Guide to Venture Capital Due Diligence & How to Conduct It (Checklist Included)

The well-documented move towards online services during the Covid-19 pandemic brought a few high-profile winners, most notably e-commerce giant Amazon.

But less well-documented was how Covid-19 convinced a growing band of investors that the new reality had made most startup companies even more valuable than they had been just a year before.

Private equity investment in venture-backed companies grew 73% year-on-year, for example.

Increased investment in venture capital brings with it a new set of due diligence challenges.

As with companies at any stage of their life cycle, due diligence is at the core of establishing the true value of a startup. This is uncontroversial to say that this is far more challenging with startups and VC-based companies than their mature counterparts.

We at DealRoom work with number of VC firms by providing them solutions for their due diligence and in this article, we address the due diligence challenges associated with venture capital, and how to overcome them.

Paradoxically, information gaps within a startup mean that investors often end up conducting even more thorough due diligence than they would for older companies, usually through an investor data room.

Why is Venture Capital Due Diligence Important?

Venture Capital Due Diligence is extremely important precisely because of the information gap and lack of historical data that we tend to associate with young companies.

The founder of AirBnB was laughed out the door by countless VC investors, who told him that the idea 'would never work' as people 'weren’t going to let absolute strangers rent their houses'.

With the benefit of historical data, we can now see that this wasn’t true. 

In his book, ‘The Dark Side of Valuation’, author Aswath Damodaran aptly captures the importance of venture capital due diligence.

He points out that issues typical of young companies include the following:

• What market is there for the (sometimes completely innovative) product or service?
• If there is a market, how will competition evolve?
• How can the company achieve scale?
• Will the company be acquired before it grows?
• What valuation can be given to a company with negative income?
• What importance can we attach to the founders of the company? 

The Venture Capital Due Diligence Checklist

As the above sections allude to, it’s common for a young company to have no comparable competitors (which can be a good thing or a bad thing), no significant history of financial results, no proven demand, and generally a dearth of data.

Time for investor due diligence.

The below checklist addresses the principal issues that will have to be investigated before any investment can be made by a venture capital investor:

1. The Company and its Market

1. Establish what specifically the company does and what its market is.
2. Understand whether the company requires any special permits or permissions to conduct its business.
3. Gain a copy of all licences and distribution agreements that the company holds.
4. Understand the trade relationships or contracts that the company has, which allow it to do business, or could prevent it from conducting business in the future.
5. Establish who the company’s competitors are (and who they are likely to be).
6. Understand if there is a way that a large competitor could potentially disrupt the company in its current way of doing business.

2. Legal Information

1. Acquire details of all existing shareholders and, if applicable, details of shareholder resolutions which have passed.
2. Acquire a certificate of incorporation.
3. Obtain details of any capital changes in the company since it was incorporated.
4. Obtain details of warrants, options, or any other rights pertaining to the share capital of the company.
5. Acquire details of debentures or other financial instruments that pertain to the company.
6. Acquire a list of arrangements (contracts) that could be terminated when the company changes control.
7. Understand the nature of contracts currently being negotiated by the company.
8. Review contracts already held by the company.
9. Understand whether the company has been involved in any legal disputes in the past, or whether any disputes are outstanding.

3. Financial Information

1. Obtain a copy of all (or any) audited accounts held by the company.
2. Understand which accounting conventions and standards have been adopted by the company.
3. Acquire a company of all management accounts since the day the company began operating.
4. Acquire statements of all bank accounts (including credit card accounts) held by the company.
5. Understand the nature of all its debts and debt securities - in particular, its debt schedule.
6. Acquire details of all budgets and financial forecasts, both past and current.
7. Gain an understanding of the company’s credit terms, both those it negotiates for its own clients and those that it has negotiated with its suppliers.
8. Obtain details of any off-balance sheet commitments of the company.
9. Understand the nature of the company’s distributions paid since its incorporation.

4. The Company’s Assets

1. Obtain details of the company’s machinery, plant, and equipment, and any documentation (maintenance contracts, leases, etc.) pertaining to them.
2. Understand whether the company has acquired or disposed of other assets in the past five years.
3. Gain an understanding of any contingent liabilities associated with the company’s assets, particularly its real estate.
4. Acquire copies of the company’s patents (if applicable).
5. Evaluate the company’s patents.
6. Understand whether the company may be in breach of any intellectual property in carrying out its own operations. Obtain any IPR that the company uses, but do not belong to it.
7. Does the company have any know-how

5. The Company’s People

1. Obtain an organizational chart of the company.
2. Obtain details about remuneration, including stock options and benefits.
3. Obtain details about any disputes with current or previous employees.
4. Gain an understanding of the company’s relationship with outside contractors and obtain a copy of the contract held with each (if applicable).
5. Understand the company’s disciplinary procedures.
6. If possible, conduct interviews with a selection of the company’s employees, and attempt to gain an understanding of the company’s culture.
7. Understand which employees left the company in the past three years, which roles they currently occupy, and whether they might represent competition.
8. Gain an overview of current positions unfilled or outstanding offers of employment.

Grab your full copy of the venture capital due diligence template and discover why DealRoom is one of the most important tools for successful due diligence process.

Conclusion

Venture capital due diligence has the same goals as any other form of due diligence.

The issue is that, with so little history, most young companies may legitimately lack much of the data that would be relatively easy to obtain from more mature companies in the same industry. This doesn’t negate the need for due diligence - quite the contrary.

If you’re considering a venture capital investment, hear more from our clients on how they use DealRoom for due diligence and the sometimes challenging venture capital due diligence process.