Startup due diligence: Key stages, focus areas, and possible issues [+Checklist]

Table of contents:

• What is startup due diligence?
• Startup due diligence process: 3 key stages
• Top 8 investors’ focus areas during VC due diligence
• Startup due diligence checklist
• Most common VC due diligence issues and best practices

Between 2020 and July 2023, there were 27,000 software companies founded in the US, the European Union, and Israel, according to Crunchbase data. And though these numbers speak about a consistent decline in the new startup formation, some resources still state that the overall number of startups in the world reaches 150 million.

However, only some startups become unicorns, like Canva, Notion, or Airbnb. The chance for startup growth usually lies in the right investment. And the secret to getting that investment is the successful due diligence. 

This article focuses on the essence of startup due diligence, its main stages, key focus areas of investors, and possible issues that may arise during the due diligence process. Additionally, it provides an example of a ready-to-use startup due diligence checklist.

What is startup due diligence?

A startup due diligence is a process of a thorough investigation of the startup’s background, financials, and other important documentation and data. The main goal of a startup due diligence process is for the potential investors to determine its potential and ensure it’s worth investing in. 

Startup due diligence is also often called venture capital due diligence (or VC due diligence), since venture capitalists or venture capital firms are among the most common startup investors, along with angel investors, banks, government agencies, and accelerators or incubators.

While the basics of startup due diligence and acquisition due diligence in the typical M&A deal are generally similar, there’s still a difference between conducting a small business due diligence and a well-established company due diligence.  

Unlike well-established companies, startups do not have lots of historical financial data that could help a venture capital or angel investor determine the true value of the business. This makes investing in a startup much riskier than in a well-established company. Such a risk is also proven by the startup failure statistics, which some of the resources provide. For instance, Failory states that 90% of startups fail, with the biggest share falling on the information sector — 63%.

Source: Failory

Startup due diligence process: 3 key stages

The process of startup due diligence is very similar to due diligence in a well-established company. At least, it comprises similar stages. However, it differs mainly in the focus areas, operation depth, complexity, and other specific nuances.

In terms of duration, the startup due diligence process can take as little as a single meeting and as long as several months.  Among other things, it also depends on whether the startup has all documentation prepared for due diligence. If yes, due diligence can take a few weeks. If not, it can take even months, as a startup will need time to compile all the required documents.

The due diligence process for a startup can be divided into three main stages:

1. Screening due diligence
2. Business due diligence
3. Legal due diligence

Let’s describe them in more detail.

1. Screening due diligence

At this due diligence phase, a potential investor, most often a venture capital firm, decides on whether a particular startup is worth investing in. 

As a rule, venture capital firms have a lot of investing opportunities at their hands, that’s why they thoroughly review each startup before proceeding with its due diligence and then investing. A screening due diligence of a startup helps to screen out those, that are less likely to bring profits and carry on with those that are more likely to offer a viable business model. 

At this stage, it’s also important for a potential investor to identify whether a startup fits its investment criteria.

2. Business due diligence

Once a startup is defined as a potential “fit”, the assigned team from the investor’s side will then move to the business due diligence phase. 

At this stage, the investor’s team closely reviews the startup’s market potential, management team, business model, and the product itself to determine its viability and evaluate its potential.

3. Legal due diligence

Once the investor has reached the point of moving forward with a particular startup, legal due diligence starts. 

At this stage, an assigned legal team, advisor, or attorney from the investor’s side performs a thorough analysis of all the startup’s legal aspects. It includes by not limited to verifying information about the company in terms of the law and addressing all the possible risks.

Top 8 investors’ focus areas during VC due diligence

In fact, potential investors pay attention to literally everything during the due diligence process. However, several aspects are especially in focus on the small business due diligence checklist: 

• People
• Financials
• Product
• Market
• Business model viability
• Cap table
• Legal aspects
• Risk management

Let’s discuss them in more detail. 

1. People 

Potential investors, especially early-stage investors, are highly interested in researching what people are involved in a startup, especially the management team or founders. 

Knowing the background of the company management is important since it’s not only about giving business money, it’s about future partnership. 

What’s more, according to Statista, not having the right team is among the top reasons for startup failure: it’s cited in 23% of cases. Another survey shows that disharmony between investors and the startup team was the reason for a startup failure in 21% of cases in 2022.

2. Financials

Reviewing the financial background of a startup is among the top focus areas for investors. This is because investors should see that startup founders and the team, in general, can manage the invested money correctly and wisely, so that the business will grow. 

This stage also includes finding out whether a startup has a bad history of previous funding or unwise debt.

3. Product

The lack of demand for a product is a reason for a startup failure in 7% of cases. At the same time, the product’s poor user-friendliness is the ground for failure in 9% of cases. These numbers speak about the importance of having a viable, well-thought-out, and market-competitive product.

That’s why product analysis is also among the key focus areas for investors. Other than ensuring the product might have a chance on the market, investors also check the ownership, patents, and intellectual property to mitigate risks of any kind of lawsuits.

