Venture Capital Due Diligence Explained
Venture capitalists (VCs) are investors who decide to support young startup companies financially, but it’s not a simple process. It is a tricky undertaking as most startups fail. So VC firms have to take their time to evaluate startups before they invest in them. In other words, they need to do due diligence.
This article will go into detail about the need for and the process of VC due diligence.
What is VC due diligence?
VC due diligence is an investigation into how a startup operates, what its current state is, its position in the market, and what its growth potential is. Due diligence done well highlights good investments as well as potentially disastrous investments.
The process is not the same for every VC firm, but the purpose is always the same: to determine that the startup has what it takes to succeed, that it’s in good legal standing, and that all risks have been identified.
Why is venture capital due diligence necessary?
Venture capitalists invest mainly in startups, which are early-stage companies with little or no proof of financial worth. This is because startups have had few business deals to prove their market value. This creates uncertainty around the startup, making it hard to know if it’s worth investing in. That is why due diligence is so important. It’s only by investigating and assessing all the information related to a startup that a VC firm can evaluate whether its investment will pay off in the long run and provide a handsome return on investment.
At what point does due diligence enter the picture?
Due diligence comes into play at the point of sourcing, that is when a startup is starting to look for funding, or a VC firm has identified a startup it might want to invest in. As soon as the parties have met, due diligence begins in some form.
How long does due diligence take?
The time due diligence will take depends on many factors, including the investor firm itself, its investment criteria, the startup and its founders, and the nature of the investment.
There have been cases where an angel investor has simply gone with a gut feeling and went ahead investing based on a feeling that the founder(s) can be trusted and has a winning proposition. In this case, due diligence happens in a matter of one or two conversations.
In most cases, however, due diligence can take anything from a couple of weeks to a few months. Many factors can contribute to the complexity of deals, which takes time to sort out. Due diligence often takes less time in the case of early-stage companies or funding rounds that are about to close.
Due diligence areas of investigation
The due diligence process differs across VC companies and startups. Every investor has a different approach and every investment situation has unique factors influencing it. However, most processes involve the following areas of investigation.
1. Management team
A startup’s founding team is the first to come under scrutiny. VCs need to determine each member’s level of expertise in their field, their general level of expertise, and the value they can bring to the venture.
The team must present more than an exciting product; they must have a long-term vision for the company. The product being introduced must improve on existing products by a considerable margin. In other words, it must be much better than anything currently on the market.
The team must have within their ranks the ability to drive product development, market and sell the product, and be able to clearly state their vision for the product. The team must be knowledgeable about the industry they are trying to enter. Do they know what they are getting into?
Considering that 23% of startups fail because the team members couldn’t work together, team cohesion is also an important factor that VCs look at. VCs look favorably at teams that survived difficult times without falling apart.
For later-stage funding rounds, when a company is getting ready for an IPO, it needs an experienced executive team to take the company to the next level. Does it have such a team, or can it afford to appoint one?
VCs look at three aspects.
- Product market fit: Lack of product market fit is the second most common reason why startups fail, according to CBInsights. Product-market fit is the best predictor of eventual growth and scalability. It is often demonstrated by effortless sales and early customer demand.
- Product differentiation: Product differentiation is achieved when a product is superior to other similar products through its unique aspects. Product differentiation means a company can achieve high returns over the long term, which is what VCs want. A product also stands out if it makes use of proprietary technology or patents that make it difficult for competitors to copy.
- Value proposition: The value proposition of a product to customers can be described as the extent to which the product is needed by the company for its continued existence. If the removal of the product would cause considerable inconvenience for customers it has a high-value proposition. If a company has not succeeded in gaining loyal customers, its product may not be providing sufficient value. The concept of pricing power is valuable in this context. A company has pricing power when raising its prices doesn’t affect sales negatively. Pricing power indicates that a product has become essential to users and therefore has value for them.
3. Business model
A startup must have a business model that succeeds for all parties, the VC partners and the founders. VCs need to determine how the company will make money, in other words, if the business model is viable. After all, a product, no matter how great, won’t sell itself.
VCs use unit economics to determine the potential success and long-term sustainability of a startup. Unit economics describes a startup’s revenues and costs in relation to an individual unit. A unit refers to any basic, quantifiable item that can make money for a business. For Uber, it would be one ride in a vehicle.
