A venture capital due diligence checklist lists questions that investors share with a company being evaluated. It's how venture capital firms or angel investors check a startup for its potential investment opportunity. The due diligence checklist contains requirements and documentation that venture capitalists would want to see to understand the company's history, operations, financials, market, compliance, and more.
Venture capital is a form of financing that deals with funding early-stage startups and new businesses. Venture capitals manage this type of funding. The firms receive investments from investors called limited partners. In turn, they use the capital to invest in companies that they've evaluated to have high growth potential. In later-stage investing, they also fund startup companies that have grown quickly and are set up for more expansion.
Businesses looking to secure funding from venture capitalists would be better prepared by learning and understanding how the process works beforehand. Read on to find out why due diligence is important and what information is typically included in the checklist.
Why Is Due Diligence Important?
Due diligence is necessary because investors can use it to assess the risk of their investment. At the same time, it allows startups to demonstrate their company's potential value. Venture capital investing can be a speculative and risky strategy because the companies are new and have no track record of making money.
Venture capital firms receive many funding applications and only have so much time to evaluate every company. The due diligence process helps investors assess a potential investment's strengths and weaknesses quickly so they can fund more new business ventures.
When Does Due Diligence Happen?
One thing is sure: No documents will be signed and there will be no cash in your bank account before due diligence is done. In terms of a timeline, the first stage of venture capital funding is screening. You can get an introduction with the venture capital firm's management through a mutual connection or by applying through their process, or you can get invited through an application process.
Meetings and presentations to the partners of the venture capital fund generally follow the introduction. After the approval of their investment committee, VC firms issue a "term sheet" to initiate funding. The term sheet covers essential facets of the financing (e.g., the valuation given to the company), control issues (e.g., how involved the VC firm would be), and post-closing rights of the investors (e.g., the right to participate in future financing).
The term sheet represents the firm's commitment to the investment. It serves as the blueprint for the relationship between the company and the VC firm. The due diligence process follows the issuance of the term sheet. And if due diligence goes smoothly, the deal will proceed to the signing of legal investment documents.
How Long Does Due Diligence Take?
The process can take anywhere from a single meeting to weeks or even months. If you have a previous relationship with the VC firm, the process may take less time. Funding that comes through from a cold pitch typically takes a bit longer.
How prepared you are also makes the process faster because you'll have the answers they're looking for and the documentation. This is why you must understand how the process works and your role in it.
How Does Due Diligence Vary?
There's more information needed and the time to complete the process takes longer when the funding happens at the later stage. This is also true when larger investments are involved. The five stages of VC funding include seed capital, startup capital, early stage, expansion stage, and mezzanine or pre-public stage.
Here's what they mean:
- Seed capital: At this stage, the company looking for funding doesn't have products yet and is seeking money to research and develop its idea.
- Startup capital: The companies looking for funding at this stage may have a sample product available. The capital will go toward hiring people to manage production or the company, doing more research, or coming up with a final market-ready product.
- Early-stage or first stage: The funding that early-stage companies receive typically goes toward production, marketing, and sales.
- Expansion stage: Companies fundraising in this stage likely have shown exponential growth and are poised for more expansion. The VC capital will fund buying other companies, entering new markets, or diversification of product lines.
- Mezzanine or pre-public stage: Companies in the pre-public stage are looking to be listed in a stock exchange as a publicly traded company. The VC funding will go toward mergers and acquisitions, sales and marketing campaigns to drive out competitors, and financing the initial public offering process.
Areas of Investigation in a Due Diligence
Every venture capital firm has its own way of conducting due diligence. The information they're looking for is not always the same either. Generally, the following are the areas that get investigated during the due diligence process.
The team refers to the founder or founding partners of the startup. Before investing, VC firms check the team of a startup. This includes anti-money laundering checks, credentials, track records, and experience. There's no set description for what makes a "good" founder and every investor has a different set of preferences.
The market a company is operating in is a critical factor for most investment considerations. Investors prefer a growing market. They also consider how crowded the market is or how difficult it is to enter. The VC firm would also want to know about the company's target customers and competition.
Potential investors will look at whether the company looking for funding has a product that is different from other products available on the market. There are several ways a startup can grow into a large company, but the most common is a differentiated product. The funding firm would also want to know how the company plans to sustain its differentiation and stay on top of the competition. Your product may also be assessed on technological advancement and user experience.
Traction refers to where the company is in the different stages of VC funding. For instance, if your startup company is in the early- stage, investors would like to know about profit margins and if your product is fully developed. In this part of the due diligence process, investors are determining your business's viability.
Venture capital investors are concerned with legal worthiness as a matter of control. They want to know their rights in relation to other investors and owners of the company. For instance, VC firms may want control of your company and would want majority ownership. They would review contracts you have with other investors and other members of your team.
The VC firms will also want to know about any outstanding legal claims or complaints against your company. Lastly, you'll need to prove that there are no competing claims to any of your company's intellectual property, if any.
In this part of the VC due diligence, your investors would like to know your company's current revenue, cash flow, profit margins, cost of production, and the cost of selling. In addition, you may be asked to produce financial statements that the VC firm can use to evaluate your company. They'd also want to know if your company has any debts. Your numbers will be assessed and compared to industry standards. They will be considered when you enter the negotiation process of how you'll pay back the funding you receive.
Due Diligence Checklist
Are you ready to start preparing for due diligence? Here are the standard documents and reports that a venture capital firm may request:
- Pitch deck
- Financial statements
- Financial projections
- Revenue information
- List of all the company's management team, employees, and their roles
- Market research and analysis
- Competitive analysis
- Active contracts: Equity agreements for the founders, previous investments, employment agreements, customer contracts, etc.
- Use of funds: Break down how the company plans to use the money it's raising
- Business plan
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The due diligence process is an integral part of getting venture capital funding. If you're looking to get your company funded, it's never too early to start learning how the process works and the documents you need to prepare. Being organized and proactive pays off in these types of deals.
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Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always do more research and consult with professionals to ensure that you're making the best decisions for your company.