A Guide to Venture Capital Due Diligence

vc-due-diligence
Ablorde Ashigbi

Ablorde Ashigbi

is the CEO of 4Degrees, a Chicago-based technology company, building relationship intelligence software for relationship driven industries. Before 4Degrees, he was an investor at Pritzker Group, and a consultant at Bain & Company.

In this guide, we present an overview of the due diligence process for venture capital investments. Due diligence allows venture capitalists to separate the good investments from the bad; it’s an investigation into the inner workings of a startup company and the broader context of the market that it’s operating in. While the process can vary substantially from VC firm to VC firm and based on the peculiarities of any given potential investment, this guide provides a framework that can be customized to suit the needs of any particular situation.

VC Due Diligence Timing

The standard venture capital investment lifecycle tends to follow the pattern of:

  • Sourcing
  • Due diligence
  • Investment decisions and deal execution
  • Portfolio company support
  • Exit

Sourcing is the point at which a startup that is looking to raise venture capital funding and a venture capital investor or firm begin to have a conversation about a potential investment.

Sourcing can be inbound (the startup or entrepreneur that is fundraising reaches out to VC) or outbound (VC reaches out to startup) and can be through an introduction (warm) or out of the blue (cold).

Once the connection has been made, due diligence typically begins right away. In many cases, the process starts informal, 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 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 is particularly true for angel investors who write smaller checks than Venture Capital firms. On the opposite end of the spectrum, an investor may get to know a startup over the years, across multiple funding rounds, before finally deciding to pull the trigger.

On average, you can expect a due diligence process to take between a week and a few months. Shorter time frames tend to be for early-stage companies and/or for investments with some time pressure (i.e., the round is closing, and the investor has to decide whether they want in or not). Longer 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 as many ways to conduct a due diligence process as there are different investors and companies looking for investment. Every investor approaches their due diligence process differently, and every potential investment calls for a different approach. That being said, most investigation tends to fall across the below categories:

  • Management Team
  • Market
  • Product
  • Traction
  • Legal
  • Financials

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 very important. They can be determined in several ways: track record (e.g., a previous successful venture-backed company), credentials (e.g., a Stanford degree), or experience (20-year industry veteran). There’s no set formula for what makes a “good” founder, and every investor has a different set of 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 probably rather the CEO have an M.D. than a degree in history.

For later-stage investments, the composition of the leadership team overall begins to matter more. For example, if a company is raising its last round before a planned IPO, does it have a professional CFO in place who can make sure 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 available for the hire?

Market

The market in which a company is operating is a critical factor for most investment considerations. How large is the market? Is it growing or shrinking? Is it ripe for the taking or overly crowded with stiff competition? Is it a spur-of-the-moment purchase by consumers or a multi-month drawn-out sales process to an enterprise or government?

Just as with the team, there’s no set definition of “good” for a market. Of course, a large, uncrowded market with an easy sales cycle sounds great, but reality rarely delivers such a perfect trifecta. Where things look a little too good, investors often ask themselves why. If the market is large and doesn’t have a lot of competition, why haven’t others yet swooped in to seize the opportunity? This line of thinking may lead to some very good answers for the investment (e.g., there’s a technical or regulatory barrier to entry that the startup has to overcome, or the market naturally lends itself to some business model that is more difficult to execute) or may reveal that the market isn’t really quite as good as it seems.

One of the key aspects of the market analysis for venture capital investors is size. Venture capital tends to be an industry that relies on “home runs” to achieve good returns. Entire funds are often made successful by a single investment out of 20 or more. As such, most venture investors are looking for deals that reasonably see an outcome of 10x or more. While the math may be a bit more complicated, many investors use a rule-of-thumb that the market must be at least $1B to support this kind of scalability and upside potential.

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.

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, the point of being different is to be better so that customers will buy your product over the competition. Superior products can come from any combination of a number of factors, including technological advancement, exceptional user experience, or even just plain 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 tacks 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

The primary concern for venture capital investors in evaluating an investment’s legal worthiness is with matters of control. What are the VC’s rights and protections in relation to the other investors and company shareholders? These questions are typically answered as a part of the investment negotiation, with investors looking for more control and the founding team (and previous investors) often looking to retain as much as possible.

Diligence will often include a broad legal review covering the investor’s bases. The review will consist of making sure the company’s contracts match what the investors have been told, identifying any outstanding liabilities or legal claims/complaints against the company, and ensuring there are no competing claims to the company’s intellectual property. This legal due diligence may be conducted by a third-party law firm if it is sufficiently complex.

Financials

Venture capital firms use a variety of financial metrics and figures to evaluate the worthiness of a particular deal. These include current revenue, revenue growth rate, type of revenue, burn rate/runway, free cash flow, product margins, the cost of selling, and a host of others. Of course, what “good” looks like for each of these numbers varies greatly depending on industry, stage, the state of the venture market, and even the company’s geographic region.

All of 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, employee contracts, 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

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