Venture Capital Due Diligence Checklist

What is Due Diligence? 

Due diligence is a detailed examination of the company’s financials, past, present, and future, along with non-financial items such checking the demand for their products, the company’s ability to compete and the ownership structure. It is a critical step in the venture capital (VC) process. All VC funds must assess the potential risks and rewards of investing in a start-up and to fully investigate all aspects of a company and its operating environment. 

How do Venture Capital Firms do Due Diligence? 

The due diligence process for VC funds in start-ups is very similar to that done by investors into mature companies. Due diligence involves taking the company’s business plan and conducting a thorough objective review of it. It will also involve a careful check of the company’s capitalization table to confirm who the current shareholders are and who has significant control of the company or other rights. 

There are many more aspects of due diligence that will need to be considered. Any potential investor will be eager to hear about the potential upside of investing in the company but will also have to investigate all the risks and potential downsides. There may be macro issues impacting a company such as new regulations restricting potential sales in the future, or there may be internal operations issues such as the factory being at full utilization and unable to provide any more products to service future sales. The financial reporting system may be slow and cumbersome, so needs reviewing into a more time-sensitive system. 

Why Due Diligence is Important for Investing in Start-ups 

Unlike investing in more established companies with longer histories, startup company due diligence can have different priorities. Startups will have less substantial evidence to demonstrate their value as the company is relatively new, and some aspects of the business growth plan may be unproven at this time. It’s harder for a VC fund to become comfortable with the potential risks and rewards of investing in that startup, given it would have an increased quantity of unknowns compared to a mature company.  

How Long Does Due Diligence take? 

A thorough due diligence process may be time-consuming, due to information gathering and the sensitive nature of data for private and early-stage companies. Investors will want full clarity on the company before investing, and it’s particularly important when looking at private companies which have very few requirements to make company information publicly available. The timeframe to complete it will depend on the availability of information from the company and the free flow of communication between the VC fund and the company.  

Due Diligence Checklist 

Go to the free download section to access the Due Diligence checklist to ensure you stay on top of reviewing all aspects of a start-up company. 

A due diligence checklist for VC funds would include reviewing and evaluating available data in the following areas: 

• Financial History, Performance, and Metrics 

VC fund analysts will check to see that the company is delivering growth and profitability in line with its financial targets. They will also confirm that the financial history has been correctly audited and is accurate. Projections always need to be robustly checked for credibility and the timeframe for the planned expansion. The company’s future growth targets need to be reviewed and made sure they are viable.  

• Sales Contracts and other Agreements 

Third party vendors and suppliers’ agreements need to be checked to ensure that pre-signed agreements do not in any way impede further growth of the company. They must also be aligned to the company’s overall growth strategy. 

• Legal and Intellectual Property 

VC funds will need to confirm what a company actually owns, and the rights attached to this ownership, whether it relates to tangible items or intellectual rights. This will also include an assessment of regulatory risks. The fund will also need to be familiar with the regulatory risks within the sector or area of business and be able to assess the potential industry headwinds and tailwinds. 

• Market Assessment: Size, Growth Metrics, Competitive Landscape, Sales Volume, and Product Pricing 

A deep dive on the targeted marketplace of the company is an essential part of any due diligence. VC funds often invest in new or emerging sectors and sub-sectors, so this aspect is important. Analysts must assess prior any market data or forecasts prior to investment, even if there is relatively little public information to glean on the new marketspace.  

This includes examining the prospective market growth and how this compares to the company’s own growth projections. Careful due diligence would also include exploring the demand and price dynamics and the competitive landscape. VC funds will want to establish how the target company compares to its peer group and whether it is the main player within a category or has the scope to challenge the current leaders and gain market share.  

• Product Evaluation, Technology Assessment, and Level of Differentiation 

VC analysts will seek to compare the company’s products and technology to alternative providers and competitors in the field to ensure that the business model has got some kind of competitive advantage. The advantage may be price-driven, such as a value-offering in the market or offer superior product or service that would be attractive to customers. 

• Business Model 

The business model needs to be scrutinized and stress-tested to ensure that it is deliverable. VC analysts will be looking at the potential for recurring revenue, scalability, and positive customer perception of the products. Typically, VC funds target a preferred sector or industry as part of the investment plan, so this allows the analysts to apply their expertise and sector experience analysing other companies to accurately quantify how attractive the target company’s business model is. 

• Sales and Forecasts 

The sales forecasts would be inspected to examine the quality of the customers and aspects such as recurring revenue and the scalability of the business. Start-ups have less sales history than mature companies to analyze so the VC fund will be carefully checking the current customer base and how viable future expansion is. This is important particularly if new investment is required for capacity expansion. Sales projections may include increasing current sales offerings, attracting a new customer base or expanding into new markets or territories to drive sales growth. 

• Founder and Key Management Team 

VC investors would be working alongside the founders and the key management team, so they look at their bios, level of experience, skillset and professional credentials and assessing how a potential new team with the VC investment will look and operate. It’s important to consider current management views on exit strategy and make sure they will be aligned with any potential investment strategy by the VC funds. 

• Series Terms and Cap Tables 

Analysts will need to study previous series funding terms and check for any additions such as pro-rata rights which are available to current shareholders. These will affect future shareholders such as the VC fund so will need to be carefully checked. Analysts will also examine the capitalization table to see who the current and previous shareholders are. This will include checking what type of shares are owned by each party and whether they have voting rights or are non-voting shares. Part of this process will involve checking the background of current investors to ensure there will be a cultural fit following any investment. 

Conclusion 

Due diligence is a vital component of the venture capital investment process, requiring a thorough and detailed examination of both the financial and non-financial aspects of a start-up. This process not only assesses the current state of a company but also its potential for future growth and competitiveness in the market. For VC funds, due diligence is imperative to understanding the risks and rewards involved in investing in early-stage companies, which often present unique challenges due to their lack of historical data and unproven business models. Through a comprehensive due diligence checklist, investors can make informed decisions, ensuring alignment with their investment strategy and the potential for successful partnerships with startup founders and key management teams. 
For more information on this topic, enrol on our Venture Capital Course. The course is designed to identify the key investor terms at various stages of VC investment, cover the types of consideration for equity investments in a priced or unpriced round, as well as some of the typical clauses or provisions in a VC term sheet. Access will also be provided to playlists in Felix detail topics such as Forms of Consideration.

Additional Resources

Venture Capital Trusts (VCTs)

What is a Venture Capital Analyst?

Venture Capital Interview Questions: The Full Guide

Venture Capital Course