By: Michelle Wu

Head of Marketing

July 16, 2024

The world of startups is dynamic and exciting, with a constant influx of new ventures vying for investors’ attention. In fact, an estimated 137,000 start-ups launch every day worldwide. Venture capital (VC) plays an important role in this scene, providing the finances that infant businesses need to expand operations and grow. 

However, the stark reality is that 90% of all startups fail. In such a high-stakes environment, due diligence becomes an extremely important tool for venture capitalists. It’s how they  determine whether a startup is likely to be a winner and therefore whether to invest in it.

This guide looks at how due diligence works in venture capital. We’ll explore the key stages involved, the essential components examined, and some of the challenges of the process and how to overcome them. 

What is venture capital due diligence?

Due diligence is a comprehensive investigation process conducted by venture capitalists (VCs) before making a final decision about whether or not to invest in a particular startup. 

It involves a thorough assessment of several factors related to the entity, including market opportunity, the skills and abilities of the management team, the viability and scalability of its business model, financial projections, the uniqueness and competitive advantage of its product or service, and many more. 

What is the purpose of due diligence in venture capital?

Due diligence serves as a vetting process for venture capitalists, ensuring that the substantial funds they commit are invested in ventures with a high potential for success.

The purpose of due diligence can be summarized as follows:

• Risk assessment: Due diligence helps uncover any potential risks associated with a startup. These risks can be operational, financial, legal, or market-related. By identifying these risks beforehand, venture capitalists can develop a plan to mitigate them or even choose to forgo the investment altogether. 
• Validation of the business model: Due diligence includes a deep assessment of the target company’s business model. It assesses the feasibility and sustainability of the core revenue generation strategy. That might involve evaluating its marketing plans, customer acquisition strategies, production processes, and cost structures. A sound business model provides assurance that the company can achieve its financial and strategic goals and grow.
• Confirmation of alignment with the VCs’ goals: Another important role of due diligence is to confirm the startup’s vision, goals, and values are in sync with the venture capitalists’ investment thesis — that is, whether the startup is a strategic fit. This alignment is important for fostering a successful long-term partnership. By dissecting the company on multiple fronts, due diligence uncovers any mismatches that might affect the working relationships between the two parties or create problems. 

Key stages of vc due diligence

Due diligence occurs in several stages. The specific stages and what’s involved in each can vary depending on the venture capital fund or firm, the startup’s size and stage, and the industry. But generally, there are three main stages that most VC due diligence processes will follow.

1. Initial screening

Venture capital due diligence typically starts with an initial screening where the VCs assess a select group of investments based on a set of pre-defined criteria. Key criteria for initial screening can include:

• Market potential: Is the startup addressing a sizable and growing market?
• Business model: Does the company have a clear and compelling value proposition and a realistic path to profitability?
• Initial traction: Has the startup achieved any initial validation through customer acquisition or user base growth?

VCs use the initial screening stage to efficiently narrow down the candidate pool to one or two promising startups for further analysis.

2. Deep Dive Analysis

For the startup that passes the initial screening, a more in-depth analysis occurs. This stage involves a thorough examination of the startup’s business and market environment, providing a detailed understanding of its potential and risks.

During the deep dive analysis, VCs often engage with various stakeholders, including the company’s executives, suppliers, industry experts, customers, and many more, to gain a well-rounded perspective. This stage may also involve site visits, product demonstrations, and detailed financial analysis to verify the startup’s claims and understand its growth potential.

3. Final evaluation and decision making

Once the deep dive analysis is complete, VCs consolidate all the gathered information to create a comprehensive overview of the startup. They then assess how well the startup aligns with their investment thesis, considering factors like risk tolerance and return expectations. 

The team then prepares a final report which includes a recommendation on whether or not to proceed with the investment and on what terms. 

Many venture capital firms have investment committees that make the final decision. These committees review the due diligence findings report and recommendation before voting on whether to move forward with the investment. If the vote is positive, the VC firm or fund proceeds with negotiating the investment terms and conditions with the startup.

Essential components of venture capital due diligence  

Comprehensive due diligence in venture capital includes an evaluation of multiple facets of a start-up to ensure a sound investment. Here’s what it entails.

Financial assessment

This is a thorough review of the startup’s financials. It includes examining historical financial statements, balance sheets, revenue projections, cash burn rate, cash flow, among others. 

Financial assessment helps a venture capitalist understand the startup’s financial health and status and how that translates into future success for the investment. That includes identifying potential financial problems or risks that could hinder the startup’s success.

Team evaluation

A startup’s founding and management team is often a key predictor of its potential for success. As part of due diligence, venture capitalists evaluate the team to ensure they possess the necessary experience, expertise, and leadership qualities to drive growth

Market analysis

Understanding the market landscape is fundamental for VCs. Here, they assess critical elements like:

• Size and growth potential of the target market
• Customer needs and buying behavior
• Competitive landscape
• Market trends
• Regulatory environment 
• Barriers to entry

Market research helps determine if there’s a genuine market need for the startup’s product or service, plus the ease or difficulty of entering this market and competing effectively.  

Product viability evaluation

Here, VCs will dissect the startup’s product and service, focusing on its unique value proposition and differentiation from competitors. They assess whether the product is built on a scalable and reliable technological foundation that can handle future growth and increased demand. Additionally, they might look at whether there are patents, trademarks, or other legal protections in place to safeguard the startup’s intellectual property. 

Early customer feedback and adoption rates (if available) can also provide valuable insights into the product’s acceptance by the market and its potential for growth. 

Legal issues and compliance assessment

During due diligence, VCs meticulously examine the startup’s legal and regulatory compliance. For example, they review the company’s legal structure, ownership stakes, and governance practices to ensure compliance with relevant laws and regulations. They will also analyze key contracts, such as employment agreements, intellectual property licenses, and customer contracts, to identify potential risks or liabilities.