4. Market

Poor timing of the startup launch in the market is the main reason for failure in 21% of cases. 

Before investing, a potential investor first studies the product market and assesses the product’s growth potential in it. Besides researching the market themselves, investors also expect a startup to provide the results of their market evaluation. 

5. Business model viability

Following from the market evaluation and product assessment, venture capital firms and other types of startup investors also ensure that the current business model is viable and competitive.

This is essential since the current market state and any possible events taking place in the world can significantly impact the startup’s success. For example, in 2022, 33% of startup failures were attributed to the Covid-19 pandemic’s effects on business.

6. Cap table

Potential investors are also interested in checking the capitalization table, which provides information about who has ownership in the company and equity dilution. For investors, it’s important to ensure that the equity is not too diluted. Otherwise, startup management should be ready to explain why that happened and reassure the investor that their position won’t have the same level of dilution.

7. Legal aspects

Reviewing the legal aspects of a startup is an integral part of startup due diligence. 

With it, potential investors ensure that there are no legal claims or pending litigation processes a startup is facing. This area of due diligence is also concerned with evaluating the investor’s level of control in the investment and searching for any red flags that may provoke the discrepancy between the startup’s current legal standing and the one initially reported to the investor. 

8. Risk management

Investing in a startup is considered a risky adventure. While some investors don’t mind taking the risk, others prefer to make sure the risk is minimal or that the startup knows how to mitigate any possible risks or have a mechanism for that.

That’s exactly why investors evaluate the startup’s potential to deal with risks that may potentially arise.

Startup due diligence checklist

Below is an example of a complete due diligence checklist, or due diligence request list, to be used during the startup due diligence process.

Financials	Financial projections Financial statements (cash flow statement, income statement, etc.) Financial history Purchase agreements Inventory Current accounting system Outstanding contracts (for instance, for materials or suppliers) Accounts payable Debts or write-offs Leases Product margins Information on funding by angel investors Customer contracts and invoices Customer acquisition cost
Product	List of all current products and services Planned launches of new products and services (if any) Sales volumes Products and services market share Products and services profitability
Market	Size of the market Current price for products or services Market growth trends Competitive landscape
Legal	Information on the headquarters Antitrust and regulatory issues Compliance and certification Licenses and permits Insurance policies Annual reports Bylaws Information on pending litigation (if any) Articles of incorporation List of all shareholders and share of their ownership Legal claims (if any) Partnership agreements Federal, state, and local tax returns for the last three years Research and development credit reports List of all the contracts involving continuous obligations
Business model	Detailed description of the current business model Business model’s scalability Information on how customers perceive the product or service Recurring revenue potential Business plan
People	Founders background, experience, and credentials Track record of other founded companies Exit strategy and IPO plans Management structure List of current employees and their compensation rates Employees benefit packages Future hiring plans List of the current outsourced specialists Nondisclosure agreements Open employee offers that have not been signed yet

Most common VC due diligence issues and best practices

During a startup’s due diligence, certain issues may arise that can lead to either a complicated due diligence process or even a deal failure. 

Below, the most common issues and possible solutions for them are described.

Lack of verifiable documentation

For an early-stage startup, it’s common to have an inefficient record-keeping process or not be able to fully access financials, intellectual property records, or partnership agreements. This can significantly slow down the due diligence process, and what’s more, present a startup to investors in a negative light. 

Additionally, startup employees and founders don’t always have all the legally binding agreements in place, which also can raise concerns for investors and complicate the due diligence process.

• Possible solution: Ensure a clear data storing system, where all the documents will be securely stored in one place and updated regularly. For this, a virtual data room (VDR) may be the way out. Explore the top VDR vendor selection on our main page.

Lack of resources

Often, a startup lacks the team to be responsible for the efficient preparation for the due diligence. Without having responsible employees who will be ready to timely address all the arising issues, a startup risks losing a potential investor’s interest or, at the very least, presenting a company in a bad light.

• Possible solution: Before the due diligence is carried out, allocate the team who will be responsible for diligent preparation of all the required documentation, as well as reacting to all the investors’ inquiries during the process.

IP troubles

Often, a startup can’t provide full and unimpeded IP ownership information and equity structure VC investors seek to know, especially when it’s in its early stage. It means that in the future, there might be complications with how the IP can be used and transferred. 

• Possible solution: The best way to address this issue is to have a dedicated legal advisor who can take care of this before the startup due diligence starts. Otherwise, the startup management should be ready (and have mechanisms for that) to tackle this issue in the future: in or out of court.

Key takeaways

Let’s summarize the key points from the article:

• Startup due diligence is the process of a thorough review of the startup’s background, management, team, and all the essential documentation to ensure it is worth investing in.
• The due diligence process for a startup can usually be divided into three main stages: screening due diligence, business due diligence, and legal due diligence.
• The main investors’ focus areas during the due diligence are the financial records, people, product, market, business model viability, cap table, legal aspects, and risk management.