Venture capital (VC) is a critical form of financing for emerging businesses, often in high-growth sectors such as technology, healthcare, and clean energy. Venture capitalists not only provide financial capital but also contribute value in the form of mentorship, access to networks, and strategic guidance. Yet, inherent in these investments is a significant amount of risk. To mitigate this risk and increase the likelihood of a successful return, venture capitalists perform due diligence.
Due Diligence: A Primer: Due diligence is a process of investigation and evaluation, undertaken by venture capitalists to assess the viability, potential, risks, and returns of an investment. This critical procedure involves examining various facets of a startup – including its team, product, market, financials, legal standing, and other key areas.
Team Evaluation: Evaluating the startup's management and team is crucial as they are the driving force behind the venture. This includes an assessment of the founders' experience, their domain expertise, ability to lead, the team's cohesion, and how they respond to adversity. For instance, when Google Ventures invested in Uber in 2013, part of their due diligence involved gauging the capabilities and resilience of the founders Travis Kalanick and Garrett Camp, in addition to assessing the business model.
Product Assessment: Venture capitalists will conduct an in-depth analysis of the product or service offered. This includes understanding the product's technical robustness, usability, market demand, scalability, and competitive advantage. As an example, before Benchmark Capital invested in Twitter in 2009, they tested the product intensively, used it personally, and found that it met a significant market need for real-time, short-form communication.
Market Analysis: Investors will also conduct an in-depth analysis of the target market. They must understand the market size, growth rate, competition, trends, and dynamics. This step is essential to determine if there is a substantial addressable market for the startup's product or service. When Sequoia Capital invested in WhatsApp, they identified a substantial global market for the messaging app, recognizing that the shift toward smartphones created a significant opportunity.
Financial Review: A thorough review of the startup's financials is essential. This includes reviewing past and current financial statements, revenue models, burn rate, profitability projections, and assumptions underlying these projections. For example, when Accel Partners invested in Facebook in 2005, they reviewed Facebook's financials and revenue models, which included advertising and virtual goods, to understand the potential for scale and profitability.
Legal and Regulatory Compliance: Investors need to ensure that the startup has complied with all relevant laws and regulations, has the necessary licenses, and does not have any outstanding legal issues. When investing in Theranos, many investors overlooked this aspect of due diligence, which led to significant losses when the company was found to have regulatory compliance issues and inaccurate claims about its technology.
Reference Checks and Third-party Verification: Investors should also conduct reference checks with previous employers, colleagues, or industry insiders and verify claims through third-party sources. Andreessen Horowitz, for example, is known for its comprehensive due diligence process, which includes intense reference checks before any investment.
Exit Strategy: Finally, investors must have a clear exit strategy. They should understand how they will get a return on their investment – typically through an acquisition or an initial public offering (IPO). For instance, when investing in Dropbox, Sequoia Capital would have considered potential exit strategies, including the possibility of the cloud storage company eventually going public, which it did in 2018.
Due Diligence Across Different Startup Stages
Venture Capitalists perform due diligence differently at various stages of a startup's lifecycle, reflecting the unique nature and risks associated with each stage. Let's discuss the considerations for due diligence at the seed, early-stage, and later-stage investment rounds.
Seed Stage Due Diligence: At the seed stage, startups usually have an idea, a prototype, or a minimally viable product, but they are yet to generate significant revenue. During this phase, the focus of due diligence is largely on:
Team: The founding team's skills, expertise, dedication, and vision are critically evaluated. This is because there's usually not much else to evaluate—no customers, no revenue, and often no finished product. The question is whether the team can convert their idea into a viable business.
Market Opportunity: The potential size and growth rate of the market are examined to ensure the idea could conceivably lead to a large-scale business.
Business Model: While this might not be fully developed, it's important to understand how the founders plan to generate revenue once the product is launched.
For instance, when Y Combinator invested in Airbnb at the seed stage, much of the due diligence centered around the founding team and the potential market opportunity, given the limited track record and the early stage of the business.
Early-Stage Due Diligence: Once a startup has some traction, the focus of due diligence shifts slightly. The business has likely started generating some revenue, has a growing customer base, and is starting to scale. Here, the due diligence would focus on:
Product/Market Fit: The investors need to understand how well the startup's product fits into the market. They'll look for signs of strong customer engagement, high retention rates, and solid unit economics.
Growth Metrics: Key performance indicators (KPIs), like user acquisition cost, customer lifetime value, monthly active users, churn rates, etc., will be examined.
Financials: The startup's financial health and projections come into sharper focus. Investors will want to understand the burn rate, revenue growth, and the startup's pathway to profitability.
For example, when Peter Thiel's Founders Fund invested in SpaceX during the early stage, they would have performed due diligence on these aspects, understanding how SpaceX's products fit into the growing private space industry and evaluating the company's key growth metrics and financials.
Later-Stage Due Diligence: In later stages, startups are typically well-established businesses with substantial revenue and a clear growth trajectory. Here, the focus of due diligence includes:
Financial Performance: A detailed review of financial performance over several years is conducted, including profit margins, cash flow, and EBITDA.
Scalability: The ability to sustain and manage growth becomes a focus. This includes evaluating the company's operational efficiency, technology infrastructure, and organizational structure.
Legal Due Diligence: The examination of legal aspects becomes more thorough, including potential liabilities, compliance, intellectual property rights, contracts, and more.
Exit Strategy: As the startup matures, the potential exit strategies become more concrete, whether it's an IPO or acquisition.
When SoftBank's Vision Fund invested in WeWork at a later stage, their due diligence process would have incorporated all these elements. However, critics argue that SoftBank may not have been rigorous enough in assessing WeWork's financial performance and governance structure, which subsequently led to issues.
Due diligence in venture capital is a dynamic process that adjusts its focus according to the stage of the startup. As a startup grows, the due diligence process becomes more complex and multifaceted, requiring venture capitalists to have a deep understanding of different industries and stages of business development. Due diligence is a rigorous and essential process that can significantly mitigate the inherent risks in venture capital investments. By thoroughly examining a startup's team, product, market, financials, and legal standing, investors can make more informed decisions and increase the likelihood of a successful return on investment. A robust due diligence process doesn't guarantee success, but it reduces blind spots, helping investors to avoid potential pitfalls and capitalize on promising opportunities.