In addition, the VCs will evaluate the startup’s adherence to industry-specific regulations and identify potential future regulatory hurdles that could impact the business. Finally, they will investigate any existing or potential legal issues, such as outstanding lawsuits or intellectual property disputes.

Common challenges in venture capital due diligence and how to overcome them

Venture capital due diligence, while crucial for informed investment decisions, is not without its challenges. Here’s a breakdown of some common hurdles VCs face and strategies to overcome them:

Lack of or limited information

Early-stage startups may not have a comprehensive track record or a wealth of data, making it difficult for VCs to assess important factors like business model viability or financial projections.

Where information is limited, VCs must rely heavily on the quality of the founding team. In this case they will focus on the team’s experience, expertise, and track record in relevant fields. A firm will then conduct thorough reference checks and speak with past employers, investors, partners, or anyone who has worked closely with the team. This can reveal valuable insights into their work ethic, leadership skills, and ability to overcome challenges. A strong and credible founding team can inspire confidence even with limited data about an enterprise.

Another way to overcome this challenge is to supplement the little information available with market research and expert consultations. Leverage market research tools and databases like IBISWorld to gain broader insights into the target market size, growth trajectory, and competitive landscape. Consult with industry experts to understand overall market dynamics. 

Information asymmetry and potential bias

Founders naturally have a vested interest in making their startup look like a good prospect.  This can lead to the presentation of selective information that paints an overly optimistic picture or that doesn’t fully capture the startup’s operations, finances, or potential risks.

To overcome this challenge, venture capitalists should seek third-party verification of key data points provided by the startup’s founders, as well as the sources of these data. 

By involving independent auditors and industry experts to validate elements and financial statements, market assumptions, and operational metrics, investors can ensure the accuracy and reliability of the information presented by founders and help ensure that VCs make good decisions.

Time constraints 

VCs often have a limited window to evaluate potential investments. This can lead to a less thorough due diligence process and increase the risk of overlooking crucial details. 

To avoid this problem, VCs should start by identifying the most critical aspects of a target firm (e.g. market potential, team experience or product traction) and prioritize due diligence efforts in those areas. Once these key aspects are addressed, the due diligence process can shift to exploring less critical elements.

Furthermore, leveraging efficient technologies like virtual data rooms (VDRs) can significantly streamline the due diligence process for both parties. 

VDRs are secure online repositories used to store and share sensitive information and documents during the due diligence process. They provide a centralized platform where startups can upload critical documents, and VCs can access them securely anywhere and at any time. This fosters easy collaboration and can expedite the overall due diligence process.  

The role of due diligence in negotiating venture capital deals

Due diligence plays a great role in shaping and negotiating the terms of a potential investment. In this next section we’ll discuss how effective due diligence contributes to deal negotiation.  

Valuation assessment

Due diligence provides a basis for assessing the proposed valuation of the startup. VCs can compare the financials to the market potential and competitive landscape to determine if the valuation is reasonable. This can inform negotiations on the investment deal terms.

Risk mitigation

As mentioned earlier, one objective of due diligence is to uncover any risks associated with the investment. These could be financial issues, legal concerns, or weaknesses in the management team.

Armed with this knowledge, VCs can propose deal terms that mitigate these risks and protect their investment. This might involve requesting additional protections or specific warranties and representations from the startup’s founders.

Control rights

VCs often seek certain control rights in exchange for their investment. The findings from due diligence can influence the type and extent of these control rights. 

For example, if the due diligence process uncovers a lack of experience in a specific area on the founding team, VCs might negotiate for board membership or observer rights to provide guidance and oversight. Additionally, they might seek veto power over major company decisions, like large acquisitions or executive compensation packages.

Building trust and transparency

The due diligence process fosters trust and transparency between the investor and the company seeking investment. By openly sharing information and addressing concerns uncovered during due diligence, both parties can build a stronger foundation for the investment relationship. The process can foster more flexible negotiations and a deal structure that benefits both sides in the long run.

Wrapping Up

Venture capital due diligence is a critical process that helps VC funds and firms make informed decisions about where to allocate their funds. 

By thoroughly examining a target startup’s financials, product market potential, team, and legal standing, VCs determine whether backing the venture makes solid sense. Furthermore, it can help them negotiate favorable terms for them and their investors.

Allvue Systems offers a comprehensive suite of venture capital software solutions designed to help VCs manage the entire investment lifecycle, from deal origination to due diligence to portfolio management. With Allvue, you can track deal opportunities, collaborate and share information with various stakeholders (including founders and investors) and gain real-time insights into your portfolio companies.

Schedule a demo today to see how Allvue can help you get the most out of your venture capital investments.

Sources

Demand Sage: Startup Statistics In 2024: Failure Rates, Funding & Insights. https://www.demandsage.com/startup-statistics/

Startup Genome: The State of the Global Startup Economy: https://startupgenome.com/article/the-state-of-the-global-startup-economy

IBIS World: Industry Research Reports: https://www.ibisworld.com/products/industry-research/

More About The Author

Michelle Wu

Head of Marketing

Michelle is a dynamic marketing leader with 15+ years of experience in capital markets, fintech, and cybersecurity technology industries. Prior to joining Allvue, Michelle was the Vice President of Product Marketing at SecurityScorecard, a global leader in cybersecurity ratings, and was the Head of Security & Compliance Marketing at Box. Before moving into cybersecurity, she led the Banking & Securities GTM strategy at Intralinks and covered capital markets clients at HSBC. She holds an MSc in Media & Communications from the London School of Economics and a BS in Marketing & Finance from NYU Stern School of Business.