Venture Capital Due Diligence: A Quick Introductory Guide

This is part of GoingVC’s Research Series on Venture Capital Due Diligence

First, Who are Venture Capitalists?

Venture Capitalists (“VCs”) are financial intermediaries who raise money from investors, known as limited partners (“LPs”), and give private companies that money in exchange for equity (usually this means shares of stock in the company).

In addition to investing capital, VCs also spend their time and resources helping the management team grow the company and become successful . Their ultimate goal is to achieve an “exit event” such as a public offering (IPO) or acquisition by another, larger company. These earnings are shared with the investors and managers of the venture capital fund and can be reinvested into new opportunities. This cycle represents the flow of funds in venture capital.

In his book Secrets of Sand Hill Road, Scott Kupor cites a 2015 study by Ilya Strebulaev of Stanford University and Will Gornall of the University of British Columbia that states since 1974, 42 percent of all US company IPOs were venture capital-backed. This accounts for 63% of the total market capitalization (i.e. value) of public companies created since that time.

What Venture Capitalists Do

The Venture Capital industry plays an important role in the development and growth of businesses across the world. This entire series is about the processes venture capitalists perform to find promising companies to invest in.

As you may know, many startups need money in order to build a team, develop a product, and bring that product to market. While some founding teams can fund themselves (this is known as bootstrapping), many require additional capital from investors to achieve these goals.

For companies seeking investment, raising capital from these institutional investors is often a daunting task. And sometimes, the odds are stacked against them.

Source: VENTURE CAPITAL & THE FINANCE OF INNOVATION (2011)

As you can see in the above graphic, not only can it prove challenging to build a successful company, but it is just as hard to raise money from venture capitalists. This is partially due to the asymmetry between the two. Entrepreneurs have only so many opportunities to build and scale a successful company, while VCs on the other hand, have the advantage of being able to decide among potentially thousands of opportunities.

The due diligence process serves not only as a function to better understand companies, but also to quickly screen out those that may not be successful or fit within the fund guidelines.

What exactly is “Due Diligence?”

Venture Capital investing requires not only figuring out what companies to invest in, but also requires the monitoring and eventually exiting of those investments. In this series, we will focus on two investing activities: prospecting for new opportunities and performing analysis on every critical component of the company.

The phrase due diligence is one commonly known to analysts and investors in publicly traded securities, who benefit from publicly available documents, professional analyst opinions, and endless streams of relevant data. On the other private side of the investing world, especially at early stages, due diligence for VCs can take on a different meaning.

Due diligence is the term used to describe what an investor does to evaluate a potential investment opportunity. For venture capitalists, this is both a very critical step and a challenging one. This is because the thorough investigation across a founding team, market, business, products, and financials involves lots of assumptions and often few reliable signals.

VCs can set themselves apart by developing consistent and methodological approaches to due diligence that create better means of sourcing and evaluating investment opportunities. Good VCs do much more than write checks. They work with the portfolio companies to carve our marketing channels, identify and hire top talent, bring products to existing networks — actively increasing the probability of success with support.

It starts, however, with due diligence. And in this series, we will cover all of the essential steps.

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