This guide presents an overview of the due diligence process for venture capital investments. Due diligence allows VC investors to separate suitable investments from those that are not a good partnership match for their firm; it’s an investigation into the inner workings of a startup company, its potential risks, and the broader context of its operating market.
While the process can vary substantially from VC firm to VC firm and based on the peculiarities of each potential investment, this guide provides a framework that can be customized to suit the needs of any particular situation and venture capital firm.
Keep reading to learn why due diligence is an integral part of the dealmaking process and how top venture capital funds approach the due diligence process to increase the odds of success.
VC Due Diligence Timing
The standard venture capital investment lifecycle tends to follow the pattern of:
- Deal Sourcing
- Due diligence
- Investment decisions and deal execution
- Portfolio company support
- Exit Strategy or IPO
Deal sourcing is when a startup is looking to raise VC funding, and a venture capital investor or firm begins to discuss a potential investment opportunity.
Sourcing can be inbound (the startup founders or entrepreneurs that are fundraising reach out to VC) or outbound (VC reaches out to startup) and can be through an introduction (warm outreach) or out of the blue (cold outreach).
Once the connection has been made, the first stage of due diligence begins immediately. In many cases, the process starts informally, and the startup may not even realize the extent to which they’re being evaluated.
The time spent on venture capital due diligence varies widely based on the investor, their investment criteria, investment thesis and the specific investment being considered.
In some cases, it’s a simple gut check by the investor on how much they trust the founder(s) and their interest in the startup’s space. Perhaps the whole process takes place in a single conversation with the cofounders. This particularly applies to angel investors who write smaller checks for early-stage startups early in the fundraising process. On the opposite end, an investor may get to know a startup over the years, across multiple funding rounds, before finally deciding to pull the trigger.
You can expect the due diligence process to take between a week and a few months. Shorter time frames tend to be for early-stage companies and/or investments with some time pressure (i.e., the round is closing, and the investor has to decide whether they want in or not). More extended time frames are generally required for later-stage investments, though they can also happen in earlier stages if there’s no time pressure and the investor does not have a high degree of conviction.
Due Diligence Areas of Investigation
There are many ways to conduct a thorough due diligence process. Every investor approaches their due diligence process differently, and every potential investment calls for a different approach. That being said, most investigation tends to identify key risks and red flags and fall across the categories below:
- Management Team
- Market
- Product
- Traction
- Legal
- The company’s financials
- Product-Market Fit
Founding and Management Team
For many investors, a startup’s (founding) team is the most important factor in considering an investment opportunity. Sometimes, it’s the only factor: the idea being that if Elon Musk or Mark Zuckerberg start a new company, you want in regardless of what they’re building.
Particularly for early-stage companies, the management team’s capabilities are essential. They can be determined in several ways:
- Track record (e.g., a previous successful venture-backed company)
- Credentials (e.g., a Stanford degree)
- Experience (20-year industry veteran)
There is no set formula for what makes a “good” founder, and every investor has different preferences.
Another essential factor is founder/market fit. It’s not always enough for the founders to be promising; are they also a good match for the specific problem they’re tackling? Do they have the know-how? For example, if the company is looking to develop a medical device, you’d prefer the CEO to have an M.D. than a degree in history.
Beyond individual qualifications, the dynamics between the founding members and the broader management team play a pivotal role in a startup’s success. VCs should seek to understand the history of the team’s collaboration: Have they worked together before? How do they handle conflicts and decision-making? Observing team interactions can provide insights into their communication styles, mutual respect, and overall cohesiveness. A harmonious team with complementary skills is more likely to navigate the tumultuous waters of entrepreneurship effectively.
For later-stage investments, the leadership team composition begins to matter more. For example, if a company raises its last round before a planned IPO, does it have a professional CFO who can ensure the offering goes off successfully? Or, if a company has clear needs for a Director of Talent or a Chief Revenue Officer, do they have the available budget and equity options for the hire?
Different VC firms take different approaches to founder diligence, but in general, most firms are looking for people who are resilient, perseverant, and can develop rapidly. This piece by Sifted offers a comprehensive overview of how VC firms conduct founder due diligence.
The Market
1. Market Size and Growth Potential:
One of the primary considerations for any VC firm is the total addressable market (TAM) of a startup’s product or service. It’s essential to gauge whether the market is large enough to deliver substantial returns on investment. This process involves analyzing the market size and projecting its growth over the next few years. A startup might have a fantastic product, but if it’s targeting a niche market with limited expansion potential, it may not provide the scale VCs typically seek.
2. Market Trends and Dynamics:
Understanding the prevailing trends and dynamics of the market is crucial. This includes recognizing emerging technologies, shifts in consumer behavior, regulatory changes, and potential market disruptors. Due diligence should also identify the market’s maturity stage. Is it a nascent market with high growth potential, or is it saturated with limited room for new entrants? Recognizing these dynamics helps VCs determine the startup’s potential to capture and maintain market share.
3. Competitive Landscape:
No startup operates in a vacuum. It’s vital to map out the competitive landscape to understand where the startup stands. This involves identifying direct competitors, their strengths and weaknesses, market share, and unique value propositions. Additionally, it’s worth considering potential indirect competitors or substitutes that might affect the startup’s growth trajectory. A deep dive into competitive analysis can reveal whether the startup has a sustainable competitive advantage or if the market is too crowded.
4. Customer Validation and Market Fit and Business Model
Lastly, validating the startup’s product or service within its target market is essential. This can be achieved by examining customer testimonials, case studies, and user feedback. A startup with strong customer validation indicates a product-market fit and the potential for traction and scalability.
Furthermore, understanding the startup’s business model and customer acquisition strategy is pivotal. It offers insights into how the company plans to generate revenue, scale operations, and achieve profitability in the context of its market dynamics.
