VCs Due Diligence Process

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In this article, we're delving into “VCs Due Diligence Process,” and we previously covered “Initial Meeting & Evaluation in Startup Investment - Part 2”. If you miss out, you can read the article here. DON’T FORGET TO COME BACK TO THIS ARTICLE.  

So let’s start the VCs Due Diligence Process

Due diligence represents the investigation phase of venture capital investing, where VCs conduct comprehensive research to validate their initial assessment and uncover potential risks before making an investment decision. This critical phase typically follows the initial screening and involves 20+ hours of intensive analysis per potential investment.

Market Size Analysis (TAM/SAM/SOM)

Business diligence begins with rigorous market size assessment, as VCs need evidence that startups can achieve the 10x+ returns required for their investment thesis. The analysis includes three key components:

• Total Addressable Market (TAM): The entire market demand for a product or service globally. For example, when Airbnb launched, its TAM encompassed the entire global hotel and accommodations industry, valued in the hundreds of billions.

• Serviceable Addressable Market (SAM): The segment of TAM that the company can realistically reach with its current products and geographical presence. For a US-based software company, SAM would represent the portion of the global market it can service from its current location.

• Serviceable Obtainable Market (SOM): The realistic portion of SAM that the company can capture, considering competition, marketing budget, and sales capabilities - typically the target market for the next 12-24 months.

• Customer Interviews and Validation: VCs conduct extensive customer validation through direct interviews with existing and potential customers to assess product-market fit. This involves gathering customer feedback, analyzing retention rates, and understanding the customer acquisition process. Evidence of strong product-market fit significantly reduces the risk of product failure and supports organic growth potential.

• Competitive Landscape Assessment: The competitive analysis examines market positioning, differentiation strategies, and competitive advantages. VCs evaluate how the startup compares to existing players, potential future competitors, and whether the company has sustainable competitive moats. This analysis helps identify both opportunities and threats in the market landscape.

Technology Assessment

Technical due diligence involves a comprehensive review of the startup's technology infrastructure, architecture, and code quality. Key areas include:

• Core Technology Review: Examination of codebase, system architecture, and infrastructure to ensure scalability and maintainability.

• Scalability Assessment: Analysis of whether the technology can handle growth and increased user demand.

• Security Evaluation: Review of cybersecurity measures, data protection protocols, and vulnerability assessments

Intellectual Property Rights

IP due diligence verifies ownership and protection of intellectual property assets. This includes:

• Patent Portfolio Review: Assessment of existing patents, pending applications, and potential patent infringement risks.

• Trademark Protection: Verification of trademark registrations and brand protection strategies.

• Trade Secrets: Evaluation of proprietary information protection and non-disclosure agreements.

• Freedom to Operate Analysis: Ensuring the startup can operate without infringing on third-party IP rights.

Product Roadmap and Development

VCs assess the product development strategy, future feature plans, and the startup's ability to execute on its technology vision. This includes evaluating the development team's capabilities, project management processes, and alignment between the product roadmap and market needs.

Background Checks and Verification

Enhanced background verification has become increasingly important in the post-FTX era, with leading VC firms conducting comprehensive checks on founders and key management. Background investigations typically include:

• Professional History: Verification of employment history, previous ventures, and track record.

• Education Credentials: Confirmation of degrees and professional licenses.

• Legal and Regulatory Issues: Review of civil, criminal, or regulatory disputes.

• Reference Checks: Conversations with previous colleagues, investors, and business partners.

Reference Verification

VCs conduct extensive reference checks beyond those provided by the CEO, often seeking "off-sheet" references to gain unbiased perspectives. The process focuses on confirming the management team's execution capabilities, leadership skills, and integrity.

Team Dynamics and Experience

Assessment includes evaluating whether founding team members have worked together previously, their complementary skills, and their ability to adapt and scale the organization. Strong team dynamics and relevant experience significantly reduce execution risk.

Revenue Model Analysis

Financial due diligence examines the startup's revenue generation mechanisms, pricing strategies, and revenue stream sustainability. Key components include:

• Revenue Structure: Analysis of different revenue streams and their contribution to overall profitability.

• Pricing Strategy: Evaluation of pricing models and their alignment with market expectations.

• Revenue Recognition: Review of accounting practices and revenue recording methods

Unit Economics Assessment

Unit economics analysis is critical for understanding business model viability. VCs focus on:

• Customer Acquisition Cost (CAC): Total cost to acquire a new customer, including marketing and sales expenses.

• Customer Lifetime Value (LTV): Total revenue expected from a customer over their relationship with the company.

• LTV/CAC Ratio: Ideally 3:1 or higher, indicating a scalable business model

• Payback Period: Time required to recover customer acquisition costs

Cash Burn and Runway Analysis

Financial assessment includes detailed analysis of cash flow, burn rate, and runway calculations. VCs evaluate the startup's path to profitability and funding requirements for reaching key milestones.

Capitalization Table Review

Cap table due diligence verifies ownership accuracy and identifies potential issues. The review includes:

• Ownership Verification: Confirmation of shareholding percentages and equity distribution.

• Option Pool Analysis: Assessment of employee stock option pools and dilution impact.

• Historical Transactions: Review of previous funding rounds, share transfers, and amendments.

• Documentation Completeness: Verification of signed agreements and proper legal approvals.

Existing Investor Rights

Analysis of existing investor agreements, liquidation preferences, and any restrictions on future fundraising or operations. This includes understanding anti-dilution provisions, board composition rights, and information rights of current investors.

Market Risks

Market risk evaluation includes assessment of market timing, competitive dynamics, and macroeconomic factors that could impact the startup's growth trajectory. VCs analyze market volatility, regulatory changes, and potential disruption from new technologies or business models.

Regulatory Risks

Regulatory risk assessment examines current and future compliance requirements, potential regulatory changes, and their impact on business operations. This includes understanding licensing requirements, industry regulations, and cross-border compliance issues for companies with international operations.

Operational Risks

Operational risk management focuses on day-to-day business operations and potential disruptions. Key areas include:

• Process Risks: Evaluation of business processes, quality control, and operational efficiency.

• Technology Risks: Assessment of system failures, cybersecurity threats, and technology dependencies.

• Key Person Risk: Analysis of dependence on key individuals and succession planning.

• Supplier and Partner Risks: Review of critical supplier relationships and partnership dependencies.

The due diligence phase culminates in a comprehensive risk assessment that weighs identified risks against potential returns, ultimately informing the investment decision and deal structure. VCs use these findings to negotiate appropriate protections, pricing, and terms that reflect the risk profile of the investment opportunity.

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