legal and operational risks.
The main stages of VC due diligence
As was already mentioned, venture capital due diligence is a sophisticated multi-step process.
From assessing market potential to scrutinizing legal compliance and financial viability, each stage of due diligence plays a crucial role in informing investment decisions:
- Assessing the investment opportunity: The initial stage involves thorough research to understand the investment opportunity, including analyzing the business model, market potential, competitive landscape, and growth prospects to align with the VC’s objectives.
- Risk assessment: Identifying potential risks such as financial health, legal compliance, intellectual property protection, and management liabilities through due diligence allows for informed decision-making and risk mitigation strategies.
- Management team evaluation: Evaluating the experience, qualifications, and capabilities of the startup’s management team is critical, as they play a pivotal role in the company’s success or failure.
- Market analysis: Analyzing the target market’s size, growth potential, competitiveness, and fit with the startup’s product or service is essential to understand the market dynamics and customer segments.
- Financial due diligence: Studying the company’s financial statements, projections, revenue model, burn rate, and capital requirements helps assess its economic viability and potential financial issues.
- Legal and regulatory compliance: Ensuring compliance with relevant laws, contracts, licenses, intellectual property rights, and resolving any legal disputes is crucial to avoid legal risks that could impact the investment.
- Technology and intellectual property assessment: Evaluating the uniqueness and protectability of the startup’s technology or intellectual property ensures it has a defensible competitive advantage.
- Customer and partner references: Speaking with existing customers, partners, and industry contacts provides insights into the company’s reputation, product quality, and stakeholder relationships.
- Valuation: Confirming the practicality of the proposed valuation based on financials, market potential, and competitive positioning allows for negotiation and setting appropriate terms.
- Synergy with existing portfolio: Assessing how the investment fits into the VC’s existing portfolio and whether it complements previous acquisitions can influence investment decisions.
- Geographic and cultural factors: Considering cultural perceptions, customer demographics, and regional market dynamics can impact the startup’s success in different geographic regions.
- Customer traction: Evaluating factors such as growing customer base, revenue, and reviews indicates market fit and potential for success.
- Exit strategy: Examining potential exit options such as acquisition or IPO early on enables investors to formulate a viable plan for realizing returns on their investment.
The main areas of VC due diligence
VC due diligence typically involves investigating the management team, market dynamics, product differentiation, traction metrics, legal compliance, and financial performance:
| Management team | Evaluates the experience, qualifications, and capabilities of the startup’s management team, assessing track record, credentials, and relevant experience to execute the business plan effectively. |
| Market | Analyzes market size, growth potential, trends, dynamics, and competitive landscape to gauge the startup’s positioning, market fit, and potential for capturing and maintaining market share. |
| Product | Assesses the uniqueness, quality, differentiation, and market fit of the startup’s product or service, evaluating its competitive advantage, technical robustness, and alignment with customer needs and preferences. |
| Traction | Measures the startup’s progress and validation, often through customer acquisition, revenue generation, user adoption, or other key performance indicators, indicating market acceptance, scalability, and potential for future growth. |
| Legal | Conducts a comprehensive legal review, examining corporate structure, governance, intellectual property rights, contracts, regulatory compliance, litigations, and employment issues to identify potential risks, liabilities, and legal barriers. |
| Financials | Analyzes financial statements, projections, revenue model, burn rate, cash flow, margins, and other financial metrics to assess economic viability, fiscal responsibility, and potential return on investment, informing valuation and deal terms negotiations. |
Management team
Evaluating the management team constitutes a critical aspect, consisting of several aspects essential for startup success:
- Track record and capabilities: Central to the evaluation process is an assessment of the management team’s track record, credentials, and experience. Factors such as previous successful ventures, educational background, and industry expertise weigh heavily in determining the team’s potential to steer the startup towards success.
- Team dynamics and collaboration: A harmonious collaboration among the founding members and the broader management team emerges as a pivotal factor influencing a startup’s trajectory. Delving into the history of the team’s collaboration, observing their communication styles, conflict resolution mechanisms, and decision-making processes offer insights into their cohesion and effectiveness in navigating the entrepreneurial landscape.
Market
When assessing the management team, three key aspects come into play:
- Track record and capabilities: Evaluating the team’s past successes, qualifications, and industry experience is crucial for predicting their ability to lead effectively.
- Founder/market fit: It’s essential to ensure that the founders have the necessary expertise and understanding of the market they’re targeting.
- Team dynamics and collaboration: Observing how the team collaborates, communicates, and resolves conflicts provides insights into their ability to work together effectively.
Product
In venture investing, analyzing the product boils down to three main things:
- Product-market fit (PMF): Ensuring the product resonates with its target market is essential for growth. Early validation proves the product’s potential to the management team and boosts its chances of attracting users.
- Product differentiation (“Moat“): Developing unique features or technology, like patents, creates barriers against competitors. This differentiation secures a lasting advantage in the market.