Unit economics can help VCs forecast profits and assess market sustainability. Unit economics is used for startups because traditional metrics used for established companies are not applicable to early-stage companies as they have limited data to measure.
In assessing a startup’s business model, VCs attempt to establish the potential for recurring revenue and the scalability of the business model.
The market that a company operates in is also a factor that affects investors. The size of the market – whether it’s growing or shrinking, whether it’s crowded or underdeveloped – are all factors that VCs consider.
If a market is large with no competition, there has to be a reason. What is preventing others from stepping in and making a clean sweep? What has been the response from the market previously? Are there regulatory restrictions preventing entry to the market?
The size of a market should be at least big enough to ensure a good return. Venture capitalists aim to make big money; in a small market that’s unlikely. It’s common to expect a market to be at least $1B so it can support high sales volumes.
VCs look for companies that have traction. That is signs that the company is making an impression in the market. Traction is evidence that a startup is gaining customers, progressing with product development, earning revenue, or attracting investors, winning industry awards, or otherwise gaining recognition.
For early-stage startups that have not earned any customers and revenue yet, investors are compelled to find other indications of traction to determine if a venture is viable. One way is to consult with experts in the industry who may be able to give valuable input on the chances of a startup of succeeding in a specific market.
In legal due diligence, VCs verify the legal standing of a startup and negotiate their future with the startup.
Diligence consists of an in-depth review of all contracts the startup is already involved in, any outstanding liabilities or legal claims against the company, and the patents held by the company. Before they negotiate any deals, VCs need to be aware of any legal disputes the startup has been involved in and whether they have been resolved.
This is also the time when VCs negotiate their future with the startup: each party’s rights and obligations and what level of control the VC firm will have.
This can be a complicated exercise involving a long list of documents that the startup has to provide for scrutiny.
Venture capital firms will scrutinize a startup company’s financials as part of their due diligence. In addition to the usual financial statements, VCs also want insight into factors like product margins, inventory, leases, customer contracts and invoices, customer acquisition cost, and customer churn rate. They look at factors like current revenue, type of revenue, revenue growth rate, and burn rate, among other metrics.
These metrics will influence the eventual deal between the parties, in particular the investment sum and what share of the company it would represent.
8. Risk analysis
Startup founders face four areas of risk:
- Timing risk – the timing of a product’s market entry is everything. In the past, startups have failed when their product was introduced too early. Startups must get the timing just right, which is very difficult to do.
- Execution risk – this is the risk that the founders will not be able to execute their business plan. There are many factors that can sabotage a startup’s efforts to make it in the market, including poor product market fit, increased competition, and internal conflicts.
- Product risk – there is the danger that the product may not completely fulfill the needs of end users, in other words, the product doesn’t solve the problem the founders set out to resolve in the first place.
- Regulatory risk – this is the risk that regulations can change and negatively influence the ability of the startup to do business.
Stages of due diligence
Due diligence is a complex process, which can be broken down in three stages.
Stage 1 – screening due diligence
This stage involves a cursory look at the investment opportunities in the market to find the ones with real potential and discard the ones that don’t meet the investment firm’s investment criteria. The purpose is to quickly find firms that justify the time and resources spent to evaluate them.
During this phase, a VC firm will evaluate if a startup meets the investment firm’s investment criteria. If that is found to be the case, more time will be spent to determine if a deal would be good for the investment firm.
Stage 2 – business due diligence
If the startup is found to meet the VC company’s investment criteria, the process will move to the next stage, which is business due diligence. This is when the VC firm takes a closer look at the founder team, the product, the market, and the business model to determine the startup’s chances of success and chances of an eventual lucrative exit.
Stage 3 – legal due diligence
Legal due diligence is initiated once the VC firm determines that it wants to go ahead with the investment. In order to go ahead though, it needs a legal team to do a complete legal review of the startup, verifying that it is in good legal standing. At this stage, the legal team and the VC firm finally assess all possible risks.
Venture capitalists take on tremendous risk by investing in early-stage ventures. It is incumbent on them to thoroughly investigate companies for investment purposes. As it is, the vast majority of startups fail, which can put an entire investment fund at risk. That is why VC firms look to find the one star company that will bring them high investment returns, to make up for the many firms that fail.