A Founder’s Guide to Startup Due Diligence

A Founder’s Guide to Startup Due Diligence

How founders can think like a VC to secure funding for their startup.

A Founder’s Guide to Startup Due Diligence
Source: Getty Images

So, you want to raise capital? Chances are, you’re a startup founder who’s spent days, weeks and months building out a product. You’ve started from scratch or with a co-founder, you might have a small bootstrapped team, and you may even have your first few customers. Your idea has traction — it’s time to get serious — you want to raise capital from a VC.

Except, there’s a problem — what are your chances of actually getting funded by a top VC? According to Marc Andreessen, founding partner of the iconic Silicon Valley VC fund Andreessen Horowitz, it’s about 0.7%. For example, Andreessen Horowitz will look at 3,000 startups, of which they will screen 200 in-depth and invest in only 20.

The reality is — there are plenty of barriers to entry for VCs when deciding which companies to invest in. After all, VCs use the due diligence process to understand what makes a startup great but also what might kill the deal. Startups might have misaligned product-market-fit, poor unit economics or indefensible products and services. But, outside of these fundamental problems, it’s your job as founder to make sure VCs don’t give you a pass because of poor preparedness when it comes getting your startup investor-ready.

As a private equity lawyer, I’ve worked with global investment managers and private equity funds in Australia and the UK. I’ve seen deals die because of a number of showstopper issues that could have been avoided in the first place. So, let this article be your guide on how to think like a VC so you can successfully navigate the fundraising process.

Before we deep dive, let’s first take a high-level look at the steps involved in the due diligence process from start to finish.

1 — Commercial Due Diligence. This stage is by far the most important for getting your foot in the door if you’re looking for capital. That being said, it can be the most broad stage covering team diligence, market diligence, product diligence, and initial financial diligence. VCs want to know if your startup has the potential for creating outsized returns. Specifically, what’s the size of the market you’re operating in? Does your product have a sustainable competitive advantage? Who’s on your team and what’s your expertise? What are your capital needs? These are all points you need to cover in your pitch-deck.

2 — Term Sheet. Once Commercial DD is done, and if (likely to be a big “if”) the VC wants to work with you, you’ll be at the term sheet phase. This is a non-binding document which covers two key areas: economics, being the amount of capital to be raised, the VC’s target ownership (which ties into valuation), and factors impacting dilution, and control, being the division of power on the Board, number of board seats acquired by the VC, and voting rights. For the purposes of this article, we won’t be focusing on the term sheet phase.

3 — Financial Due Diligence. The specifics of Financial DD will be guided by your startup’s business model. For example — if you’re a SaaS startup, VCs may want to look at metrics like your monthly recurring revenue and customer acquisition cost, but if you’re an eCommerce startup, metrics like gross margin and compounded monthly growth rate may be the centre of attention. Keep in mind, Financial DD will be conducted in two stages — first, VCs will look at the financial metrics that you provide during Commercial DD which might include unit economics, assumptions and key metrics, and second, VCs will verify those metrics by asking for your financial statements and models during Financial DD.

4 — Legal Due Diligence. This is often one of the last, but also one of biggest hurdles during the due diligence process. During this stage, you will be asked to provide a broad suite of documents covering each aspect of your startup. This can include general corporate information, corporate governance information, material contracts (i.e. supplier contracts/customer contracts), IT contracts/policies, intellectual property documents, employment arrangements, and financing arrangements. The extent of Legal DD will depend on the stage of your startup and the cheque size. If you’re a pre-seed startup, you probably don’t need to worry about complicated stock option plans or debt financing arrangements just yet.

5 — Funding. Provided the VC is satisfied that your startup is all it’s cracked up to be, based on the information obtained from the above due diligence steps, you can expect a wire transfer of the agreed funds. Congratulations, you’re officially in the 0.7% of startups to actually get funded.

