Venture capital due diligence is similar to due diligence for mature businesses. It involves thoroughly examining a young company by specialists who usually venture capital investors to determine if they can invest in it at what price and on which terms.
Looking to level up your VC skills? We’ve got you covered.
Venture capital due diligence involves assessing a company’s financial condition and potential commercial opportunities. Due diligence is essential for VCs. It involves thoroughly understanding the target company’s assets, liabilities, and management.
This exercise is designed to ensure all risks are understood and accounted for, that there are no obstacles to investment and that the target company has a solid foundation from which to grow.
Venture capitalists are not like private equity firms, which tend to invest in established companies.
Venture capitalists instead invest in startups. Startups are challenging to evaluate, especially early-stage ones. These companies often have less evidence to support their value.
Due diligence is essential. Your VC firm can only be sure that your investment will succeed if it gathers all relevant information and assesses and appraises it.
A VC Due Diligence Checklist is another tool your firm has in its toolbox. It helps you evaluate and analyze potential investments. A checklist for VC diligence is similar to a pilot’s flight checklist or a surgeon’s preoperative checklist.
The standard due diligence checklist will include legal, tax, and asset-related information. However, depending on the VC fund and deal type, you may add additional categories to this list. VCs tend to pay more attention to a startup’s founder, as opposed to PE firms. VCs often seek out more information on marketing and sales.
To ensure that nothing is left to chance, your due diligence checklist should be as thorough as possible. Your checklist should be as comprehensive as possible, regardless of how large the deal. For example, a company seeking Series D funds will need more diligence than a company seeking Series A funds.
Most of the items in a due diligence checklist will be questions or requests for information that the VC deal group will send to the evaluated company. However, the deal team will need to look into some of the items on the checklist.
These are the areas that most VC due diligence checklists cover:
This template can be used as a guideline for your own VC firm’s due diligence checklist.
Keep everyone on the same page by putting your final checklist in a central, shared location (such as your customer relationship management platform).
The most critical piece of an investment puzzle for startups is often its finances. Therefore, the finance section of your due diligence checklist will be the most prolonged and most complicated.
This section addresses the legal and regulatory issues that surround the company.
This section includes information about employees, benefits, and management structures.
This section contains tangible and intangible company assets, such as intellectual property, inventory, and equipment.
This section should include all information technology hardware, plans, and software.
This section discusses revenue streams and the company’s products, services, and market share.
This section will provide information about the company’s marketing and sales initiatives, key metrics, and plans.
This section will give you all you need to know about the company’s position among its competitors.
Venture capital differs from private equity because the founders’ personal history and brand are essential. This section will provide information about the founder of your company.
When evaluating the viability and potential portfolio companies, your deal team should use a practical due diligence checklist for VC. This template is a starting point for identifying red flags and problems before they become costly to your company or legal issues.
This will allow you to invest in solid, reputable businesses well-positioned to grow, and your company will look attractive to potential investors.
Related reading: How to get better deal flow
You need to complete many workflows before you can reach the due diligence stage in evaluating investment opportunities. Affinity CRM platforms for relationship intelligence support your team.
Every VC firm is different in how it conducts due diligence. Each potential investment requires a unique approach. There are many types of information that deal teams need to know about.
A VC deal team may need to know a company’s financials to evaluate the potential for a startup investment. There are many financial statements and information that you need to collect, regardless of the target company or the firm.
VC firms typically send a due diligence checklist to startups and ask the founders or management team to gather all relevant documentation.
A deal team must look out for red flags in legal, due diligence that could indicate a mismatch between the startup’s legal status and what they have reported back to the VC firm.
This due diligence section also examines the VC’s control over the investment. The documentation required by a deal team includes the following:
A startup’s market is just as important as its product. VC deal teams need to determine the strength of the market and the potential for growth in the future.
This information is essential:
Even though a startup company’s market, legal and financial aspects look promising, it won’t succeed if they don’t sell the right product for the space in which they operate.
VC firms look at these critical metrics when reviewing a startup’s products.
Understanding how the company was set up to deliver the product or service is key to understanding how VC firms will make money.
This is some of the information that a deal team needs:
A VC firm’s team members and investors spend a lot of time with portfolio company founders, cofounders, and management teams. Getting to know these key players early on in the deal process is essential.
The VC firm might lose trust in its ability to work with startups if there are apparent personality conflicts or conflicting values. The company’s history is a crucial indicator of its future direction. This information is often used to assess the capabilities of the founding team:
Although the cofounders or founders are the most critical leadership elements in a seed-stage company or early-stage startup’s success, it is also essential to consider the rest of the management team for startups later in their development. VCs can use fundamental leadership changes to identify potential deals and follow up.
Venture capital firms expect to spend at least 20 hours researching each potential investment.
Rushing to complete due diligence can put your firm and venture capital investors at serious risk. Although it is a lengthy and complex process, venture capital due diligence can be broken down into three key stages.
No single firm can manage many investment opportunities on the market. Not all of them are suitable investments for the company. Before deal teams spend too much time and resources evaluating companies, the screening stage of due diligence allows them to filter out those that do not fit their investment thesis.
Your VC firm should evaluate what they know about the target company about the fund’s investment criteria and mandate. A junior or senior member of your team can review the deal further to determine its viability if the company meets the criteria.
The assigned deal team will begin business due diligence if the target company passes screening. This stage is where VC firms often look more closely at the market and product and the founders and management teams to assess the likelihood of a profitable exit.
If everything is in line with the VC firm’s expectations and the fund is on the path to a favorable investment decision, then a lawyer will be brought in to conduct a legal review. The lawyer and deal team verify the company information and assess the risks.
Your firm can make a better investment decision if it has more information about the target company. Doing thorough research can uncover potential problems before they become costly to your company. It will also help you avoid unpleasant surprises and position your firm to close the best deals.
Innovative startup founders will understand the value of working with your company. Due diligence by VCs can reveal weaknesses in a company and allow the company to fix them before they become a problem. Once the company has completed due diligence, many collected documents will not need to be gathered again. This makes future due diligence much more efficient.
Doing your due diligence right can make a difference and set you up for long-term success.
VC firms leveraging their venture capital technology stack make better data-driven investment decisions before due diligence starts. VCs who are quickly moving can use technology to reduce the potential investment pool and to identify opportunities to build stronger relationships.
Venture capital due diligence is the same as any other type of due diligence.
Because most companies have so little industry history, they may be unable to access the data available from older companies. However, this doesn’t negate the need for diligence.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.