July 4, 2023
8 min read
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Venture capital (VC) companies operate in a unique investment landscape. Unlike traditional forms of investment, venture capital focuses on funding early-stage companies with high growth potential, among which competition is especially fierce.
According to Ernst & Young, thorough due diligence helps investors better mitigate risk, uncover hidden value drivers, negotiate better deal terms, and ultimately enhance the value of their investment process.
In this article, we will explore the importance of due diligence in the context of venture capital investment. Specifically, we will delve into the components of a due diligence checklist that investors should consider when evaluating potential investment opportunities.
The importance of due diligence checklists for investors
The due diligence processes for mature companies and venture projects differ significantly due to the contrasting nature of their business stages and risk profiles.
While due diligence for mature companies centers on evaluating past performance and stability, due diligence for venture projects focuses on assessing future potential, innovation, and the ability to disrupt existing markets. Let’s explore it further.
Due diligence for mature companies
For mature companies, due diligence focuses on evaluating their historical financial performance, market position, competitive landscape, operational efficiency, legal compliance, and potential synergies with the acquiring entity. The emphasis is on assessing the company’s stability, growth prospects, and ability to generate consistent cash flows.
| Key takeaway: The due diligence process for mature companies tends to be more standardized and relies heavily on historical data and industry benchmarks. |
Due diligence for venture projects
Due diligence for venture projects primarily revolves around assessing the company’s future potential rather than its historical performance.
- Note: Venture capital should not be confused with private equity. A private equity investment refers to capital invested in non-publicly listed entities, while venture capital refers to funding provided to promising businesses with high growth potential.
Startups seeking funding often lack an extensive operating history, making it challenging to rely solely on past financials. As such, key challenges of venture capital due diligence include:
- Evaluating market size, growth, and competitive landscape for a young company.
- Verifying ownership, protection, and value of intellectual property assets of a startup.
- Assessing capabilities, experience, and track record of the founders and team.
- Scrutinizing financial projections, revenue streams, and profitability assumptions.
- Identifying the viability of an investment strategy and forthcoming investment risks.
To overcome these challenges, VC due diligence focuses on evaluating the team’s capabilities, the uniqueness of the product or service, market opportunity, competitive advantage, scalability, intellectual property, and growth strategies.
| Key takeaway: Due diligence for venture projects requires a forward-looking approach and a thorough understanding of the industry landscape, market dynamics, and disruptive potential. |
To conduct due diligence for both mature companies and venture projects, following step-by-step diligence checklists is necessary.
Types of VC due diligence
Due diligence goes beyond a mere financial audit — it entails a comprehensive investigation into various aspects of a company. It encompasses examining factors such as compliance with environmental regulations and assessing the entirety of a company’s IT infrastructure.
A well-executed due diligence process uncovers any potential risks that require attention and mitigation. Let’s review some of the key components and types of VC due diligence.
| Due diligence type | Description |
| Market analysis | Assessing market size, trends, competition, and demand |
| Technology evaluation | Evaluating the startup’s technology infrastructure |
| Financial assessment | Analyzing financial projections and viability |
| Team and management | Evaluating the capabilities and experience of the team |
| Legal and regulatory | Verifying compliance with laws and regulations |
| Intellectual property | Examining ownership and value of intellectual assets |
| Operational efficiency | Assessing the startup’s operational processes |
| Risk analysis | Identifying and quantifying potential risks |
| Exit strategy assessment | Analyzing plans for potential exit opportunities |
An example of a due diligence checklist for investors
Venture capital firms employ a structured due diligence process to evaluate potential investment opportunities. As a result, founders and their businesses undergo meticulous scrutiny, requiring startup teams to be well-prepared.
Structure of venture capital due diligence
According to Sophia Parvizi-Wayne, CEO at Kanjo, a children’s mental health platform, “Make sure you have an explicit understanding of why investors want this or that, and be aware when people are dragging you around in circles, because it will mess up your round.”
For instance, at Leta Capital, the due diligence process typically consists of seven steps. Below, we outline each step and provide a short description of each:
- Initial screening — A preliminary assessment of the startup’s pitch deck and market potential.
- Management evaluation — Evaluation of the capabilities, experience, and track record of the startup’s management.
- Business model analysis — Assessment of the startup’s business viability, revenue streams, cost structure, and scalability potential.
