How Do Private Investors and Venture Capital Firms Perform Due Diligence?

June 24th 2023

Updated on July 26th 2023

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  • Whether you are looking for venture capital backing for your startup or seek a way to become a private investor in the future, understanding how private investors and venture capital firms perform due diligence is crucial to reach your goals.
  • In this article, we will walk you through the state-of-the-art methods widely used by venture capital firms worldwide.
  • We will wrap up by listing a few pieces of advice for founders currently seeking investment their first private investment.

The Purpose of Due Diligence.

Whether you are looking for venture capital backing for your startup or seek a way to become a private investor in the future, understanding how private investors and venture capital firms perform due diligence is crucial to reach your goals. In this article, we will walk you through the state-of-the-art methods widely used by venture capital firms worldwide.

Mind that there is no universal scenario for due diligence. Investors in various parts of the world have differing preferences for how to parametrize investment opportunities.

For instance, New York-based investors are known to focus on the SWOT analysis while the Bay Area-based investors mostly pay attention to the size of the opportunity, namely the Total Addressable Market (TAM). Similarly, investors’ taste can vary from city to city.

Understanding the purpose of due diligence is a fundamental step before jumping into nitty-gritty details of how due diligence Is performed today.

In general terms, the purpose of due diligence in venture capital firms is to carefully examine and understand potential investment opportunities before making investment decisions as well as moderating the level of investment risk.

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1. The Pre-Due Diligence Process.

Before the start of the due diligence process, private investors and venture capital firms should go through a number of preliminary steps to establish their investment criteria and identify potential opportunities.

Establishing Investment Criteria.

Investors must define their investment criteria to align with their strategic objectives and risk calculation. This criteria may include aspects such as the market focus, the company size, the speed of growth, or the geographic location.

By clearly defining their investment preferences, the equity buyers can narrow their search and focus on opportunities aligning with their long-term goals.

Identifying Potential Investment Opportunities.

Once the investment criteria are established, investors scout for possible investment options. The search process involves:

  • Actively researching and monitoring the market with the help of appointed scouts (usually, seasoned entrepreneurs, industry experts, or other individuals with knowledge of specific markets or tech),
  • Attending industry conferences and networking events,
  • Leveraging on personal professional networks,
  • Observing social media used by many tech founders such as Twitter,
  • Tracking news in the industry via reputable sources of information such as ForbesBusiness Insider, or Harvard Business Review,
  • Tracking new products and gadgets in their industry on websites such as ProductHunt,
  • Tracking crowdfunding websites such as KickStarter or IndieGogo and observing the trends and interest among the audience,
  • Attending demo days at reputable startup accelerators such as Y Combinator or TechStars,
  • Reaching out to business brokers, industry experts, and other sources on information.

Initial Screening and Filtering.

In this stage, venture capitalists initially screen the identified opportunities to filter out those not meeting the basic requirements. This step may involve reviewing high-level information such as company profiles at CrunchBase and in other business databases, executive summaries, or pitch decks. The screening aims to narrow the potential targets for further in-depth evaluation in the due diligence process.

2. Gathering The Information about the Business.

When a number of potential investment opportunities are shortlisted, the due diligence process starts for real. This step aims to understand the company’s know-how, business proposition, team, and current market condition. Of course, as not all the information is available in public, investors need to stay in close touch with the founders in this stage.

Assessment of the Company Background and History.

To start with, investors delve into the company’s background and history. This step includes examining the company’s founding team, significant milestones or achievements, bottlenecks, major pivots and turning points, and overall track record.

Understanding the company’s history builds trust towards the founding team and provides important context for evaluating its potential for future success.

Assessment of the Founding Team and Core Team.

One essential part of the due diligence process in the evaluation of the founding team and core team. Investors analyze the founding team and the core team with respect to their skills, professional experience, and history. 

This incorporates assessing their skill in business, their capacity to execute projects, and their history of effectively managing and scaling companies. Profound specialist education finished with a PhD title and successful exits in the past certainly would earn points here!

A solid and competent founding team is often considered a major sign of a firm’s true capacity for progress. Now begs the question: how does an optimal team look? The common view is that most investment firms prefer investing in teams consisting of at least two founders, while in fact, solopreneurs often become more successful than founding teams. 

According to the urban legend, this preference is associated with the impact that have of teams including multiple co-founders: since no one has majority decision power, the team is easier to steer.

Regardless of how many founders the startup has, responsibilities should be shard logically, and the communication between the founders should be fluent. One can assume that the more a stake, the more time investors will spend observing collaboration between founders to make sure that it’s a synergistic team of high integrity.

Assessment of the Business Value Proposition.

To put it in simple terms, value proposition is the value added by the company, or, the reason why a customer should buy the company’s product or service. If you seek investment, investors will ask you: “Why you?” “Why your product?” “How is it new or different?”

Good value proposition should contain precise target group, clear problem and solution, and clear list of benefits for the customers. As a rule of thumb, providing a painkiller (namely, a product that is absolutely necessary for the customer) is preferred over producing vitamins (experience enhancers) or candies (pure entertainment).