VCs will conduct Commercial DD in-house. This stage can includes your initial interactions with an associate at the VC fund, submitting a pitch-deck, pitching the VC partners, and responding to subsequent information requests.

Each interaction is crucial. Founders need to understand what factors are important to VCs — who are ultimately deciding whether or not to invest.

So, what’s important to VCs?

Although VCs consider countless factors when making investment selection decisions, venture capital data from Gompers, Gornall, Kaplan and Strebulaev revealed that the management team, fit with the VC fund’s investment thesis, and the product technology were the three most important factors. Other business-related factors such as business model, total addressable market and industry focus were also notably considerations. We will break each of these down below.

Source: Paul Gompers, William Gornall, Steven N. Kaplan & Ilya A. Strebulaev

— Management Team.

VCs want to know who’s driving the bus. The management team’s capabilities are by far the most important consideration, and even more so when it comes to first-time founders. Do you have the grit and expertise to win? The drive and passion to keep going when you inevitably face obstacles? Good judgement to seek out help? Sizing up strengths, weaknesses, potential, and drive all within a few interactions seems almost impossible, but this what VCs will look to do. Although these are intangibles and there’s no set formula for the perfect management team or founder, there are proxies that VCs will use to assess your capabilities.

Source: Paul Gompers, William Gornall, Steven N. Kaplan & Ilya A. Strebulaev

VCs consider ability, industry experience, passion as the three most important qualities in a management team with teamwork and entrepreneurial experience as other key considerations. It’s your job as a founder to clearly demonstrate your competence and abilities in these areas, making sure these are showcased in your pitch-deck.

Specifically, VCs will want answers to the following questions:

  • Ability — Who are the founders and members of the management team?Can the team develop a commercial product from the existing minimum viable product? Is the team capable of geographical expansion?
  • Industry experience — What is the team’s domain expertise and understanding of the market pain? What is the educational background of the team? What are the gaps in talent?
  • Passion — What motivates the team? Why is this particular team capable of executing the startup’s longterm plan and vision?
  • Teamwork — What is the board composition? Are there non-executive directors providing support? How are roles distinguished within the team?
  • Entrepreneurial experience — Is the founder a first-time founder? Have team members had prior startup success?

— Strategic Fit.

VCs like startups have their own differentiating focus. This is referred to as the investment thesis, and is essentially the doctrine by which investments are made. It’s a form of specialisation. From the VC perspective, narrowing their focus to a particular subset of startups increases the likelihood of success. Also, VCs may have a niche skillset (e.g., Biotech commercialisation) which they want to deploy to add maximum value. And so, startups looking for funding have to fit within the investment thesis of the VC. Before reaching out to a VC, make sure you’re familiar with their investment philosophy — a good starting point is their past investments and exits.

The VC investment thesis comes in all shapes and sizes. Some common specialisations include:

  • Startup stage — specialisation by stage is very common as VCs will have a preference to invest either at the early-stages (seed, series A and series B) or later-stages (series C, series D and beyond). This preference is often due to the VCs expertise as well as the fund size. The likes of Sequoia, Andreessen Horowitz and First Round are great examples of VC funds who invest in early-stage startups. Kleiner Perkins, Accel and Bain Capital Ventures are common late-stage VC investors.
  • Industry focus— specialisation by industry focus is almost always a result of the VC’s expertise. VCs specialising in software or technology investments were likely themselves ex-tech entrepreneurs. Just take a look at the Andreessen Horowitz enterprise technology investment thesis:

“We back entrepreneurs who are building technology for the next generation of enterprise. Many of us are former founders, and collectively, we have achieved exits of over $4 billion with our own companies. Now as investors, we invest in technology — from satellites to open source to security — that transforms the way the world does business.”

