Due diligence is one of the last but most prolonged and exhausting phases of deal flow and the pipeline leading to venture capital funding. Since it is so detailed, many startup founders and venture-capital evaluators fail to consider all requirements, projected or otherwise.
Many third-party due diligence services provide needed expertise and experience in exhaustive research and recommendations. Many firms, because of this, opt to outsource portions or all of the due diligence to an external firm. For those considering whether it’s worth the expense, here are a few bare-minimum demands placed upon a startup during due diligence.
What is Due Diligence?
Due diligence is the pre-decisional phase of venture capital deal flow. It's the step between formal consideration after venture capital leads weeded out many candidates based on investment packages but before the venture capital committee meets to decide whether your startup is a viable investment.
During due diligence, they'll overturn every stone in your startup. Financial analyses, market research, sales and product data, IT infrastructure, legal compliance, and more – they'll be scrutinizing every aspect of your operation during due diligence.
There's no element of the venture capital representatives playing "gotcha" or working under the assumption that you're hiding anything. Instead, due diligence is the venture capital firm's necessary step in managing its risk. They're deploying substantial capital and expect returns, so due diligence shows whether you are a viable investment.
What Goes into Due Diligence?
You should expect anything and everything under your startup’s total enterprise to be subject to due diligence. Therefore, many firms work with third-party evaluators and experts before formal due diligence. These firms can do initial audits of the business's commonly inspected aspects and help correct any deficiencies.
Venture Capital Analyses
Because a venture capital investment requires a holistic and deep understanding of the startup, venture capital analyses will inspect each activity along your value chain. Comprehensive inspection shows venture capital your comparative strengths and weaknesses while showing founders opportunities to grow and improve. This broad-scope aspect of due diligence is the sum of many parts.
Product or service:
- Value proposition and product fit – ensure that you are providing a solution to an existing need.
- Differentiation – whether your product or service is sufficiently different from the competition and whether your moat is sizeable.
- Customer retention rates, pricing opportunities, and cross-selling opportunities – if you make a sale and never see the customer again, you don't have a sustainable investment. These metrics are a proxy for growth potential.
Management. Yes, they'll scrutinize you and your co-founders alongside the rest of the enterprise. You're as vital as the rest of the operation, and investors must be as comfortable investing in you as they are in the company.
- Managerial vision and time horizon.
- Product expertise and technical proficiency.
- Good business sense – will you blow the venture capital cash like it's the Dot-Com era, or will you maintain a sense of fiduciary responsibility over their funds?
- Cohesiveness – if the founders are constantly bickering or walking on eggshells around one another, then the likelihood of personality conflicts bringing down the operation is high and represents increased risk to investors.
These are just two of the (at least) nine links in your value chain. We can't go into each of them or even expand upon these two further because doing so would stagger the mind, and we don't want to dissuade you from due diligence.
If you aren't comfortable speaking in-depth to each of these and more, you should seek outside help before you get to formal due diligence. A small upfront investment can pay dividends if your portfolio blows a due diligence team away and leads to funding.
Modeling and Valuation
You provide a business plan and financial model to venture capital when you submit your investment package during deal sourcing. But, while your deliverable piqued their interest, they will vet your analysis and projections during due diligence.
They must make accurate and informed decisions about your startup’s investment potential. This driving need for accuracy means they will send accountants and financial managers as part of a due diligence team to assess your inputs and projections. These financial wizards will also likely build a parallel series of models with information from the other due diligence data like sales, market, and pricing potential.
Term Sheet Analysis
Due diligence isn’t just detailing your company operations. Venture capital, and you, as founders, must also do due diligence on the relationship you’re building. Although interpersonal due diligence is an iterative process, you will need to assess your term sheets and legal documents critically.
You likely have a draft term sheet as part of your investment package or data room, so the firm knows where you stand pre-negotiation. But before they even see that draft sheet, ensuring it’s viable and maximally valuable is critical. Plagiarizing other term sheets or throwing a wishlist onto a document isn’t enough.
The term sheet must be practical and realistic without selling yourselves short. Even if you’re comfortable generating favorable terms and conditions, you may not be the best objective judge, so having a fresh and unbiased set of eyes is crucial. Term sheet analysis and editing are other areas in which third-party analysis and expert help may mean the difference between excellent terms leading to a quality liquidation event and handing over the keys to your company to corporate raiders.
Due diligence is detailed and invasive but doesn’t need to be scary. Think of due diligence as a chance to show off all the hard work you’ve done and put into your startup rather than an inquisition. To best protect yourself, ensure you’re auditing your value chain independent of due diligence teams regularly, and even if you’re comfortable with the status of your startup, consider hiring help – you never know what you may be missing.