The venture capital (VC) industry uses due diligence to describe what the investor does to evaluate a potential investment opportunity. By definition, investing in early-stage companies is risky. The due diligence process should select the potential winners, identify the key risks associated with the investment and develop a risk mitigation plan with company management as part of a potential investment.
Due diligence is a rigorous process that determines whether or not the venture capital fund or other investor will invest in your company. The process involves asking and answering a series of questions to evaluate the business and legal aspects of the opportunity. Once the process is complete, the investor will use the outcomes of the process to finalize the internal approval process and complete the investment. If the VC acts as a lead investor in a syndicate, then they may also share the outcome of their due diligence with other investors.
There are three states of due diligence:
Stage 1: Screening due diligence
Venture funds review and evaluate hundreds of business opportunities over the life of the fund and use predetermined criteria to identify which opportunities to focus on as possible investments. This allows them to quickly flag the ones that fit and indicate that they will spend more time and money evaluating.
Typically, for each 100 opportunities reviewed, ten will receive a detailed review (Stage 2 and Stage 3 of due diligence) and the fund may invest in one of them. Most opportunities do not make it through screening for two reasons:
The opportunity does not fit the fund’s mandate or criteria (e.g., the business’ stage, geographic region, size of the deal, industry sector).
Some funds will only review opportunities that have come via a referral from a trusted source.
Stage 2: Business due diligence
Once the opportunity is determined to “fit” the fund’s investment criteria, the deal is assigned to a junior and senior member of the team who will investigate further to determine the viability of the deal. Each firm may have a specific process, but it tends to involve reviewing the management team, market potential, the product or service (and the need it meets) and the business model.
Stage 3: Legal due diligence
Once the fund has reached the stage of moving toward a favourable decision, their lawyer will complete a legal review. Make sure that your lawyer is prepared to answer their questions. The advisors you choose can reflect favourably on you, including your lawyers, so do your research to find the right ones. Ask for references to determine which firms investors respect and use themselves. If the VC is highly experienced in this area (or has in-house legal counsel), they may take on part of the review to reduce the overall deal expenses.
Tips for startups on due diligence
Once you’ve decided to raise money from outside investors, take the time to prepare due diligence binders. Assign the coordination of binders to one person who will keep track of information and update documents when appropriate.
Having due diligence binders ready will demonstrate to the potential investor that you are prepared. It will also speed up the review process. Using these business and legal checklists enables you to anticipate most of the information requested. Respond quickly and professionally to any additional investor requests. Remember that they are evaluating the content of your response as well as how you respond to the various requests as part of the assessment.
After an investment, you will experience both good and bad times, and events might not unfold as planned. Make sure that this investor can become a long-term partner.
Have one person coordinate the responses to the VC. This ensures the consistency of your messaging to the investor.
As you answer an investor’s questions, circle back to make sure that you’ve provided a complete response. Take the opportunity to see if the investor is still warm to the deal. It is better to find out early that they are not likely to invest.
Take the feedback you receive throughout the process to course correct with other potential investors. It’s likely that one group’s concerns may come up with other investors.
Getting through the due diligence process is an important step to successfully raising money but also a critical part in the development of a relationship with the investor. During this process, you’ll build trust and establish the groundwork for an ongoing partnership.
A positive outcome of the business due diligence process should lead to the issuance of a term sheet.