  • Geography — geographical specialisation is less common, but does exist since some VCs prefer to have proximity to founders. VCs may also have a better understanding of macroeconomic drivers within particular geographies. That being said, it is unlikely that VCs would pass up on an investment that ticks all the boxes but is not within designated geography.
  • A mix — VCs will often combine the above specialisations into one overall investment thesis that sets out industry focus, cheque size, geography and stage. The following investment thesis template from the Founder Institute is a good example of this:

“[Fund Name] is launching a [$x MM] [Stage] venture fund in [Country / City] to back [Geography] [Sector / Market Companies] [with Secret Sauce]”

— Product.

This is obvious — of course, VCs will care about what kind of products or services your startup is selling. Given the breadth of products and services (e.g., enterprise software products v. eCommerce v. gene therapy services) that are out there, Commercial DD will be highly individualised. However, there’s a standard methodology that VCs will deploy when looking at your product or service.

Almost always, VCs will want answers to the following questions:

  • Value proposition / differentiation — What problem is the startup solving? Is the product differentiated? Does the product offer a quantifiable improvement over competitor products? Is there a roadmap for sustainable differentiation into the future as competitors mimic the product?
  • Stage of development — Where is the product in terms of development stage? What are the key product milestones? What is the timeline for these milestones? What risk factors or roadblocks could impact subsequent development stages (e.g., regulatory approvals)?
  • Defensibility — How easily or quickly can a competitor or new entrant launch a similar product? Which is more important — the swiftness of execution or the startup’s secret sauce? Are intellectual property rights sufficiently protected? Does the startup’s primary intellectual property align with the product? Is the startup reliant on intellectual property licenses from third-parties?

— Business Model / Go-to-Market Strategy.

This may not be set in stone if you’re a pre-product startup, but VCs will want to know how value is created and subsequently monetised. That is, what’s your business model? Your startup might operate under a subscription model (e.g., Netflix or Dollar Shave Club), a marketplace model (e.g., AirbnB or OpenSea), or a transactional model (e.g., Stripe or Block). But whatever the case may be, the assessment of a startup’s business model will be individualised. As with assessing your product, VCs will assess your business model using first principles.

VCs will want answers to the following questions:

  • Who are the target customer segments? How will the target customers perceive value in the product? What are the drivers behind customers adopting your product? Have existing customers been surveyed?
  • How is the product distributed? What distribution channels are the strongest? What is the distribution strategy moving forward?
  • What is the revenue model (i.e., recurring, subscription, one-time fee)? What is the gross margin? What’s the go-to-market strategy?
  • When do you expect to hit your next revenue milestones? How quickly can you expect revenues to grow?

— Market / Industry Focus.

There’s no shortage of failed startups with products in search of non-existent markets. The market in which your startup operates will play a significant role in whether VCs would consider making an investment. But, it’s more complicated than just identifying a “good” market. As a founder, you have to show that you’re not only disrupting an industry, but also fundamentally changing the way customers interact with the target market.

VCs will look at three main factors when conducting market analysis:

  • Size — After all, the difference between a small business and a startup is scalability. VCs are looking to make home runs of 10x-20x on their investment, and even higher if investments are made at early-stage. It could be that an entire VC fund’s success is be attributable to 1 or 2 exits out of 20–30 investments. And so, for your startup to be in contention, you need to have a large total addressable market (TAM) where high-growth can be achieved. As a general rule, VCs will want to see at TAM of at least US$1 billion to warrant an investment.
  • Competition — It might be that you have a large TAM, but are there large incumbents in your market? For example, the TAM for ride sharing might be enormous, but this market is also dominated by Uber and Lyft, so the barriers to entry are likely to be significant. Equally, you may have a large TAM but the market could be completely fragmented into countless small players. So you will have to make a differentiation play to try to distinguish your product from others to gain market share, which could be a costly exercise.
  • Demand — Is there a pent-up market demand for your product? Here’s the bitter reality that founders often forget, the market must actually want what you’re selling. It’s true that customers rarely know what they want ahead of time. But, you have to demonstrate that there’s a strong market pull for your product. The best way you can do this is through your traction metrics — app downloads, unique active users, traffic generated, revenues, or bookings etc.
Source: Shutterstock

Financial DD provides VCs a snapshot of the investment worthiness of a startup. During Commercial DD, you will provide VCs with financial metrics either on your pitch-deck or as responses to their questions. So, you’ll have to paint a financial picture of where you are and where you are going. Also, these metrics will tie into the valuation of your startup and its future growth potential. During Financial DD, VCs will verify these metrics by asking for financial statements, tax returns, forecasts, and key assumptions.

