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How to Conduct Startup Due Diligence

The difference between investing and gambling

Zeb HastingsJan 12Edit postPin on home pageExclude from Top

When a venture investor has conviction in a founder and business, the decision to invest will be easy. We’ve all heard stories of startups getting a term sheet after the first meeting (this is rare). Even in these exceptional cases, there is a caveat: venture capitalists need to conduct due diligence on the founder and the business to ensure there are no issues with the investment opportunity. Today we will discuss what due diligence is and some tips for conducting it.

What is Due Diligence?

Every financial investment has a level of risk associated with it. Startup investing is particularly risky, given high failure rates. Due diligence is a formal legal process and investigation that helps determine whether an investment will be beneficial. This process looks at various parts of a business, including intellectual property, business operations, and financial track record. There are also likely background checks into the founders and others associated with the company, including customers and other investors on the capitalization table.

How to Conduct Due Diligence

In general, there are three stages of conducting diligence:

  • Preparation: In this stage, investors set priorities for what they want to discover. Different investors will weigh certain business aspects as a higher or lower priority.
  • Investigation: Investors collect relevant information from the business. All necessary documentation, interviews, and other resources will be collected and reviewed.
  • Results: Once the investigation is complete, the investor will decide to wire money and sign a term sheet.

Due diligence can be a lengthy process that can last weeks. To better prepare for pending due diligence, there are steps that startups can take to speed up the process and make things readily available for the investor to access. One highly recommended method is to prepare what is known as a “data site” or “data room,” which is a folder with all pertinent material about your business that you can easily forward to an investor. Some of the material that founders should include in the data room are copies of original business organization (Delaware C-Corp), a detailed list of stockholders and capitalization table organization, and copies of financial records, budgets, significant customers, and employment agreements.

There are several resources that detail documents you should include in data rooms. You can find Y Combinator’s here, and you can discover Cooley’s here.

Things to Consider When Conducting Due Diligence

Diligence can vary based on the different stages of a business. Early-stage companies have less financial information than later-stages, and other verticals serve other customers.

  • Seed: In this stage, even though there is little diligence to conduct, it is still valuable for both founders and investors. For investors, it always helps to determine what it will take for a company to be successful. If you’re not doing this, then you are merely gambling and not investing. It’s valuable for founders because the process provides insight into what VCs care about, how they work, and if they will be a great partner. In this stage, it’s good to start by understanding the market. What solution is the founder going after? Is it big enough? Is it the right time? Next is to focus on the founder, their vision, ability to recruit people, and execute. Last is the product and technology, which might be nothing more than a PowerPoint at the earliest stage.
  • Series A and Onward: In this stage, the market is no longer a future state; it should be a present state. Ask if people are paying now, or is this something that will they will purchase down the line? Customer feedback and experience also come into play at this stage. The team is much more robust at this point, and investors can gauge how they function. They can also assess the founders’ leadership skills and the company’s board construction. VCs can do a small financial model, measure success, and figure out what it will take to succeed.
  • Lead vs. Co-Investor: As a lead investor in a startup funding round, it is critical to document all of your findings and share them with your co-investors. It is your responsibility to help bring the financing together, so your references and diligence will be crucial in making that happen. With that being said, co-investors should be conducting their own diligence as well. When you are a VC managing other people’s money, you should not be outsourcing your diligence process to the lead. This process, in many ways, should be a collaboration.

This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.

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