In summary, a thorough market analysis is foundational in VC due diligence. It ensures that the startup is positioned in a promising market and has the strategies and capabilities to thrive amidst competition and evolving market conditions.
The Product
Of course, it could go without saying that potential investors generally care about what a company is making and selling. Although the types of products startups produce vary widely–from software to electronics to medical devices–investors will analyze some standard attributes in determining the strength of a potential investment opportunity’s offering.
Investors will also look at how well a product is built. Does the product need substantial updates to be competitive and offer material value to customers? Is there a large amount of technical debt that may become an issue?
One of the most important aspects of a product is whether or not it is differentiated. Put simply – is it different from the other products available on the market? Although there are several different ways for a startup to scale to a large company, a differentiated product is probably the most common. And it’s not simply enough to be different than what’s on the market today; it’s also essential to have a plan for sustainable differentiation: how to stay distinguished as competitors try to copy you.
Of course, being different means being better so customers will buy your product over the competition. Superior products can come from various factors, including technological advancement, exceptional user experience, or even a better brand. Being different in a “better” way is often a matter of subjective perspective.
Investors often exercise their judgment in this determination. Still, they will also turn to their network: relying on experts in the specific field who may have a better grasp on what improvement looks like.
Traction
Traction is the measurement of how “far along” a company is. It most often refers to the number of customers and/or revenue for seed-stage startups, but it can be used in a similar context for later companies (i.e., this company doesn’t have enough traction to be raising a Series A, B, etc.)
Traction can also be used for a more general sense of progress. For example, it denotes how mature a product is in its development cycle (particularly for products with long cycles like pharma or some hardware).
At the earliest stages, before revenue, investors may need to look at other signs of traction to determine a business’s viability. While there are many tracks they can take, it is common for VCs to lean on their network to identify experts in the space who can more accurately understand these early indications that a startup may be on to something.
Legal Due Diligence
1. Corporate Structure, Governance, and Shareholder Relations:
At the forefront of legal due diligence is a thorough examination of the startup’s corporate structure. This involves reviewing the company’s articles of incorporation, bylaws, and other foundational documents to ensure they are in order. The governance mechanisms, including the board of directors and key executives’ roles and responsibilities, should be clearly delineated. Additionally, understanding the rights, obligations, and relationships among shareholders is pivotal, especially if there are complex arrangements or potential conflicts with the founding team.
2. Intellectual Property (IP) Rights and Legal Review:
For many startups, intellectual property forms the bedrock of their value proposition. A comprehensive legal review must assess the ownership, validity, and enforceability of patents, trademarks, copyrights, and trade secrets. Ensuring that IP rights are properly registered and free from disputes or potential infringements is crucial.
3. Contracts and Agreements
A deep dive into all contracts and agreements is essential. This includes customer contracts, supplier agreements, partnerships, and employee agreements. For startups with significant real estate holdings or leases, reviewing terms, ensuring clear title, and identifying any potential encumbrances or liabilities is vital. The goal is to spot any unfavorable terms or clauses that might restrict the startup’s growth or operations, especially those related to exclusivity, termination, or breach penalties.
4. Regulatory Compliance, Litigations, and the Founding Team:
Ensuring the startup’s compliance with relevant laws is paramount. This encompasses local, state, and federal regulations specific to the startup’s industry. Additionally, any ongoing or potential litigations, disputes, or legal claims against the startup or its founding team should be brought to light.
5. Employment, Labor Issues, and Shareholder Equity:
Adherence to employment laws is crucial. This involves reviewing employment contracts, compensation structures, and employee benefit plans. Issues related to employee equity, stock options, and vesting schedules, especially those involving shareholders, should be meticulously examined.
In conclusion, legal due diligence is a rigorous process that protects VC firms against potential pitfalls and liabilities. While the allure of a startup’s product or market potential can be captivating, the legal foundation and integrity often determine the soundness of an investment.
Financials
Venture capital firms use a variety of financial metrics and figures to evaluate the worthiness of a particular deal. These include customer acquisition costs (CAC), current revenue, revenue growth rate, type of revenue, burn rate/runway, churn, free cash flow, product margins, the cost of selling, and many others. Of course, what “good” looks like for each of these numbers greatly depends on the industry, stage, the state of the venture market, and even the company’s geographic region. Additionally, the examination of a company's historical tax filings can offer insights into its fiscal responsibility and compliance with regulatory requirements, further informing the investment decision.
These metrics (and the other aspects of the diligence process) are weighed against the deal’s financial terms: most notably, how much the investor has to pay to receive what share of the company (i.e., valuation). These terms (along with control provisions) are often negotiated through the term sheet.
The Venture Capital Due Diligence Checklist
Finally, we provide a due diligence checklist (high-level) of the standard documents and reports that a venture capitalist may want to request as part of the process.
- Pitch deck – To understand the investment’s narrative and get high-level details to drive the due diligence process
- Financial statements – Income statement, cash flow statement, and balance sheet
- Financial projections – Estimates of growth and burn over the coming quarters
- Revenue breakdowns – Deep-dive analysis into revenue over time and by type
- Org chart – List of all of the company’s employees/roles
- Active contracts – Equity agreements for the founders, previous investments, employment agreements, customer contracts, etc.
- Market analysis – Company’s view on its market size and segments
- Competitive analysis – Company’s view on its major competitors and advantages
- Use of funds – Break down how the company plans to use the money it’s raising
- Business plan – A detailed document that is becoming less and less common
To get started with your venture capital due diligence, there are various templates online to ensure you capture all the necessary information before investing.
Even though venture capital is a type of private equity investment, we’ve also published a guide on conducting private equity due diligence that considers the specific points and nuances of PE.