- Market assessment — A thorough evaluation of the target market’s size, dynamics, trends, and competitive landscape takes place.
- Product and technology due diligence — Examination of the startup’s product or technology, assessing its uniqueness, differentiation, and potential barriers to entry.
- Financial analysis — Investigation of financial numbers, projections, and key metrics are reviewed to assess the startup’s financial health and growth potential.
- Legal and compliance review — Study of the startup’s legal documents, contracts, intellectual property rights, and compliance with regulations.
By understanding and preparing for each step of the due diligence process, entrepreneurs can effectively address the concerns of venture capital firms, increase their chances of securing investment, and pave the way for successful partnerships.
Key components of venture capital due diligence
Now, let’s take a closer look at each stage of venture capital due diligence and discover some pro tips entrepreneurs use to navigate each successfully.
1. Initial screening
The initial screening phase aims to determine if the startup possesses the potential to proceed to further scrutiny. Once the connection between the founder and the investment analyst is established, the first stage of investment due diligence commences promptly. Often, this stage begins informally, with the startup potentially unaware of the extent of evaluation taking place.
Through initial conversations with the founders, the VC firm conducts a preliminary review of the company’s business plan, market opportunity, and management. Based on this assessment, the firm makes an initial judgment regarding the startup’s profile and determines whether to proceed with further observation.
- Pro tip: At this due diligence stage, entrepreneurs should focus on crafting a compelling pitch deck that highlights the unique value proposition and growth prospects of their business.
2. Management team evaluation
Potential investors prioritize having a professional founding team for startups because the lack of effective management skills is a significant red flag. This is why each venture capital firm thoroughly assesses the team’s background, education, and experience. To do it, VCs examine employee profiles, hiring strategies, compensation, and future hiring plans. They also assess ownership involvement, potential conflicts, and risks related to poor management.
Legally, this type of venture capital due diligence focuses on incorporation documents, ownership, contracts, compensation, and risk mitigation. Qualified lawyers can assist with hiring and contracts to meet VC requirements.
- Pro tip: Entrepreneurs should showcase their expertise, leadership skills, and industry knowledge to instill confidence in the team’s ability to execute the business plan.
3. Business model analysis
When evaluating business viability, VCs assess startup companies’ performance through financial analysis, reviewing their balance sheets, income statements, and cash flow statements. They also evaluate revenue, expenses, projections, capital structure, and customer acquisition models.
- Pro tip: At this stage, entrepreneurs should demonstrate a clear understanding of their business model, its viability, and the potential for sustainable revenue growth. For this, founders must provide accurate financial statements, well-supported forecasts, and evidence of transparent accounting policies.
4. Market assessment
Following the screening stage and the due diligence of the management and a business model, the investment committee investigates the market size, competition, trends, and growth potential related to the startup’s product. Investors assess the potential market share of a target company while also evaluating the demand for the offered product and its ability to follow industry trends and win over the company’s competitors.
Investors understand that perfect markets don’t exist and thus seek markets with significant potential where startups can thrive. However, even high-growth markets carry risks, including more intense competition, rapid technological changes, and regulatory challenges.
- Pro tip: To complete this stage, entrepreneurs should provide comprehensive market research, highlighting the market opportunity, target audience, and potential market share.
5. Technology due diligence
A key aspect of any due diligence process is the evaluation of a company’s products. Technology due diligence aims to assess the quality, uniqueness, and market appeal of the products, as well as the company’s ability to bring them to market and scale operations. The product should address the needs and preferences of the target customers rather than being the sole offering or a generic solution. Customer validation processes, such as gathering user feedback, help confirm the product-market fit.
Additionally, the VC firm investigates the startup’s technology to evaluate its quality, capabilities, limitations, and scalability. This may involve reviewing code, software architecture, hardware systems, and technology platforms, as well as conducting user testing and assessing integration capabilities with other systems.
- Pro tip: Entrepreneurs should be prepared to showcase the innovation, functionality, and scalability of their product or technology.
6. Financial due diligence
Venture capitalists evaluate performance through financial information analysis, which includes reviewing the company’s balance sheet, income statement, and cash flow statement. They assess revenue, expenses, long-term price movement projections, capital structure (including debt-to-equity ratio), trade secrets, and the company’s customer acquisition model.
