Venture Capital Due Diligence for Startups

Due_Diligence

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For the past few years, start-ups are on the rise. Everybody is giving their dream venture a chance, and why not? Thanks to the connectivity of modern times, entrepreneurs can connect with investors across the globe without wasting a significant portion of their initial capital on visa and flight tickets. It is incredibly easy to connect with investors and start a business, and equally easy to lose it all if the entrepreneur is not aware of the due diligence conducted by investors before investing in a company. 

Did you know that nearly 67% of startups fail at some point in the fundraising process? This percentage can be reduced by being prepared for the due diligence process before approaching potential investors. So, what is the right approach to start-up due diligence for venture capitalists, angel investors, and other fundraisers?

Venture Capital Due Diligence for Start-Ups

When start-ups approach investors, it is good to have answers to some common concerns or questions that investors have. It is even better to support these answers with proper documentation. Also known as ‘soft due diligence’. However, in some cases, investors hire accountants and legal professionals to review and check the authenticity of the start-up’s records.

Having said that, there is no specific due diligence process for investors. One investor may be interested in the product, while another may be curious about the team behind it.  Some may carry out a soft due-diligence process where they may ask you questions relating to the business and look at minimum documents. While some may want to deep dive in and require elaborate documentation of the startup.

Some of the due diligence queries for start-ups are generally regarding:

The Team

A knowledgeable and experienced team can make a great difference even with an average product. Some investors will willingly take a chance based on the team.

The Product

What is the product or service? How useful is it? It is good practice to have a MVP or at least a draft that shows the feasibility of the product ready before reaching out to investors. If your VC has software development knowledge, they may also want to look at the coding and other documentation.

Existing Market

The investors would typically like to know the existing players, their market share, competition, consumers, and what is your go-to-market strategy.

Financial Budget and Forecasts

It is good to have a projected P&L in place, along with the Balance sheet and cash flow statements for at least the first 5 years.

Third-Party Vendors

This may come as a surprise but VCs may also be keen to know who your third-party service providers are, if their pricing is feasible, and do they have a good reputation in the market, etc. It is always good practice to carry out the required due diligence before finalizing any vendor/third-party service provider.

Here are a few ways to be prepared for start-up due diligence.

Proper Financial Record

Investors will want to see the financial record of the company, the margins, the turnover estimates, the budgeting for third-party service providers. Having a projected financial forecast along with details about the expected revenue, and estimates for vendors helps investors conclude that the founder has done their due diligence in understanding and analyzing the market. This also provides investors an estimate of the time by when they can start expecting a return on their investment.

Therefore, do include the balance sheet, cash flow, and income statements along while pitching to the investor for funds.

Details of the Founder(s) and Other Team Members

Investors are heavily invested in the team behind a startup. They like to know whether the team members are skilled and experienced enough to create a high-quality product(s) and market them. A team that has members who specialize in product development, management, and marketing is more preferable to a team that has all its members specializing in only product development. The latter scenario makes the investor skeptical about the success of the startup. Therefore, it is ideal to reach out to an investor once a team with diversified skills has been formed. The primary concern of many investors is whether the business will be able to sustain and grow on a lean budget. Improper financial management resulting in faster depletion of funds is another primary reason for a failed startup.

Go-To-Market Strategy

A lot many times, startups fail when they do not have a proper marketing strategy in place. Investors are keen to know – Who the target audience is? How the founder intends to approach and connect with the market? What is the cost of acquiring per customer?

Having a Go-To-Market strategy is crucial while approaching investors. It ensures that you have done your research and prepared a product as per your target audience’s/market’s need.

Company Registration and Other Documents

Every investor will first check whether your company has the right legal structure and licenses to carry out the mentioned business.  If the license work is in progress, the founder can present the filed application documents and any other document issued by the legal authority. Startup companies should present their articles of incorporation, organizational structure, annual meeting notes, and other relevant information documents to show that they are in good standing with the concerned regulatory authorities.

Intellectual Property and Patents

If you have informed the investor that your product is one-of-a-kind for which you have IP rights and patent, it is best practice to support this information with proper documentation. These are vital information and should be in place before approaching any investor.

Existing Litigation

Although as a startup, your company may not be involved in any lawsuits in the initial stages. Sometimes, companies could end up with lawsuits against them. It is good to update investors about these legal situations in advance before their hired legal professional discovers them. Being honest helps build credibility, an investor may lose interest if they find out about the lawsuit(s) from a third party.

Key Vendors and Clients

Although an investor may not want to know the entire list of vendors and customers, they would like to know about your key vendors and clients. It is important to integrate third parties/vendors that fit into the business plan without becoming major expenses in the long run. Being aware of your key vendors and their costs provides investors a rough estimate of the business running costs at least for the first three years. Similarly, in the case of clients, a business that has major corporates as its clients is likely to stay afloat and manage the business operations cost.

Existing Business Contracts

Businesses enter into contracts on a regular basis. Often times some contracts may end in lawsuits which could result in significant expenses for the company. Investors will want to scrutinize these existing contracts especially the ones with international companies or companies that have mixed reviews in the market.

Having said that, gathering and keeping a record of all the above information may be overwhelming and appear as an unnecessary burden, but having all of these documents present while approaching an investor leaves a good first impression on the investor. These days there are multiple virtual data rooms that startups can use to store their company-related information, the founders can provide access to investors who wish to view these documents. Not only does this ease the due diligence process but also accelerates the funding process.

About Penser

Penser has provided due diligence services to clients from across the globe and advised them on their investments in the payments and fintech space. If you own a startup and need assistance while reaching out to investors, or are an investor looking forward to investing in startups, Penser could be of help. Our team comprises of highly experienced professionals who are experts in their respective sectors.