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This guide provides you with a comprehensive due diligence checklist.
Key Takeaways
- The due diligence process enables VC investors to make informed decisions, identify risks and foster collaboration with startup leaders.
- The process includes commercial, legal, and financial aspects, and it involves an assessment of the product, the market, the business plan, and the startup team.
- Working with a seasoned advisor is an integral part of the due diligence process.
Disclaimer
The contents of this article are for educational purposes only. They are not intended to be a source of professional financial advice. You will find experts on financial planning and financial management here.
Investment advisors for VCs
One on hand, without the due diligence process, any investment in a startup is based on guesswork and will likely fail. Investors in a highly complicated industry such as Biotech discovered this at great cost after pumping money into Theranos.
On the other, due diligence involves examining so much data that it can become a bit confusing. For example, the big numbers that startup founders usually have in their pitch deck can be misleading, since such big numbers only make sense in certain contexts.
A task such as due diligence for venture capital investments are best handled with the help of investment advisors and analysts who are familiar with the investment process and the startup language.
Bay Street Capital Holdings is a leading US-based investment firm with a wealth of experience in venture capital investments. The firm's chief investment officer, William Huston, is an expert in private equity investments as well as VC investments.
As a venture capital investor looking for viable startups to invest in, collaborating with a firm like Bay Street can simplify the due diligence process for you. Schedule a session here to speak with William.
What is VC due diligence?
Due diligence is a thorough investigation of a company being considered for investment, in order to make sure everything is in order and that the relevant rules and regulations are being followed. For a VC firm that provides funds to startups, it's a way to distinguish between good and bad investments. This process involves closely examining a startup company and its market context.
Through due diligence, investors can confirm whether the information they have is accurate. They analyze the startup's financial situation, organizational structure, legal documentation, key personnel, contracts, clients, and more. This helps them make informed decisions about whether their initial funding choice is well-founded.
Why is venture capital due diligence important?
Investments come with inherent risks, but acknowledging these risks shouldn't lead to avoiding all investments and holding onto funds, nor should it be an excuse to skip the due diligence process.
The due diligence process is vital for everyone involved in a venture capital investment. It helps investors in making well-informed decisions, identifying key risks tied to the investment, and collaborating with the company's leaders to create a strategy for minimizing those risks.
Furthermore, a wise startup founder will recognize the benefits of involving their venture capital investors in this process. Venture capital due diligence can reveal areas where the company might have weaknesses, giving the company an opportunity to address significant issues before they negatively impact the business.
What are the types of due diligence for investments?
Although the focus might change depending on the investment situation, there are generally four main types of due diligence:
- Commercial
- Legal
- Financial
- Tax assessments
But, let's consider the first three categories.
1. Commercial Due Diligence
The commercial or business due diligence involves closely looking at how the company stands in the market. This includes its possible market share, what makes it grow, and its future possibilities. The main point is to get a fair review of how much the business is expected to sell.
The commercial due diligence process includes the following steps:
- Determine the specific products or services of the company and its target market.
- Find out if the company needs any special permits or approvals to run its operations.
- Obtain copies of licenses, like the company's intellectual property rights, and any distribution agreements the company holds.
- Understand the trade relationships or contracts the company relies on for business.
- Identify the company's competitors and potential future competitors.
- Determine if there's a possibility that a big competitor could disrupt the company's current business approach.
2. Legal Due Diligence
This step in the due diligence process deals with various legal matters. These include confirming that the company is set up correctly, understanding any agreements, clarifying who owns which assets, and identifying any current legal problems.
The main goal is to double-check if the rights the investor is acquiring are real and to find any legal problems that could make the investment worth less.
Here are steps that comprise the legal due diligence process:
- Get a hold of all existing and past shareholder information including past share resolution.
- Secure a copy of the company's certificate of incorporation, and details of any capital changes in the company since it was incorporated.
- Secure information on any financial instrument pertaining to the company.
- Clarify the nature of contracts being put forward by the company.
- Review previous contracts already entered into by the company.
- Find out if there have been legal disputes or there are outstanding disputes.
3. Financial Due Diligence
The financial due diligence is a comprehensive approach that serves a dual purpose:
Validation of Valuation Assumptions: in this process, investors look at the company's past performance. This helps to see if how the company performed in the past matches up with what we think it will do in the future.
Identifying Financial Uncertainties: this part of the process tries to find things that could cause problems or extra costs for investors.
Steps in the financial due diligence process include:
- Obtain copies of the company's audited accounts and financial statements.
- Familiarize yourself with the accounting rules and standards the company follows.
- Collect statements from all the company's bank accounts, including credit cards.
- Get a clear picture of the company's debts and debt securities.
- Collect records of past and current budgets and financial forecasts.
- Understand the credit terms the company uses with both its clients and suppliers.
- Acquire information about any commitments the company has that aren't shown on its balance sheet.
- Gain insight into the distributions the company has made since its establishment.
Venture capital due diligence checklist
The VC due diligence process involves various steps. Let's explore the key points in this checklist.
Initial Screening
An initial screening process assists a VC investor in deciding if the startup is worth more investigation. This may include verifying if the venture capital firm and the startup match. Once the link between the startup founder and the investment analyst is set, the first phase of due diligence starts.
Assess the Product
Next is the value proposition examination process. The heart of a startup lies in its product, service, or technology. Investors need to closely assess its uniqueness, functionality, and potential to meet market demands.
Assess the Market
Then investors can look wider into the market. Investors should examine the market landscape to understand the startup's potential competitors and to gauge how well the product or service could stand out.
Assess the Plan
Subsequently, investors can look into the company's plan. A startup's roadmap to success is a crucial aspect. Investors should delve into details such as the execution plan, scaling strategies, market approach, and the overall business model.
Assessing the Team
Finally, the management team behind the startup are then weighed. Investors need to evaluate the team's experience, skills, and commitment to ensure they have the capability to drive the business forward. This understanding helps investors gauge the team's ability to achieve their goals.
Risks of a due diligence process
It is important to note that due diligence can also pose significant risks and challenges for all parties in a venture capital investment. These risks include information imbalance, hidden liabilities, and deal-breakers.
A practical suggestion for investors is to think creatively about how they do the due diligence process. There isn't a single way that works for all investors, especially with each industry becoming more specialized.
Work with the A-team
Venture capital due diligence is a structured process that involves thorough investigation. Such a detailed examination is required for meaningful investment decisions.
As an investor seeking good ROI and to have societal impact, it is in your best interest to work with an investment advisor and analyst who has experience in venture capital and startup investing. They are best at identifying the strengths and weaknesses of a startup.
Bay Street Capital Holdings can provide everything you need for a successful investment journey. You can schedule a meeting to take advantage of the firm's services.
Bay Street Capital Holdings
Bay Street Capital in Palo Alto excels in wealth management, focusing on risk management alongside returns. Led by William Huston, among Investopedia's Top 100 Financial Advisors, it's a notable Black-owned firm.
Their partnership with Resthaven Properties earned them a finalist spot in 2023 WealthManagement.com Awards. In 2021, Bay Street was a CSR finalist among 900 firms, showcasing their commitment to diversity and impact.
