Mastering the Art of Due Diligence: 4 Tips to Know When Approaching a VC
Due Diligence. We’ve seen this term being slapped on everything between consumerism to court law, however how does the term apply in venture capital and why is it so important?
Due diligence is the differentiating factor between whether a firm will choose to invest in a startup idea or not. Due diligence, by definition, is the meticulous examination of a potential investment, with the aim of assessing its compatibility with an investment thesis alongside the verification of the business’s credibility and trustworthiness. In venture capital, it’s important that both investors and entrepreneurs partake in due diligence to ensure the people and the product they are working with are credible.
So what does due diligence look like for venture capitalists? The due diligence process can look different for each VC firm depending on what they choose to focus on, but usually the due diligence process happens across various verticals.
VC’s get their deal sourcing from various channels including pitch competitions and networking. Typically, a follow up call will be held for the founder and investor to meet one on one with the investment groups’ team. Investors will oftentimes have a due diligence checklist for things that they are looking for. Prior to hopping on the call, they will run through the checklist and pinpoint gaps in their understanding of the company’s business model and product. Depending on how much exposure the VC firm got with the company at the initial encounter, the call may involve having the company pitch again or just answer a series of questions from the venture capitalists.
Additionally VCs may request samples of the company’s product or service to see how effectively it addresses the need you are targeting from a user perspective. With that, they could draft up their own research report which will include information about the company and what their business aims to solve, their product and revenue streams, how they are leveraging new technology, their different product and revenue streams, how cohesively their team is formed, et cetera. All these steps are executed to ensure that investors don’t miss any red flags when proceeding with an investment.
However, as a startup or an entrepreneur, “How do I know what VCs are looking for when conducting due diligence on my product and I?”. While there is no unanimous master checklist that all VCs look at, here are a few big pointers that investors will be keeping an eye out for.
1. “A” Team Over an “A” Product
Venture capitalists oftentimes place greater emphasis on the manner in which questions are addressed rather than just focusing on the answers themselves. Contingent on the partnership the firm is looking to have with the company (General vs Limited), VCs may assess how open minded the company seems to be working with the investors. If the company seems too stringent on its own way of conducting business, it may come off as a red flag to investors that they’ll be tough to work with. Investors are more likely to invest in an “A+” team with a “B-” product/service versus a “B-” team with an “A+” product.
2. Vision Without Distraction
Investors will also direct their attention to a company’s strategic focus. Being too broad without a niche market signifies that an entrepreneur is taking on more than they can handle. This over ambition may seem like something VCs want to see but in reality it comes across as a lack of attention being paid towards developing a central product/service. However, being too niche and not having room to expand your business may repel investors as well. Whether the goal of your startup is anything from getting acquired by a more established company to seeking funding to potentially IPO one day, setting your intentions from the beginning is crucial for you and your business.
3. Understanding the Gaps
While it may be tempting to idealize our idea and believe that it’s the solution to the problem it is addressing, it’s important to be able to take a step back and assess the potential risks or concerns that investors could point out. A great way to do this is by bringing on advisors to get second opinions. This may be professionals from the industry, angel investors who have invested predominantly in the respective industry, or anyone with previous advisory experience. By doing this before meeting with potential investors, not only are you anticipating what VCs might hit you with on a founder call, but you are also instilling a deeper understanding within yourself about your business model.
4. Numbers, Numbers, Numbers
The #1 rule of venture capital is plain and simple – make money. In theory, it should be straightforward and to the point, however failing to recognize it could set you up for failure. Passion and purpose will fuel the ignition of a business idea, but capital is what will keep that motor going. When approaching a venture capitalist, it’s important to understand where they are coming from. Providing clear financial statements, projected burn rates, and desired capital allocations is crucial in selling your idea to a VC. The more assurance you can bring that their investment in your business will yield them a Net IRR, the better prepared you will be.
It’s easy to get discouraged when getting turned down by potential investors, but just like everything else in life, every investor is different. Thus they will have different critical attributes they will be looking for throughout their due diligence process before proceeding with a deal. It’s important to not lose faith and keep working hard and soon enough you will find yourself a team of LPs willing to push your idea forward.