Of course, in practice, estimating value proposition is often a complex, meticulous process requiring taking multiple assumptions, especially if the company pitches novel products in response to the newest demand in the market.

Analysis of the Market Opportunity and the Competitive Landscape.

Another key component of due diligence process is a comprehensive market analysis. Investors assess the target company market, including its size, growth potential, and dynamics.

One established way of building scalable businesses is the “Zero to One” method popularized by the innovator and investor Peter Thiel. This method assumes first dominating a market niche and then expanding to take over the whole market sector. To achieve this goal, the niche must be well-defined and narrow enough and the target market should be much larger.

The popular metrics to evaluate the market opportunity are:

Of course, the above markets relate to each other, namely SOM is a subset of SAM, and SAM is a subset of TAM:

Ontology Of Value Total-Addressable-Market-Serviceable-Available-Market-Serviceable-Obtainable-Market-TAM-SAM-SOM-1024x576 How Do Private Investors and Venture Capital Firms Perform Due Diligence? Business Development  jobs for Masters graduates

Investors also evaluate the competitive landscape to spot existing players, analyze their market share, and potential incoming threats in the market. This analysis helps the investor gauge the company’s ability to capture a considerable market share and sustain a competitive advantage. 

Despite some fresh founders’ beliefs, the existence of market competition is good news to investors!

3. Financial Due Diligence.

Financial due diligence means evaluating the company’s financial performance, stability, and projections.

Reviewing Financial Statements.

Investors screen the company’s books, including reports on assets and liabilities, salaries, and track of the revenue streams and investments / expenditures. This steep sheds light onto the company’s financial health: revenue, resources, and liabilities and allows to calculate and track the runway time.

Analyzing Financial Ratios and Key Performance Indicators.

In addition to reviewing the financial statements, investors analyze financial ratios and Key Performance Indicators (KPIs) to better understand the company’s financial performance.

This assessment may include ratios such as profitability ratios, liquidity ratios, and efficiency ratios. Investors can assess the company’s financial stability and growth potential by comparing these ratios to industry benchmarks and historical performance.

Revenue and Growth Projections.

Of course, investors also evaluate the company’s revenue revenue and growth projections. This analysis helps them determine the company’s ability to generate sustainable revenue and achieve its projected growth targets. Investors may scrutinize the revenue pipeline, customer acquisition strategies, and market trends to assess the feasibility of the company’s revenue projections.

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4. Legal Due Diligence.

The legal due diligence involves a comprehensive review of the target company’s legal documents, including Intellectual Property (IP) protected by patents, copyrights, and trademarks, contracts, and licenses, and spotting potential legal risks.

Reviewing Legal Documents.

Investors cautiously analyze existing agreements such as the previous investor arrangements and business contracts.

This examination assists investors in understanding the organization’s structure, the scope of proprietary Intellectual Property, and administration instruments.

Assessing Possible Legal Risks and Liabilities.

Investors evaluate the startup’s legal threats and liabilities, including prosecution in progress, administrative inconsistencies, and lack of necessary licenses or IP protection.

5. Operational Due Diligence.

Operational due diligence concerns the company’s operational processes, systems, scalability, and growth potential.

Assessing Operational Processes and Systems.

Investors analyze the company’s production cycle to assess their efficiency, adaptability, and compliance with industry standards.

This process incorporates analyzing multiple steps of the process, from the conceptual stage, through production, quality control, to client support. Understanding the production cycle allows investors to assess the company’s capacity to fulfill clients’ needs and scale production.

Evaluating Scalability and Growth Potential.

Investors research the organization’s adaptability and development potential by examining its plan of action and market opportunities. In example, they assess the capacity to extend geologically, enter new market sections, or further innovate current products. Evaluating scalability helps investors determine the company’s potential for long-term success.

Analyzing The Supply Chain and Distribution Channels.

Investors also analyze the company’s supply chain management and distribution channels to assess their effectiveness and reliability. This process includes evaluating relations with suppliers, inventory management practices, the quality of logistics and procedures involving suppliers.

Understanding the supply chain and distribution channels helps investors identify potential risks and challenges impacting the company’s operations and profitability.

6. Technological and Intellectual Property Due Diligence.

Technological and Intellectual Property (IP) due diligence involves evaluating the company’s technological infrastructure, IP assets, and the resulting competitive advantages in the market.

Evaluating Technology Infrastructure.

Investors assess the target company’s technological infrastructure, including software and hardware systems, data management, cybersecurity and data protection practices.

Reviewing Intellectual Property Rights.

Investors examine the company’s licensed innovation portfolio, including licenses, trademarks, copyrights, and proprietary advantages such as patented technologies and their commercialization potential. Understanding the intellectual property landscape helps investors evaluate the company’s competitive advantages and ability to protect its market position.

Assessing Competitive Advantages in the Market.

Investors investigate the target company’s competitive advantages, such as unique technologies, proprietary processes, or exclusive partnerships.

