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.

 

Takeaways:

  • When you raise capital, potential investors will assess your company’s strengths, weaknesses, and prospects.
  • Due diligence is essential for both the investor and the business owner. You demonstrate the potential value of your company while the investor evaluates the risks of investing.
  • Venture capitalists (VCs) who are looking to fund startups, have a long way ahead of them. They must also prepare detailed information about their company. Startups looking to raise capital from VCs need to prepare a due diligence checklist to assess their company and prepare for their first round of funding.

 

 

Looking to level up your VC skills? We’ve got you covered.

 

 

 

What is the venture capital due diligence process?

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.

 

What is the importance of due diligence in venture capital?

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.

 

What is the checklist for venture capital due diligence?

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.

 

What parts of due diligence should this checklist cover?

These are the areas that most VC due diligence checklists cover:

 

  • Finance
  • Tax
  • Legal
  • HR
  • Assets
  • IT
  • Services and products
  • Marketing and sales

 

VC due diligence checklist

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).

 

Financials

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.

 

  • Financial projections
  • Financial history
  • Statement of income
  • Statements on cash flow
  • Balance sheet
  • Additional financial statements
  • Outstanding contracts (for supplies and materials, etc.
  • Inventory
  • Purchase agreements
  • Accounts payable
  • Schedule of bad debts and write-offs
  • Information about customers, including invoices and contracts
  • Current accounting system
  • Angel investors may fund any funding

 

Tax

  • Federal tax returns for the last three years
  • The last three years of state and local tax returns
  • All correspondence with tax authorities after the company was founded
  • Reports on research and development credit
  • Two periods of 409A Valuation Reports

 

Legal

This section addresses the legal and regulatory issues that surround the company.

  • The location of the startup’s headquarters
  • Antitrust and regulatory issues
  • Respect for statutes and regulations
  • Environment issues
  • Insurance policies
  • Permits and licenses
  • In progress litigation
  • Articles of incorporation
  • Bylaws and their amendments
  • Annual reports
  • List of shareholders and ownership percentages
  • Any partnership agreements

 

Human Resources

This section includes information about employees, benefits, and management structures.

  • Organizational chart
  • Management structure
  • Current employees, salary schedules, and employment agreements
  • Current contractors, consultants, or other outsourced professionals
  • Benefits packages for employees
  • History of unemployment and workers comp
  • Resumes of employees
  • Nondisclosure agreements
  • Future hiring plans
  • Unaccepted open offers for employment

 

Assets

This section contains tangible and intangible company assets, such as intellectual property, inventory, and equipment.

  • Trade secrets
  • Copyrights
  • Patterns
  • Trademarks
  • Industrial designs
  • Real estate, both owned and leased.
  • Inventory for the current period
  • Equipment (both leased and owned)
  • Location and schedule of fixed assets
  • Material contracts
  • Other assets

 

Information Technology

This section should include all information technology hardware, plans, and software.

  • Software used by the company
  • Software licenses
  • Analyze the current IT system
  • Data security and management
  • Agreements with IT companies outside the company
  • Documentation of disaster recovery plans

 

Products and Services

This section discusses revenue streams and the company’s products, services, and market share.

  • Current products and services
  • Services and products planned
  • Products and services that have been discontinued
  • Sales volume
  • Profitability for all products and services
  • Market share by product or service
  • All regulatory documentation related to products or services

 

Sales and Marketing

This section will provide information about the company’s marketing and sales initiatives, key metrics, and plans.

 

  • Lifetime customer value (LCV).
  • Customer acquisition cost (CAC).
  • Current marketing strategy
  • Marketing tactic to break down traction
  • Execution of the marketing strategy at a cost
  • Marketing strategy planned
  • Current sales strategy
  • Current sales processes
  • Executing a sales strategy is expensive
  • Changes to the sales strategy

 

Competition

This section will give you all you need to know about the company’s position among its competitors.

 

  • List of primary competitors
  • SWOT analysis (strengths and weaknesses, opportunities and threats)
  • Current market share
  • Analyze future market share

 

Founder Background

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.

 

  • The professional background of the founders
  • Publicly shared personal history of founders or co-founders
  • Qualitative assessment by co-founders and founders of their passion for the company
  • Exit strategy
  • The geographical location of the co-founders or founders
  • What co-founders or founders want from a VC

 

A VC due diligence checklist can help you get better deals

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.

 

  • Automating contact data capture
  • Supporting deal sourcing
  • Assisting in the nurturing of existing relationships and building new ones
  • High-quality deal flow from start to finish

 

VCs should focus on which areas of a company during due diligence.

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.

 

  • Financial
  • Legal
  • Market
  • Product
  • Model for business
  • Founder//or management team

 

Financial

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.

 

  • Statement of income
  • Statement on cash flow
  • Balance sheet
  • Financial projections
  • Schedule of bad debts and write-offs
  • Accounts payable
  • Current accounting system
  • Leases
  • Inventory
  • Materials contracts
  • Margins for products
  • Invoices and customer contracts
  • Cost of customer acquisition
  • Customer lifetime value
  • Customer churn rate
  • Intellectual property

 

VC firms typically send a due diligence checklist to startups and ask the founders or management team to gather all relevant documentation.

 

Legal

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:

 

  • Articles of incorporation
  • List of shareholders (including angel investors) and ownership percentages
  • Bylaws and their amendments
  • Annual reports
  • Respect for federal and state laws
  • Any legal claims against the company
  • All outstanding liabilities

 

Market

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:

 

  • Size of the market
  • Trends in market growth
  • Competitive landscape
  • Sales volume
  • Product pricing

 

Product

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.

 

  • How well-built is the product it? (i.e., Do substantial changes/updates have to be made before the product is more than a minimum viable version? Software companies need to find out if there’s any tech debt that could hinder their growth.
  • How the company provides value to customers
  • What is the difference between what is currently available on the market and what is offered by the company?

 

Business model

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:

 

  • Current business model, or how the company sells its product
  • Customer perceptions of the product’s worth
  • Potential for recurring income
  • Scalability of the business model

 

Founder /management team

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:

 

  • Relevant experience
  • Similar professional credentials
  • Reputation with other companies they founded/led
  • Exit strategy and IPO plans

 

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.

 

The stages of due diligence

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.

 

Stage 1: Screening due diligence

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.

 

Stage 2: Business due diligence

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.

 

Stage 3: Legal, due diligence

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.

 

Making more more-informed, data-driven investment decisions

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.

 

Bottom line

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.

 

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