Due diligence is the process that venture capital investors use to vet a potential investment. The importance of due diligence is highest in the seed and early-stage funding of a company, when a startup is still in the process of hiring a professional management team, creating a commercialized product, and developing its overall brand and reputation in the marketplace.
Due diligence is enormously important during the VC investment process due to the risky, speculative nature of new startups. Less than half of all startups that receive seed financing ever raise another round of capital, so it’s essential that VC investors mitigate their risk as much as possible upfront. Those startup risks are only magnified when new, emerging or unproven technologies are at play. Thus, you can count on a VC firm to conduct a due diligence process lasting several weeks or longer to “kick the tires” and make sure that all of the promises and assurances of the company’s founders stand up to greater scrutiny.
While every VC firm has its style and approach to due diligence, the process usually proceeds as a series of different phases or stages. If everything checks out in one phase, then it’s time to move on to the next phase of due diligence. For example, the first thing that VC investors will want to do is check on the background of the company’s founders. There’s much less risk working with a serial entrepreneur than a first-time entrepreneur. And there’s much less risk working with someone who has an industry background than an academic background (such as a group of Ph.D. students who are convinced that they’ve created the greatest thing since sliced bread).
Next, VC investors will want to examine your product or service. If you have customers or users already, they may want to talk with them. If you have any beta tests or field tests, they may want to see the results and initial observations. This is not mere curiosity on the part of the VC investor – he or she wants to be confident that you have a real product with plenty of long-term revenue and profit potential. If everything checks out here, VC investors will likely want to drill down on your financial projections, stress-test some of your future scenarios, and talk with industry insiders to see just how viable your new product or service is.
The last stage of due diligence – assuming everything else checks out, and the VC team is comfortable with your ability, background, and experience – is to run the numbers one last time for economic viability and future revenue. VC investors will be much more comfortable with your company if you can show that you have a significant competitive advantage over your peers (such as some form of intellectual property that others can’t match).
Due diligence occurs in every subsequent round (e.g., Series A, Series B, Series C), but can often be done on a significantly scaled down level once the initial due diligence has been completed. A lot depends on the amount of capital being committed, changing market conditions, and the perceived risk/reward profile of your new startup company.