It’s the moment every entrepreneur has been waiting for! Your startup has successfully attracted a venture capital investor. They are excited about the investment opportunity in your compelling business case, your great product idea, and you have just signed the term sheet. Now comes the time for the venture capital due diligence process, but are you ready for your startup due diligence by a venture capitalist?
Why is Due Diligence important?
Before investors write the cheque, they will conduct their due diligence. They need to assess the main risks surrounding the company, including technology risk, market risk, people risk, and financing risk. Venture capital firms will use due diligence to manage their relationship with the entrepreneur, price the deal, and most importantly, decide whether to invest in the business.
How does a founder determine what their early stage company is worth?
It is notoriously hard to value a startup accurately as it does not have any revenues, profits, or even a viable product. However, this should not deter the avid entrepreneur from estimating what their new venture is worth when trying to raise capital. For example:
- Market Multiple: Venture capitalists lean towards this methodology as it is a pretty good indicator of what the market will pay for a business. The market multiple approach uses recent acquisitions of similar companies in the market to value a company and estimates a valuation close to what investors are willing to pay.
- Discounted cash flows (DCF): This method is used to value startups and established businesses. Since the value for early stage companies largely depends on their future potential, DCF calculates the valuation based on the forecasted cashflow using an expected rate of return on investment. A higher discount rate is usually applied to startups as there is a higher risk the startup will fail in generating sustainable cash flows.
- Cost-to-duplicate: Unique to startups and early stage investing, the cost-to-duplicate method calculates the cost of building a similar company from scratch, with the rationale being that an intelligent investor wouldn’t pay more than the cost to duplicate the business. The fair market value of assets is often used as a basis in this approach.
- Stage Valuation: Angel Investors and VC firms also use this method to estimate the range for a company’s value. The “rule of thumb” values are generally set by the early stage investors, based on the startup’s stage of commercial development. As the company progresses along the development pathway, the risk lowers, and value increases.
What information is required?
Until now, the investors have met with the founder and CEO, gone through your winning pitch decks and presentations, and probably studied some written documents. Now, every smart investor will want to meet with your founding team, key channel partners and customers, and evaluate your product. It’s an integrity check on all aspects of your business plans, product or service, business model, management team, customers, and financials. Investors need to ascertain if you have a strong team behind you, how excited your customers are, your product readiness for launch, and any hidden risks. If the diligence process results don’t align with what the founder has promised the investor, do not be surprised if they back out of the deal.
All private equity firms have their own methodology behind due diligence (unlike institutional investors), but the investor due diligence process generally focuses on the following requirements:
- Intellectual Property: Verification of ownership, protections, and status.
- Legal Commitments: Review of material contracts for potential legal issues.
- Market need and size: Investors will want to validate whether potential customers face an actual pain that your solution will help solve. They will talk to channel partners and prospective customers, likely starting with your well-prepped reference list. They will undoubtedly leverage their existing connections within their portfolio companies and get the opinion of industry leaders and technical experts.
- Competitive advantage: Investors need to determine if your key differentiating factors are unique and sustainable. They will confirm with industry analysts, and if investors find unanticipated competition or that your unique selling proposition is not that unique after all, they will kill the deal.
- Product or service readiness: Investors will conduct technical due diligence on your product and process to validate your assertions about your product features and quality and ascertain whether you have the team and strategy to be viable in the long term. This usually begins with a full-day review with the product marketing and engineering staff.
- Team Strength: Investors will interview key team members and check the management references. They will evaluate the team’s strengths and weaknesses, teamwork, management style, depth of talent, loyalty, and commitment.
- Business and financial status: Investors will need to create the future market capitalization sheet for your startup, and this begins by validating your existing investments and share ownership. Given that your startup may not have enough financial history, they will look towards the founder’s credit and legal history (e.g., bankruptcies, poor credit, or active lawsuits) to evaluate risk.
When does the Startup Due Diligence Process start?
The due diligence period begins after the buyer (or target company) and seller has signed an offer letter, otherwise known as a Letter of Intent or LOI. The LOI details the general terms of the deal agreed by both parties and includes the purchase price, structure (asset or share purchase), etc.
The acquirer must complete due diligence before the final purchase agreement is signed and the transaction is closed. The typical due diligence request list contains hundreds of items and is time consuming. The due diligence process requires a lot of planning and organization to complete.
If you want access to venture funds, you have to be prepared. It requires so much more than when you were trying to raise money from friends and family.
The venture capital firm usually hires teams of professionals (lawyers, accountants, human resources firms, etc.) to go through every aspect of your business before closing the transaction. However, it is not an audit or investigation. It is merely a process by which the investor will identify any key deal issues that will impact your startup’s purchase or the purchase price valuation.
Due Diligence Documents
Regardless of whether your venture capital is within your local geographic region or from the Silicon Valley, standard due diligence documents include:
These documents should help your investor understand the company’s background, structure, and key employees.
Investors use the legal documents and articles of incorporation to identify the legal entities that form your startup, its incorporation status, rights, and obligations of the existing shareholders, and any impacts to contracts resulting from the venture capital funding (e.g., a change in control clause).
- Intellectual Property (IP)
IPs include trademarks, copyrights, and patents. There should be sufficient documentary evidence to prove ownership. The more IP your startup owns, the more valuable it will be.
- Financial Due Diligence
Essential documents include your financial statements (balance sheet, income statements, cash flow statements) and tax returns, which will help investors understand your company’s current financial standing. These will help support your earlier claims around revenue (whether it’s monthly recurring revenue (MRR) or annual recurring revenue (ARR)), customers, and suppliers. They will also look at your normalized EBITDA, working capital requirements, debt and debt-like items, and free cash flow. You will also need to prepare financial forecasts and projections to help investors understand your startup’s future value.
List everything that your startup owns, which helps form the valuation basis for the VC’s potential investment. The asset list also helps the acquirer assess any issues surrounding zoning regulations, property tax, title insurance, real estate transactions, buying a property.
Some Practical Tips for the Due Diligence Process
Be proactive. Ensure that you have answered all the key questions. Don’t be afraid to ask how your startup compares to others. Don’t waste time. Be truthful.
Prepare due diligence binders or have the information in a physical or virtual data room. This ensures consistency of the information presented to potential investors and keeps everything in one spot. It also demonstrates to the investor that you are prepared and will speed up the review process.
Use these business and legal checklists to help you anticipate the information requested. Keep your responses professional and respond quickly to any additional queries. Remember that the investors are evaluating your content and how you react to their questions.
Centralize your communications Assign a point person to coordinate responses to the Venture Capital so that your messaging is consistent.
Due diligence works both ways. Each founder needs to do their own due diligence on the potential investor. Seek legal advice if you do not know how to conduct startup due diligence. This forms the basis for the long-term relationship and builds the same comfort and trust level for both buyers and sellers.