Due Diligence by VC Firms on Startups

How does a VC firm choose which startups to invest in and which to pass? How should startup founders prepare themselves for screening by VC firms?

VC firms conduct thorough due diligence on startups before deciding which startup is worth their time and money. Due diligence is the process of investigating a startup before conducting any monetary transaction with it.

VC firms generally conduct due diligence in three stages.

In the first stage, called screening due diligence, a VC firm checks if a startup operates in the same sector, stage and geographical location as the ones it invests in. For example, Kleiner Perkins is a US-based VC firm that invests in all stages of startups globally, but only in the consumer, fintech, enterprise, hard tech, and healthcare sectors.

The second stage of due diligence is called business due diligence. This is a thorough assessment of all matters related to the business, including a company’s products/services, market, business model, founder and management team, and financial issues.

VC firms incline towards startups that serve one or more large markets. This facilitates traction and improves the likelihood of a trade sale when the VC firm wants to exit the company.

They also prefer to invest in companies with little to no competition, as capturing market share becomes difficult when competitors already operate in a market. For example, when Uber launched its ride-sharing services in Bangladesh, it had no direct competitor, so it could quickly capture a significant market share before other players like Pathao, Shohoz, and Shuttle entered the market.

When VC firms assess a startup’s offering, they look for products/services that provide an innovative solution to an existing problem. For example, mobile financial service provider bKash addressed the difficulties faced by unbanked people when transferring money from one place to another using middlemen.

VC firms prefer to invest in scalable products/services. A product/service is scalable when a single version can be sold to infinite people. For example, bKash developed a single app that serves millions of Bangladeshis.

VC firms also check if a company’s business model is scalable-i.e., the cost per unit of its product/service decreases as production and sales increase. A business model with recurring revenues is another desirable aspect for investors. For example, Netflix has a recurring relationship with customers- customers renew their subscriptions monthly by paying a fee. This leads to a steady and predictable income stream.

VC firms prefer to invest in founders with experience and credentials related to their startups and a history of founding other businesses that gave high returns on investment. For example, while Elon Musk is famous for founding SpaceX and Tesla, his first company was Zip 2 Corp, a tech company set up in 1995 and sold for $305 million in 1999.

VC firms also check the financial state of a company before investing in it. The three most important documents in this regard are a company’s income statement, cash flow statement and balance sheet. They also want to know about any outstanding loans a startup may have, the schedule of loan repayment, and the startup’s financial projections for the next few years.

The third and final stage of due diligence is called legal due diligence. It evaluates a company’s legal, regulatory, and compliance issues and is done when a VC firm is reasonably certain that it wants to invest. At this stage, a startup shares its licenses & permits, intellectual property registrations, proof of previous investments and payments of taxes, contracts with clients, and any legal dispute it may be involved in.

After a company passes this stage, it is fully qualified to receive funding.

As the due diligence process of VC firms is complex, lengthy, and time-consuming, startups should prepare all required documents beforehand. This is part of being investment-ready and gives an excellent impression to investors about startup founders.

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