Additionally, VCs examine the startup’s plans for utilizing the funds raised. To advance in the financial due diligence process, founders must be ready to provide accurate and comprehensive financial statements, well-supported forecasts, and evidence of transparent accounting policies and practices.
- Pro tip: Entrepreneurs should provide accurate and transparent financial data, along with realistic projections that demonstrate a path to profitability.
7. Legal due diligence
Legal due diligence is probably the most important. This step involves reviewing the company’s legal and regulatory compliance status, along with identifying potential legal risks. Legal due diligence aims to uncover and evaluate any legal or contractual issues that could affect the investment decision or hinder the company’s operations.
- Pro tip: To pass this stage of due diligence, entrepreneurs should ensure their legal documentation is in order, intellectual property is protected, and the company complies with applicable laws and regulations.
Venture capital due diligence checklist
Now, let’s review an example of a due diligence checklist for venture capital firms that can be used as a basis for VC fundraising preparation.
| Initial screening | Pitch deck and business model overview Market analysis report Competitive landscape analysis Market trends and growth projections Target customer analysis Value proposition and unique selling points Product roadmap and development plan Marketing and sales strategies Financial projections and assumptions |
| Management team | Resumes/CVs of key executives Track record and past experience verification Reference checks for key team members Organizational structure and roles/responsibilities Board members’ ownership structure Advisory board and external mentors’ profiles Employment agreements and compensation plans Succession planning and talent development strategy |
| Business model analysis | Business model canvas or business plan Revenue model and pricing strategy Cost structure breakdown Scalability and sustainability assessment Customer acquisition and retention strategy Partnerships and strategic alliances agreements Key operational processes and workflow documentation Business development pipeline and key milestones |
| Market assessment | Market research report Competitive analysis report Target market size and growth potential evaluation Customer segmentation and acquisition strategy Market share analysis and competitive positioning Marketing campaigns and customer feedback data Market entry barriers and regulatory requirements Industry trends and market outlook reports |
| Product and technology due diligence | Product documentation and specifications Intellectual property portfolio review User testing and feedback report Technology scalability assessment Technology development roadmap Technical architecture and system diagrams Data security and privacy policies Integration capabilities with third-party systems |
| Financial analysis | Financial information (balance sheet, bank statements, cash flow statement) Revenue projections and financial forecasts Key financial metrics and ratios analysis Capital structure and funding requirements evaluation Break-even analysis and profitability assessment Historical financial performance and growth rates Burn rate analysis and cash runway projections Debt and debt-to-equity ratio analysis Loan agreements Debt schedule |
| Legal and compliance review | Incorporation documents (certificate of incorporation, articles of association) Shareholder agreements and stock options Partnership agreements (if any) Compliance checklist for applicable laws and regulations Certificate of good standing Intellectual property documentation (patents, trademarks, copyrights) Licensing agreements Contracts with key customers and suppliers Litigation history and pending legal disputes Data protection and privacy policies Regulatory permits and licenses Employment contracts |
Please note that the number of documents can vary based on the specific needs of the venture capital firm and the nature of the startup’s business. Therefore, the checklist can be adjusted accordingly.
How VDRs help with due diligence for investors
According to Gillian White, partner at Howard Kennedy LLP, “If the founders know funding will be applied for in the future, it’s useful to arrange documentation from the very beginning.” A properly structured and set-up virtual data room can help do just that.
One of the most important tools to prepare and structure due diligence checklists is a virtual data room.
For venture capitals, data rooms for due diligence offer the benefits of efficient structuring, sharing, and storing due diligence information, with advanced search capabilities, Q&As, and customizable workflows.
The best data rooms for venture capital companies include iDeals, Intralinks, and Datasite.
Conclusion
Now, let’s quickly summarize key findings from the article:
- The due diligence processes for mature companies and venture projects differ significantly, with the former focusing on past performance and stability, while the latter emphasizes future potential, innovation, and market disruption.
- Usually, venture capital due diligence involves several due diligence types. In this article, we used a 7-step venture capital due diligence model, which consists of initial screening, management evaluation, business model assessment, market assessment, technology due diligence, and financial and legal review.
- We’ve presented a detailed due diligence checklist for venture capital, which you can use as is or adjust to the specific needs of your business.
- Virtual data rooms are among the best tools to facilitate the creation, distribution, and storage of due diligence checklists for venture capital.