When venture capitalists perform due diligence on startups, they are looking for potential market leaders in large markets – and VCs’ return expectations are huge. Most early-stage investors want any given investment to be able to return the entire value of the fund! That means that during diligence, the investors need to get comfortable that the company has massive potential.
A good diligence process confirms tactical things, like the company is in good legal standing and the finances are how the founders described. But it also needs to reinforce that the market opportunity is huge, the product (or product vision, depending on the stage) is solid, the team is the best one to attack the problem, and that the competition is like the porridge in Goldilocks, just right.
Here are some of the big picture items VCs will want to dig into during their research into a startup:
Management Team
Venture capitalists focus on assessing the management team in charge of the startup. They look at:
- Domain Expertise: The knowledge and expertise of the management team in the specific industry or sector they operate in.
- Total Experience Level (and Relevance): The years of experience and the relevance of the experience to the startup’s industry.
- Individual Value Contribution: The unique skills and contributions each member brings to the team.
- Venture capitalists want a management team that has a long-term vision for the company, technical product specialty, business acumen, and management cohesion.
Tip: Remember, the VC is looking to confirm that you are the right team to create a huge company in your chosen industry. One of the qualities venture capitalists value highly is a team’s ability to learn and adapt quickly, especially in fast-moving and uncertain markets. During due diligence, emphasize instances where your team has rapidly assimilated new information, pivoted strategy, or made swift course corrections that led to better outcomes. This is something even young, inexperienced founders can showcase.
Product Analysis
VCs analyze three fundamental components of the product being offered:
- Product-Market Fit (PMF): It’s important for startups to demonstrate PMF, defined as the validation of the product concept in the target market, as signified by consistent organic consumption and word-of-mouth promotion. PMF is often considered a qualitative trait recognized from customer engagement and feedback.
- Product Differentiation: VCs are interested in products that have a competitive edge and high barriers to entry. This could be due to economies of scale, network effects, proprietary technology or patents, high switching costs, or strong branding. Products that lack differentiation can become commoditized and compete solely on price, which can lead to margin erosion.
- Value Proposition: VCs want to know why the customer needs the product and the value it provides. If a product is essential for business continuity, it is considered “mission-critical.” High customer churn or short customer relationships may indicate that the product does not offer enough value.
Business Model Viability
VCs examine the unit economics of the business, which involves breaking down the revenue and cost structure into the smallest units possible. They look for repeatable and scalable business models with high operating leverage, where a large proportion of costs are fixed relative to variable costs. On the development side, software startups are particularly attractive to VCs because once the software is developed, it can be sold to millions of customers without significant additional development costs.
Sales and marketing is another area where venture capitalists look for scalability. By analyzing the company’s sales and marketing strategies, VCs can evaluate the startup’s market positioning, competitive advantage, and potential for growth. Sales and marketing diligence also helps VCs identify any gaps or weaknesses in the startup’s go-to-market approach that may affect its scalability and long-term success. Of course, a seed stage business is going to have a very different sales and marketing diligence process vs. a Series B startup. At the earliest stages, the investor wants to know that the founders have a plan that is realistic and professional, and that they can incorporate feedback from the market into their plans. At a Series B, they’ll look for metrics that prove that there is a scalable sales and marketing engine in place that can ingest more capital to keep the growth rate up.
Assessing Financial Health
Financial due diligence is usually a critical component of the VC’s overall assessment of a startup, and it becomes more important as the company grows and accesses later rounds of financing. When they are evaluating a startup’s financial situation, VCs generally focus on:
- Financial Health: VCs analyze the startup’s financial statements, cash flow, and burn rate to assess its current financial position and future sustainability.
- Revenue Model: They examine the company’s revenue streams, pricing strategy, and customer acquisition costs to ensure the business model is scalable and profitable.
- Financial Projections: VCs scrutinize the startup’s financial forecasts, looking for realistic growth assumptions and a clear path to profitability. At the early-stage, this may be the primary focus.
- Capital Efficiency: They evaluate how efficiently the company has used its previous funding and how it plans to utilize future investments - this includes understanding the funding history and cap table.
- Financial Controls: As startups grow, VCs expect to see more sophisticated financial management systems and processes in place. Most VCs won’t look too deeply early on (although they should!).
For a comprehensive overview of what to expect during financial due diligence and how to prepare, refer to our detailed guide on finance due diligence. Understanding this process can help founders present their financial story more effectively and address potential concerns proactively.