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7. Market Due Diligence.

Market due diligence focuses on evaluating the target company’s target market in detail: customer demographics, expectations, and behavior, and detailed market stratification.

Identifying Target Market Segments.

Investors analyze the company’s target market segments to understand their size, growth rates, and key characteristics.

Analyzing Customer Demographics and Behavior.

Investors examine the target company’s customer demographics, including age, gender, income levels, and geographic location. This analysis helps evaluate the company’s ability to effectively reach and engage its target customers.

Additionally, investors may analyze consumer behavior, purchasing habits, and customer satisfaction to evaluate the company’s product-market fit and potential for growth.

Assessing Market Size and Growth Potential.

Investors assess the overall market size and growth potential of the target company’s industry or niche. This includes evaluating market trends, the market share of competitors, and forecasted growth rates.

Understanding the market dynamics helps investors determine the company’s growth prospects and the level of competition it may face.

Evaluating Market Competition.

Investors analyze the market to recognize key contenders in the market, their portion of the cake, and their competitive advantage. They also assess consumer faithfulness and advertising strategies for various brands in the market.

8. Investment Decision and Post-Due Diligence.

After completing the due diligence process, the investor analyzes the gathered information, evaluates the risks and opportunities, and makes a final investment decision.

Assessing Investment Risk and Return.

Investors take into account the risks and potential returns associated with the investment opportunity. They consider market conditions, competition, regulatory risks, financial stability, and growth prospects. This assessment helps investors determine the level of risk they are comfortable with and whether the potential returns justify the investment.

Negotiating Investment Terms.

If investors decide to proceed with the investment, they negotiate with the company to finalize the investment terms. It includes discussions around valuation, equity or debt structure, shareholder rights, and specific conditions or milestones. The negotiation process aims to align the interests of both parties and ensure a mutually beneficial agreement.

Post-Due Diligence Monitoring.

After the investment is made, the investor engages in post-due diligence monitoring to track the progress of the investment and mitigate risks.

This may involve regular communication with the target company, reviewing financial reports, attending board meetings, and providing guidance or support whenever necessary. The post-due diligence monitoring phase aims to safeguard the investment and maximize its potential for success.

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How To Prepare for Due Diligence?

Now, we would like to share a few pieces of advice for founders who seek venture  investment at the moment.

Build a Strong Bond With Your Co-founders.

The synergy in your team is one of the key actor which will decide about your success or failure to land venture capital. Before going out to the wild and seeking investors, make sure that you have common vision and objectives with your co-founders, well-defined responsibilities, fluent communication, and plan of action in case of differing opinions or other obstacles. If you built a fresh team for the project, perhaps it’s time to travel together to get to know your cofounders better.

Please find more information on finding and maintaining strong bonds with co-founders in our article “Business Development Responsibilities: Looking for a Co-founder? Read This Before You Make Your Choice.”

Expose Your Product Online.

In most cases, the cost of the lost opportunity is too high to stay quiet about your products and inventions. If you are investment-ready, talk about your project on social media to increase your odds of getting noticed. You could even consider a crowdfunding campaign to raise awareness about what you do.

Furthermore, be open about your plans on social networks such as LinkedIn. Please find more information on how to effective network on LinkedIn in our article “Top 11 Rules For Effective Networking on LinkedIn.”

Create a Strong Pitchdeck.

…and make sure that it’s easy to find. Pitch deck is like a business card in the startup world and you should always jeep it at hand. Also, remember to memorize your numbers as having them on paper is not good enough. Investors need to feel that you have your finances under control.

Surround Yourself With Investors.

If you feel investment-ready, you might consider moving to one of the startup hubs where many investment firms and private investors reside in a relatively small area, such as San Francisco, New York, Berlin, or Singapore. More networking opportunities means more exposure, better chance for serendipity and fruitful introductions.

Answer Investors’ Questions Honestly and Thoroughly.

When interrogated about the history of your company, don’t hide any information about the pivots, goodbyes, and bottlenecks you went through. In the world of venture capital, honestly is gold. In particular, don’t hide the fact that you have competition but rather the opposite: share openly how big and rich they are! Believe it or not, it’s good news.

Conclusion: How Do Private Investors and Venture Capital Firms Perform Due Diligence?

In conclusion, due diligence is vital in private investment and Venture Capital scene. It allows investors to gather comprehensive information, evaluate risks and rewards, and make informed investment decisions.

Each phase of the process contributes to a holistic understanding of the investment opportunity, from assessing financial performance and legal aspects to evaluating market potential and growth capabilities.

By conducting thorough due diligence, investors can mitigate risks, identify opportunities, and increase the likelihood of successful investments. Remember, thorough due diligence is key to achieving investment success in the dynamic and competitive world of private investing and venture capital.

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Please cite as:
Siddiqui, H, Bielczyk, N. (2023, June 24th). How Do Private Investors and Venture Capital Firms Perform Due Diligence? Retrieved from https://ontologyofvalue.com/how-do-private-investors-and-venture-capital-firms-perform-due-diligence/

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