Startup due diligence is one of the most important components of the funding process for a new business…
It’s up to the entrepreneur to validates the opportunity to angels or VCs…
This validation, or lack thereof, ultimately leads to the decision of whether or not angels/VCs will execute the subscription documents, sign a check and invest.
Angel groups and VCs conduct due diligence of a startup opportunity by investigating and evaluating it. The process enables the investor to make more informed decisions concerning the investment’s potential and their related level of interest. It covers the entire life of the startup, beginning with its establishment and spanning into the potential future as far as can reasonably be predicted. The approach utilized by experienced players is typically intentional and reflective. It is, in essence, a discovery process. This enables the investor to obtain an in-depth understanding of the company, its technology, business model, management team, culture, processes and ultimately, its investability.
Nobody enjoys the process, neither the entrepreneur nor the investor. However, this homework increases the potential of an individual investment’s success which affects their entire investment portfolio.
So what are the specific reasons investors in scalable startups conduct due diligence?
Compliance with Angel Group or VC’s Investment Criteria
Angels and VCs consider investment opportunities based on the assumption that the opportunity fits their portfolios. Therefore, they establish investment criteria, and the due diligence process confirms that the opportunity does or does not meet that criteria. Some criteria are openly stated and apparent – they only invest in certain industries/segments, certain geographies, at certain investment levels. Others are less obvious and may never be shared with the entrepreneur. For example – strategic alignment with other businesses to which they are affiliated. This screening begins at initial contact with the investor and continues long after the investment closes. This continued screening may be related to the viability of additional investment in follow-up rounds.
Company Valuation / Valuation of Assets
There are a number of methodologies used to determine the value of companies and assets. In the case of mature, established companies, many of the methods are analytical in nature, such as DCF analysis. For scalable startups, which have minimal sales and potentially modest cash flows, valuations are more difficult. Other issues, like the quality and breadth of the management team, their interest in accepting coaching and counsel, and their ability to execute are strongly considered in addition to the customer validation of the concept, the “go to market strategy” and the potential size of the market. While due diligence is always important, it is this writers’ opinion that with startups, due diligence is even more critical.
Identification of Significant or Material Defects
Early identification of potentially fatal defects is the investor’s highest priority. Identification of material issues early in the process allows the investor and entrepreneur to address them and potentially establish mitigation approaches. If it is not possible to mitigate the risk, the investor has the opportunity to disengage, reducing expenditures of further time and treasure on an opportunity that will never close. This benefits both parties.
It should be noted that an opportunity may present a fatal flaw to one investor, depending on their criteria but be fully acceptable to another. Therefore, it should not be concluded that just because a fatal flaw exists, the startup is un-investible. It is entirely possible other angels/VCs have differing criteria or approaches to mitigate the defined risk.
Negotiations of Terms and Price
As mentioned earlier, due diligence provides validation! If reasonable terms and valuations were agreed on in the term sheet and the company stands up to the startup due diligence scrutiny well, little negotiation likely remains. Experienced angel groups and VCs are desirous of startups that stand up well to their scrutiny as it not only validates their initial assumptions, but it permits them to move on to other deals, effectively using their scarce resources.
Defining Representations and Warranties
Many of the assurances and promises made in the closing process are standard across deals. However, each company is different and each investor perceives risk differently. Due diligence helps identify items important to the parties. Entrepreneurs who have represented the facts accurately to the investors are simply re-validating the opportunity.
Experienced entrepreneurs recognize that they are preparing for due diligence and investor scrutiny from the very beginning of the effort, even at the concept stage. They establish structure and processes to support the development and growth of an investible company. Taking these steps in advance of the need for outside financing ensures the company is prepared when the need arises. More importantly, it assures the startup due diligence process will validate the opportunity.
Note: The author is not an attorney and FundingSage is not a law firm. FundingSage’s employees do not provide legal advice. We recommend that you seek the services of an attorney if legal advice is required.