Of course, if we take a traditional view, we know that a company is worth the present value of its future cash flows. However, assessment of valuation and financial metrics becomes slightly more nuanced when it comes to startups given that financials will vary greatly depending on the business model, size, stage and industry, and startups (particularly early-stage startups) are often deficient when it comes to typical financial metrics. For example, a startup may be pre-revenue but its unique active users may be growing at 100% month-over-month.

— Metrics.

Identifying which financial metrics are relevant comes down to your business model. The industry you operate in is irrelevant — rather, how you charge your customers is what is important. It should be noted that this is equally important for startups as it is for VCs. For example, if you’re an enterprise software startup, metrics like annual recurring revenue, bookings, and churn rate will be front and centre in your conversations with VCs. Similarly, if you’re a marketplace startup, metrics like gross merchandise volume, compounded monthly growth rate, customer retention rate, and customer acquisition cost will be important. Tailor the metrics you showcase to VCs to be relevant to your business model. You can see what metrics are relevant for which startup business model here.

— Start with the Assumptions.

Since historical financial metrics may not be available to your startup, you will have to substantiate your forecasts (and financial claims generally) with assumptions. VCs will always want to know the reasoning behind your projections. That is, what you assume to be true such that your projections/forecasts will then be true. You can formulate your assumptions using sources such as market research, website traffic, conversion rates, competitor pricing, customer contracts, or keyword tools etc.

This is the best way to look at your forecasts and assumptions:

If, Assumption #1 and Assumption #2 are correct, then, Forecast #1 will be true.

— Bottom-up Approach.

More often that not, using a bottom-up approach is the preferred method when it comes to forecasting metrics like revenues and costs. This approach uses the key value drivers of the startup to make future projections. Specifically, it achieves realistic figures and excludes external factors like macro conditions.

On the contrary, using a top-down approach will result in exaggerated figures that are unlikely to be realistic. For example, solely suggesting that your expected revenues will be $100 million because you plan to capture 10% market share of a $1 billion market will not be well received by any VC.

Let’s take a look at an example of forecasting revenues using the bottom-up approach for a B2C eCommerce startup (let’s call this Startup X).

  • Business model — Startup X sells eco-sustainable sneakers online at $100 per pair. Customers are acquired purely online through paid and organic customer traffic to their website.
  • Website traffic / Conversion— Startup X had 50,000 website visitors last month, and has historically grown 2% in website visitors per month. Startup X has a sale conversion rate of 5% from its website visitors.
  • Last month’s revenue — Based on the above, Startup X would have generated $250,000 in revenue. That is, 50,000 website visitors x 5% conversion rate x $100 purchase price.
  • Assumption / Forecast — If we factor in the historical growth rate in website visitors and conversion rate, based on the above we can assume that this month Startup X will generate $255,000 in revenue. That is, 51,000 (i.e. 50,000 plus 2% growth) website visitors x 5% conversion rate x $100 purchase price.

There are however limitations to the bottom-up approach. It doesn’t take into account products going viral nor does it factor network effects and word-of-mouth traction. You should look to implement the bottom-up approach in shorter term forecasts (where more foundational justifications are required) and the top-down approach in longer term forecasts (so that you can capture potential traction not yet accounted).

Congratulations, you’re on the home stretch — one more step, Legal DD. If you’re expecting a large cheque size, Legal DD will likely be conducted by a law firm who will prepare a report outlining any red flags. If the cheque size is on the smaller end, the VC fund itself or a sole legal practitioner might carry out this process. Either way, you’ll receive a due diligence checklist asking for a suite documents relating to different aspects of your startup.

