Decoding the Founder-VC Relationship: #2 Due Diligence

We continue the Founder-VC series by diving into the diligence process that VCs employ while evaluating a possible investment. The diligence process itself builds on themes that we explored earlier like- Market Potential, Team Strength, and financial traction.

This process helps investors avoid problems, figure out if a startup is likely to succeed and negotiate good deals. Doing thorough research minimizes the risk of making Type-1 errors and improves the chances of supporting startups that have a right to win. The significance of making smart decisions in the unpredictable world of venture capital, protecting investors' money, promotes the requirement for a stringent diligence process.

Now that we know the importance of due diligence in VC, let’s break down each venture capital due diligence process component.



The Components of Due Diligence:


1)     Assessing the Product/Service

Value proposition: What problem does your product or service solve? This often involves a demo from the founders to showcase how their product/service works.

User stats and info: We check things like- how often people use the product, What the interaction time with the product is, and other relevant metrics to gauge customer stickiness.

Customer feedback: It’s important to ensure that there isn’t any disconnect between the product and the target audience. This involves getting on customer feedback calls, understanding their use case, and developing an ICP (ideally the founder’s job)

Development stage: What stage is the product at right now? What are its accomplishments? What are the near-term and medium-term goals? We ask founders to come up with a timeline for these goals.


2)     Founder-Diligence:

Early-stage startups, by definition, haven’t been around long enough to help investors assess their potential. Hence, due diligence at this stage starts with VCs checking the founders’ backgrounds. We make reference calls and talk to as many people as possible, including founders’ former colleagues, customers, and investors. Questions to founders would generally revolve around:

Personality traits of the founders: Are they Diligent, resilient, curious, and optimistic.?

Founders’ professional background: How does the founders’ previous experience align with the market?

Past achievements: What have they accomplished in their careers? Have they excelled in sales, recruited a strong team, or helped their previous employers enter new markets?

Founders' relationship: Do they know each other well and what have they achieved together?


3)     Business Model:

Founders need to demonstrate clarity in how they plan to make money. This involves founders having a complete understanding of their costs, revenues, and the plan to scale.

Pricing strategy: Will it be through selling directly, subscriptions, advertisements, or licensing?

Distribution channels. How is the product reaching your customer, and what was the rationale for choosing that method?

GTM strategy. How are you going to introduce your product or service to the market and get people to use it?


4)     Market Analysis:

Venture capitalists analyze the target market to gauge its size, growth potential, and competition. They assess market dynamics, customer segments, and the startup's unique value proposition to evaluate market fit.

Differentiation: How will this startup stand out and outperform competitors?

How many countries are visible in the picture & how does its GTM differ in each market? Is the startup aiming for a large enough market? What is the plan for expansion?


5)     Financial due diligence:

Comprehensive VC due diligence involves studying a startup's financials to assess its economic viability, revenue model, and capital requirements. Investors look for potential issues in the financials and ask for metrics like customer lifetime value, customer acquisition cost, retention rate, and revenue. The specific metrics depend on the industry, such as annual recurring revenue, churn for software startups and user acquisition & engagement stats for EdTech startups.


6)     Legal and Regulatory Compliance:

Assessing investment risks through due diligence helps identify potential risks that might arise in the future. This includes evaluating the startup’s financial health, legal and regulatory compliance, intellectual property protection, and potential liabilities. Assessing and identifying investment risks through due diligence early in the process allows investors to make informed decisions and consider risk mitigation strategies.

Regarding intellectual property rights: Are your intellectual property rights sufficiently protected? Does your startup rely on licenses from others? Do you have any patents? How easy would it be for competitors to copy your technology, Company structure and rules. How is your company organized?


7)     Exit Strategy:

Investors conduct due diligence in startup investments to evaluate potential exit options, such as acquisition or IPO. This includes gathering information to create a plan for a return on investment.

Exit plan and vision: When do you think you can exit? Being transparent about your timeline enables investors to assess if their investment objectives align with your startup’s strategies.

 Having a clear exit plan shows investors that you’ve thought things through and have a solid roadmap.


8)     Valuation:

The thorough examination significantly influences the success of an investment, especially when determining a valuation. It assists investors in confirming whether the proposed valuation is realistic based on the company's financials, market potential, and competitive positioning. It also empowers investors to negotiate terms if necessary. We will explore Valuation dynamics between Founders & VC in the future.


Wrapping Up:

Due diligence is pivotal in venture capital investments, encompassing scrutiny of startup finances, market viability, management, IP, and competition. This process enables informed decision-making and risk mitigation. Additionally, it aids startups by offering feedback, refining strategies, and fostering transparency between investors and founders.

In the dynamic landscape of venture capital, due diligence remains paramount. As technologies, industries, and business models evolve, rigorous due diligence is indispensable. It guides through the complexities of the startup ecosystem, enhances the prospects of entrepreneurial success, and propels innovation.

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