6 Tips to Nail the Venture Capital Due Diligence Process

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For many venture capitalists, the due diligence process is an unglamorous and mundane “check the box” inevitability of their job. It is mired in grunt work and lacks the excitement and thrill of other parts of the gig. Conducting due diligence on early-stage companies can be particularly challenging as these companies typically have less tangible evidence to demonstrate their worth. Fortunately, the startup due diligence process need not be daunting. By following a few simple survival tips, you can ensure that you’re investing in reputable businesses that are positioned to thrive.

1. Conduct a holistic analysis

Startup due diligence must be comprehensive. To avoid overlooking any critical details, venture capitalists must evaluate potential startups from multiple vantage points. According to the Angel Investment Network, there are six principal elements that should be evaluated as part of a comprehensive and effective due diligence process:

  • Team and Management: Involves evaluating the current ownership of the business, the funding strategy, the share price, the valuation, and the potential exit value and strategy.
  • The Business: Involves evaluating the potential of the business idea, business model, and underlying assumptions.
  • The Market: Involves evaluating sales volume, pricing, and market assumptions.
  • The Technology/Product: Involves evaluating the promise of the technology and product that the business runs on.
  • Finance and Tax: Involves evaluating cash flow, financial projections, and profitability assumptions.
  • Legal: Involves evaluating incorporation documents, arrangements with directors, assets, intellectual properties, compliance with laws and regulations, debt securities, contracts, trading arrangements.

2. Prioritize conversations with customers

Oftentimes, the most telling indication of a promising startup is customer traction. Sonja Perkins, the founder of Broadway Angels, an all-women angel/VC group, explains, “The number-one indication of the company being successful or not is its customers. That’s where I start with due diligence”.

Talking with customers is a telling and informative way to conduct due diligence. As part of her tried-and-true due diligence process, Perkins interviews several existing and prospective customers and asks three questions:

  • What is your problem?
  • How are you solving this problem today?
  • How would this new solution solve this problem for you?

If customers are “dying to have the solution”, Perkins is confident she’s stumbled on a promising opportunity worth investing in.

3. Recruit experts

It’s easy to become sidetracked by a hot trend and swayed by a cogent sales pitch. It’s alright not to be 100% versed in a specific technology or industry. But if you’re not an expert in the field, you need to recruit experts who you can trust to help you evaluate the prospects of the business. These experts should be able to evaluate the product and, if applicable, the intricacies of the technology. They should be able to assess whether there are any red flags in terms of how the product has been built or manufactured. And they should be able to gauge how the product compares to current offerings on the market and whether it has the potential to disrupt the market and offer a significant improvement.

4. Evaluate trustworthiness

The most successful entrepreneurs and business prioritize trust and honesty above all else. We’ve seen the startup darlings of yesterday cripple amidst revelations that the founders haven’t been trustworthy. Companies such as Facebook and Theranos have recently been mired in controversy due to their lack of trust.

When conducting due diligence, it’s critical to perform an interpersonal analysis of the co-founders to determine whether they are trustworthy. Have they been 100% honest about everything they’ve said? Are they reliable? Are they open about challenges and obstacles? Do they tend to meet their targets? Talk to customers, former employees, and partners. Are there any red flags? Jennifer Carolan, a partner at Reach Capital, explains, “As an institutional investor, I expect to be working closely with the founding team for years. It’s critical that we can trust one another and that the founder can be open about the problems so we can tackle them together.”

5. Research past employees

Resources like Glassdoor can be goldmines for venture capital due diligence. These platforms always tend to attract the forever grumpy individuals, so don't be surprised at a negative review or two. But if you are looking to invest in a company and there seems to be a lack of trust in leadership, then reading these reviews could save you.

The best CEOs are aware of any negative comments or reviews and usually have thoughtful answers to the situation. The founders to be weary of are the ones that become hyperdefensive and refuse to take any responsibility.  Founders don't have to be right all the time and mistakes will happen. In the end, it is about how they react to them. 

6. Aim for at least 20 hours of due diligence

Too many investors try to race through the due diligence process, only doing the bare minimum. Relying on shortcuts such as word-of-mouth, superficial metrics, error-prone projections, and biased testimonials can be a recipe for disaster. According to research by UKBAA, investors who devote at least 20 hours to the due diligence process see a positive impact on the likelihood of a multiple investment return.

7. Be on the lookout for reverse due diligence

A sign of an astute entrepreneur is whether or not they do their own reverse due diligence on you. You know they’re sharp when they vet you and put you through the wringer. They should be looking for red flags too. They should be contacting your current and former portfolio companies. They should be asking you tough questions about failed investments. They should be more interested in what value-added resources you bring to the table than how much cash you can offer.

It’s tempting to speed through the due diligence process. But it pays to cross all of your “t’s” and dot all of your “i’s”. By doing your homework early, casting a wide net, and following the advice described here, you’ll set yourself up for success.


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