— Due Diligence Checklist

The due diligence checklist will be broken down into multiple sections, which might include corporate records, business plan and financials, intellectual property, material contracts, and information relating disputes/litigation etc. Once again, the bigger the cheque size (and the later the round of funding), the more extensive this checklist is likely to be.

Here are some examples of due diligence checklists:

— Virtual Data Room.

The best way to deal with document requests is to setup a virtual data room and create folders corresponding to the sections of the due diligence checklist. You can then upload the relevant documents as they are requested. As a means of best practice, you should setup the virtual data room ahead of time and upload all relevant documents. This will save you from having to rush during the due diligence process. You can use data room providers like Ansarada, Admincontrol, or Digify, or if you want to keep it simple (and free), you can also use Dropbox or Google Drive.

Example Virtual Data Room | Source: Admincontrol

Common Legal Issues.

Issues are inevitable, but a lack of transparency is a sure way to kill your chances of being funded. Transparency is key. So, if there’s an issue that seems worthy of bringing to the attention of the VC, you probably should.

Let’s take a look at two common legal issues that arise during due diligence:

  • Missing or incomplete capitalisation table— to verify the complete shareholding of your startups, VCs will want to see a complete capitalisation table. That means — details of all shares issued (whether to founders, employees, angel investors or other VCs) and any convertible securities (i.e. convertible notes or SAFE) issued. For example, it’s not a good like if your capitalisation table shows that shares have only been issued to you and your co-founder, but as it turns out, 20% of the shares were previously issued to a third co-founder who’s since left the business. The details of the capitalisation table should line up with any share issuance documentation and corporate authorisations approving such share issuances. You can use this free template Capitalisation Table to accurately document your startup’s shareholding.
  • Intellectual property assignment — a startup’s most important asset is its intellectual property. Founders and members of the founding team will often develop and work on their product before incorporating a company. If that’s the case, the founder (not the startup) will own the startup’s intellectual property. VCs want to see that the founder has assigned all relevant intellectual property to the startup itself, given they are investing in the startup. Also, if the template employment contracts for employees and third-party contractors doesn’t already cover intellectual property assignments — the VC will ask that each employee (particularly those who have worked on the product) also assign all relevant intellectual property to the startup itself. Save yourself the hassle and complete these intellectual property assignments ahead of starting the due diligence process. You can use this free template Intellectual Property Assignment Deed to make the assignments.

1 — Virtual Data Room. Setup your virtual data room as soon as possible, even if you’re not fundraising. This is just best practice. As you come across key documents (e.g., company constitution, tax returns, shareholders’ agreement etc.), transfer these into the corresponding folders.

2— Fundraising Process. Select someone from your startup team to help you manage the fundraising process. Think of this as a seperate workstream. That way, at least two people will have visibility over the process. Any initial interactions with VCs should come from the founder and/or senior management team.

3— Think like a VC. Use the due diligence process set out in this article to vet your startup from a VC’s perspective. Write out answers to all the questions that you contemplate VCs will ask. I would go as far as writing an investment memo (like a VC would) about your own startup covering all key areas in this article. That way, you can anticipate questions that a VC might ask. You can use this free template Investment Memo.

4 — Be over-prepared. If you’re going to make claims (whether on your pitch-deck or otherwise) as to future projections, be ready to back it up with well-reasoned assumptions and metrics where possible. Again, I would go as far as annotating your pitch-deck (for your own reference) with a thorough explanation for each figure stated.

5 — Investor Due Diligence. Just like VCs are assessing you and your startup, you should be doing the same for them. Reach out to founders of the VC’s portfolio companies to ask about their experiences working with the VC and what kind of value-add they provide. It’s going to be a 5–7 year relationship at a minimum — so, you better be happy with who you’re going into business.

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Entrepreneur's Handbook – Medium

Author: Baz Banai