- Value proposition: Demonstrating why customers need the product is vital. Factors like pricing, uniqueness, and comparison to alternatives play a role. A strong value proposition leads to loyal customers and increased sales opportunities.
Traction
When evaluating traction, several key elements warrant consideration:
- Customer acquisition: Understanding the number of customers and revenue generated provides insights into the company’s growth trajectory and market demand for its products or services.
Product development stage: Assessing the maturity of the product’s development cycle helps determine its readiness for market launch and scalability. - User engagement: Analyzing user engagement metrics such as active users, retention rates, and customer feedback offers insights into the product’s value proposition and market fit.
- Industry comparisons: Benchmarking the company’s traction against industry standards and competitors provides context for its performance and growth potential.
Legal
Legal due diligence encompasses several key areas to ensure compliance and mitigate risks:
- Corporate structure and governance. Reviewing articles of incorporation, bylaws, and corporate governance documents to ensure proper organizational structure and compliance with regulations.
- Intellectual property rights. Examining patents, trademarks, copyrights, and trade secrets to verify ownership, validity, and enforceability. Identifying any potential infringement risks or disputes that could impact the company’s competitive advantage and market position.
- Contracts and agreements. Reviewing contracts with customers, suppliers, partners, and employees to identify any legal obligations, restrictions, or liabilities. Ensuring compliance with contractual terms and conditions, including termination clauses, exclusivity agreements, and intellectual property rights.
- Regulatory compliance and litigation: Assessing compliance with local, state, and federal regulations relevant to the company’s industry and operations. Identifying any ongoing or potential litigations, disputes, or regulatory actions that could affect the company’s financial performance and reputation.
- Employment and labor laws: Reviewing employment contracts, compensation structures, and benefit plans to ensure compliance with labor laws and regulations. Assessing employee equity arrangements, stock options, and vesting schedules to mitigate risks related to employee disputes or turnover.
- Shareholder equity and ownership: Examining shareholder agreements, equity allocations, and voting rights to understand ownership structures and potential conflicts of interest. Ensuring transparency and fairness in shareholder relations to maintain venture capitalist confidence and trust in the company’s governance practices.
Financials
While financials appear the last on this list, they are the essentially important part of venture capital due diligence.
- Financial metrics: Assessing metrics like CAC, revenue growth, burn rate, churn rate, free cash flow, and product margins provides insights into the company’s financial health and growth potential.
- Historical performance: Examining past financial records and revenue trends helps investors gauge fiscal responsibility, identify risks, and predict future performance.
- Valuation and deal terms: Understanding the company’s valuation, equity structure, and deal terms allows investors to estimate potential returns and negotiate favorable terms.
- Industry and market comparison: Benchmarking the company’s financial metrics against industry averages and competitors’ performance aids in assessing its competitive position and growth prospects.
- Risk identification and mitigation: Identifying and addressing financial risks, such as market volatility and regulatory compliance issues, helps investors protect their venture capital investments and optimize returns.
Ready-to-use VC due diligence checklist
Here’s a comprehensive venture capital due diligence checklist to guide investors through the evaluation process:
Market analysis
- Market size and growth potential
- Market trends and dynamics
- Direct and indirect competitors
Product assessment
- Product-market fit (PMF)
- Product differentiation (MOAT)
- Value proposition:
Traction evaluation
- Customer acquisition, revenue, and growth metrics.
- Customer testimonials, case studies, user feedback
- Revenue generation, customer acquisition strategy
Legal due diligence
- Corporate structure, governance, and shareholder relations
- Intellectual property (IP) rights and legal review
- Customer contracts, supplier agreements, partnerships
- Regulatory compliance and litigation history
- Employment and labor issues, shareholder equity
Financial analysis
- Revenue, growth rate, burn rate, free cash flow
- Financial statements, tax filings, revenue trends
- Equity structure, control provisions, exit strategies
- Benchmarking against industry averages, competitors’ performance
- Risk assessment and mitigation strategies
Operational due diligence
- Scalability, resource utilization, cost management
- Scalability, security, and compliance
- Vendor relationships, logistics, and inventory management
- Feedback mechanisms, response times, and resolution rates
Exit strategy and investment thesis
- Exit options: IPO, acquisition, secondary market sale
- Fit with the fund’s investment strategy and goals
- Growth opportunities, competitive advantages
Wrapping up
Let’s briefly summarize key findings from the article:
- Due diligence is crucial in the VC landscape due to the high risks associated with investing in startups, helping investors mitigate risks and maximize returns.
- Understanding the principles of effective due diligence empowers investors to navigate the complexities of the VC market more easily.
- The venture capital due diligence checklist provides a structured framework for investors to comprehensively evaluate potential investment opportunities, covering management team assessment, market analysis, product evaluation, traction metrics, legal compliance, financial analysis, and some other aspects.