Quality due diligence work is how venture capital (VC) deal teams identify good investments in a sea of possibilities. Though it might not be as exciting networking or as person-forward as sourcing new deals, it’s a vital part of closing a good ratio of high-value deals.
Venture capital due diligence can be challenging, but if you follow best practices, it doesn’t have to be difficult. With an effective due diligence process, your firm can quickly get a solid understanding of the market landscape as well as the inner workings of a target startup before you present a term sheet.
In this VC due diligence guide, you’ll learn what good due diligence is, why it’s important, and what leading VC firms focus on to separate the good deals from the poor ones.
What is VC due diligence?
Venture capital due diligence is the process of appraising a company’s current state of affairs and its commercial potential. Due diligence for VCs means getting a deep understanding of the target company, its assets, its liabilities, and its management.
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The purpose of this exercise is to ensure all risks are accounted for and understood, there are no obstructions to the investment, and that the target company has a good foundation to grow from.
Why is venture capital due diligence important?
Unlike private equity firms that tend to invest in more established companies, venture capitalists invest primarily in startups. By their nature, startups are harder to assess—especially early-stage companies. These companies often have less substantial evidence to demonstrate their value.
This is exactly why due diligence is so important, though. Only by gathering all the pertinent information, and thoroughly assessing and appraising that information, can your VC firm be assured that the investment has a high likelihood of profitability.
Which areas of a business should VCs focus on in the due diligence process?
Each VC firm has its own way of conducting due diligence, and each potential investment requires a unique approach. But there are several categories of information that almost every deal team needs to gather insights into:
- Financial
- Legal
- Market
- Product
- Business model
- Founder and/or management team
Financial
The company’s financials may be the most important information a VC deal team needs to assess the potential of a startup investment. No matter the firm and no matter the target company, there is a long list of financial statements and information to gather, including:
- Income statement
- Cash flow statement
- Balance sheet
- Financial projections
- Schedule of bad debt and/or write-offs
- Accounts payable
- Current accounting system
- Leases
- Inventory
- Materials contracts
- Product margins
- Customer contracts and invoices
- Customer acquisition cost
- Customer lifetime value
- Customer churn rate
- Intellectual property
Typically, a VC firm will send a due diligence checklist to the startup and task the founder or management team with gathering all the relevant documentation.
Legal
In legal due diligence, a deal team should look for any red flags that may indicate a mismatch between the startup’s legal standing and what they have reported to the VC firm. This area of due diligence is also concerned with assessing the VC’s level of control in the investment. A deal team should ask for documentation including:
- Articles of incorporation
- List of shareholders (including angel investors) and percentages owned
- Bylaws and amendments
- Annual reports
- Compliance with state and federal laws
- Any legal claims against the company
- Any outstanding liabilities
Market
The market a startup is competing in is as important as the product the startup sells. VC deal teams must determine how sound the market is, and what the potential is for the company to grow in the market in the near future. Information to gather here includes:
- Market size
- Market growth trends
- Competitive landscape
- Sales volume
- Product pricing
Product
Even if the financials, legal, and market look promising, if a startup isn’t selling the right product in the space they’re in, they aren’t likely to succeed. When VC firms look at a startup company’s products during due diligence, they’re looking for these key metrics:
- How well-built is the product? (i.e. do substantial changes/updates need to be made before it’s more than a minimum viable product, or for software companies, it’s important to know if is there a substantial amount of tech debt that may hinder growth)
- How the company delivers value to customers
- How differentiated the company’s product offering is compared to what else is available in that market
Business model
To understand how the VC firm is going to make money, they need to understand how the company is set up to deliver their product or service. The information a deal team is looking for here includes:
- The current business model, i.e., how the company sells its products
- Customer perception of the product’s value
- Potential for recurring revenue
- Scalability of the business model
Founder and/or management team
A VC firm’s team members and investors spend a lot of time with portfolio companies’ founders, co-founders, and/or management teams—so it’s important to learn about these key players early in the deal process. If there are obvious personality conflicts—or worse, conflicting values—the VC firm may lose confidence in their ability to work well with the startup. Not to mention, the company’s founding team is an indicator of the company’s trajectory. The founding team’s capabilities are often assessed by gathering the following information:
- Amount of relevant experience
- Related professional credentials
- Track record with other companies they have founded/led
- Exit strategy and IPO plans
While the founder or co-founders may be the most important leadership factors in a seed-stage or early-stage startup, for later-stage startups, the rest of the management team should be taken into consideration too. Tracking key changes in leadership roles can often be an indicator for VCs to follow-up on an opportunity if they’re looking for a potential new deal.
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Stages of due diligence
VC firms can expect to spend 20 hours or more on due diligence for each possible investment. Rushing through only puts your firm and your venture capital investors at risk. It’s a complex and lengthy process, but in venture capital, due diligence can be broken down into three core stages.
Stage 1: Screening due diligence
There are more investment opportunities in the market than any single firm could possibly manage—and not all of them are good for the firm. The screening stage of due diligence helps weed out companies that don’t fit the firm’s investment thesis or ideal company profile before deal teams spend too much time or too many resources evaluating them.
In this initial screening, your firm should measure what they know of the target company against the fund’s investment criteria or mandate. If the company meets the criteria, then a junior and senior member of the team can look further into the deal to determine its viability.
Affinity supports this first stage of due diligence with Industry Insights, which provides AI-driven information about competing and related companies, and Employee Growth Insights, which surfaces data on prospect company headcount growth and churn. With these insights presented alongside company profiles in Affinity, you can focus on analyzing and acting on data instead of drowning in it.
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Stage 2: Business due diligence
If the target company passes the screening stage, the assigned deal team will move on to business due diligence. In this stage, a VC firm is often looking more closely at the market, product, business model, and founder or management team to quantify the company’s current progress and evaluate their likelihood for a lucrative exit.
Stage 3: Legal due diligence
Finally, if everything up to this point lines up with what the VC firm is looking for, and the fund is moving toward a favorable investment decision, a lawyer is brought in to complete a thorough legal review. In this stage, the deal team and the lawyer are verifying the company information and more deeply assessing the risks.
Making more more-informed, data-driven investment decisions
The more your firm knows about a target company, the better decision you can make about your investment. Thorough due diligence can reveal problems before they cost your firm money, help you avoid unpleasant surprises in the deal, and ensure you are positioning your firm to close on the highest quality deals.
A smart startup founder will also understand the benefits of going through this process with your firm. VC due diligence can uncover the company’s weak spots, giving the company an opportunity to close critical gaps before they become detrimental to the business. And once the company has gone through due diligence once, many of those collected documents won’t have to be gathered again, making future due diligence processes that much faster.
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Due diligence doesn’t have to be “grunt work.” Done right, it can be a superpower—and set your VC firm up for long-term success.
Tech-forward VC firms that are leveraging their venture capital tech stack are making better data-driven investment decisions before the due diligence process even begins. Using technology to narrow the pool of potential investments and identify inroads to warmer leads and better relationships is essential for VCs that are moving quickly.
Learn how a relationship intelligence CRM platform like Affinity is helping teams find, manage, and close better quality deals by improving pre-diligence workflows and supporting better relationship building with prospects.
Talk to the Affinity sales team today to find out how you can make better investment decisions and build better connections with relationship-driven technology.
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