Venture capital (VC) due diligence implies to the process of appraising the current state of affairs of a company, along with its commercial potential. Earlier, Anand Jayapalan had spoken about how due diligence for VCs involves gaining a good understanding of the target company, its assets and liabilities, as well as its management. The key goal of this process is to make sure that all risks are accounted for and understood, the target company has a good foundation to grow from, and there are no obstructions to the investment.
As opposed to private equity firms that generally invest in more established firms, venture capitalists typically invest in startups. Startups, early-stage companies in particular, can be very hard to assess. Such companies generally do have not much substantial evidence to demonstrate their value, which makes due diligence extremely important. Gathering all the relevant information about the target company, and subsequently thoroughly assessing and appraising that information, can help a VC firm to make sure that their investment has a high likelihood of profitability.
Every VC firm has its distinctive way of carrying out due diligence. Moreover, every potential investment tends to require a distinctive approach. On the whole, there are multiple categories of information that almost every deal team needs to gather insights into. Here are a few of those categories:
- Financial: The financials of the target company would invariably be the most vital information a VC deal team has to assess in order to gauge the potential of a startup investment. There would be a number of financial statements and information that has to be gathered and checked, including balance sheet, financial projections, intellectual property, accounts payable, income statement, cash flow statement, as well as a schedule of bad debt and/or write-offs. Ideally VC firms send a due diligence checklist to the startup and task its management team or founder to gather all the information needed.
- Legal: For legal due diligence, the VC deal team must keep an eye out for any red flags that might indicate a mismatch between the legal standing of the startup and what they have reported to the VC firm. This domain of due diligence also puts emphasis on assessing the level of control of the VC in the investment. For legal diligence, one may need information like annual reports, articles of incorporation, compliance with state and federal laws, bylaws and amendments, legal claims against the company, and outstanding liabilities.
- Market: It is vital to take into account the market where the startup is competing, as it would have an impact on the potential profitability of the startup. The VC deal team must try their best to determine how sound the market is, as well as what the potential is for the company to grow in the market in the near future. The information they need to gather would include the market size, sales volume, product pricing, and market growth trends.
Earlier, Anand Jayapalan had spoken about how the team members of the VC firm have to spend a lot of time with portfolio companies’ founders and management teams, and hence it is vital to know about these key players early in the deal process. Assessing the management team of the target startup is a part of the due diligence process. After all, this team would also be a vital indicator of the company’s trajectory.