What Does the Venture Capital Due Diligence Process Look Like? Here Is Your Step-by-Step Guide.
Venture capital firms typically follow a due diligence process when evaluating potential investment targets. This is a step-by-step explanation of it prepared by a seasoned venture capitalist.
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Venture capital firms typically follow a due diligence process when evaluating potential investment targets. That means founders and their businesses are carefully examined, so the startup team should be aware of how to deal with it. Usually, the process at Leta Capital involves seven steps. Here are those steps, along with what entrepreneurs should know about each one:
1. Initial screening
Initial screening is carried out to identify if the startup has the potential to even be under scrutiny. Once the connection between the founder and the investment analyst has been made, the first stage of due diligence typically begins right away. In many cases, the process starts informal, and the startup may not even realize the extent to which they're being evaluated. During the first conversions with the founders, the VC firm makes a preliminary review of the company's business plan, market opportunity and management team. From that point on, we can superficially assess the profile of the startup and make a decision regarding further observation.
Related: 4 Tips for Simplifying Due Diligence (and Why It's Even Needed)
2. Market research
After the screening, the investment analyst investigates the market size, competition, trends and growth potential for the startup's product. We observe the market share that the startup is targeting and determine if there is enough demand for the product being offered. That's a truly crucial component of the due diligence process. Keep in mind that investors know well there is no "perfect market" to enter and thus look for markets with significant potential, where they can back startups eager to find a sweet spot. However, even high-growth markets come with their own set of risks, such as intense competition, rapid changes in technology and regulatory challenges.
3. Financial analysis
VCs also estimate performance by conducting financial analysis. It comprises a review of the company's balance sheet, income and cash flow statement, assessment of revenue, expenses and projections along with capital structure, including debt-to-equity ratio, evaluation of its customer acquisition model and plans for how it will use the funds raised. In order to progress, founders should be prepared to provide accurate and complete statements, well-reasoned forecasts and proof of transparent accounting policies and practices.
4. Legal review
Next comes the process of reviewing a company's legal and regulatory compliance status, as well as its potential legal risks. The purpose of legal due diligence is to identify and assess any legal or contractual issues that may impact the value of the investment or the ability of the company to operate effectively. The startup should demonstrate a clear understanding of its governance structure, contractual obligations and intellectual property, awareness of all legal requirements related to its business and readiness to resolve any pending or possible litigation/disputes.
Related: The 7 Due Diligence Basics for Investing in a Startup
5. Technology assessment and customer validation
The pivotal point of any due diligence process is the analysis of the company's products. The purpose of product due diligence is to assess the quality, uniqueness and market appeal of a company's products, as well as its ability to bring these products to market and scale its operations. The product shouldn't be the only of its kind or cure-all for the entire market segment but needs to really meet the needs and preferences of its target customers. That's what we try to confirm with the customer validation process aimed at gathering users' feedback. Along with that, the VC firm proceeds with the investigation of the startup's technology to assess its quality, capabilities, limitations and scalability. A technical examination may involve reviewing code, software architecture, hardware systems and technology platforms, as well as conducting user testing and evaluating the company's ability to integrate with other systems.
6. Management evaluation and reputation check
VCs also draw particular attention to the experience, skills and track record of the startup's management team to ensure that it has the expertise to execute its business plan. Moreover, analysts ask industry peers about their experience of working with the founder. And these days, it is not even about how productive or famous the founder is, but how one can lead the company through periods of growth and expansion, adapting to changes in the market and business environment — and here is where reputation matters.
7. Due diligence report
After conducting these evaluations, the VC analyst will write a due diligence report summarizing their findings and making a recommendation to the Investment Committee on whether to invest or not. As a result, the VC firm obtains a thorough understanding of the startup and its potential for success before making an investment decision.
It is essential for an entrepreneur to understand what is happening inside the VC world. They need to be aware of what the due diligence process looks like and be ready to cooperate. It's likely that many have heard of the scandals involving top funds, and none of the VCs want to get into a similar situation. That is why a due diligence process is an absolute must, especially at growth stages. Remember that reverse due diligence is also important and makes you look professional: Check the VC's background and reputation, as you will have a long road toward success together.