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As a secure workspace, designed for venture capital funding projects , FirmRoom has the opportunity to work with startups looking for funding and the venture capital firms looking to invest in them.
This experience has given us insights into the challenges involved in venture capital due diligence from both perspectives. In this article, we go through these challenges, highlighting the issues that need to be addressed to ensure value creation in VC transactions.
Venture capital due diligence is the process through which investors at the venture capital phase conduct a thorough evaluation of a company’s potential to decide whether they should invest in the startup, and under which terms.
Given the specific nature of startup companies (few financial records, little track record, and possibly undefined target market), venture capital due diligence brings a particular set of challenges for VC investors.
Due diligence of any investment is important, but arguably, none more so than for those at the venture capital stage. Companies at this stage tend to possess several characteristics which make their value (or potential) more difficult to establish. These characteristics include:
Most companies funded by venture capital firms have relatively little history, meaning there is less information to make informed decisions on.
While the common assumption is that startups experience explosive growth, the short-term reality is often far more volatile growth, making long-term growth harder to project.
There’s a good chance that a startup will already have claims on its equity from early-stage investors or founders that have since the business.
If the product or service is new, there may be no proven mass market for it, even if early sales have been achieved.
Faced with this reality, VC investors still need to make an informed decision, reduce their risks, and uncover the true value of the startup. Even with less information, investors need to reach a point where they have enough information to gain a good picture of the company and its market.
This means combing through whatever information exists on the company and effectively utilizing what amounts to a mosaic theory of investment.
It’s important that this is conducted as soon as possible. More important still, is that no mistakes are made. Accurate and thorough due diligence is where value is created.
Achieving this requires a project management platform like FirmRoom (See a VDR providers comparison). These platforms tend to underpin successful due diligence, which is why they are continuously used by the largest VC companies as well as startups looking for funding.
On the surface, most startups don’t have much information.
But successful VC investors will go well past the surface in their due diligence process when looking at a potential company to invest in.
Our suggested VC diligence checklist includes:
In broad terms, due diligence of venture capital investors involves three stages:
Whereby the venture capital company meets the owners and decides if they can work well together.
Whereby the venture capital company looks at the company beyond its pitch deck, ticking off many of the boxes listed in the previous section.
Whereby the venture capital company puts a legal contract in place to acquire equity in the company pending certain conditions.
There is a reason that all venture capital companies and startups use data rooms for their due diligence.
Due diligence is, at its core, a highly structured process with lots of detail, lots of collaboration between colleagues, and lots of detail. This combination means that it’s simply not something that can be conducted over Slack.
Add to this to the fact that most VC companies will be conducting due diligence on several startups at once, and the issue becomes even more pronounced.
A well-chosen data room for due diligence will bring:
Enabling the VC firm to create a coherent setup for the hundreds of documents that come their way. Startup founders are typically a fast-paced disorganized bunch. When there’s several sending documents at once, you need a structured system to cope.
By creating structure, the VC firm enables better communication both in-team and with the startup founders. Better communication enables VC firms to ask the questions that need to be asked.
Efficiency is important in the VC world. If there is a unicorn’s pitch deck sitting on the company’s servers, it’s better that due diligence is conducted quickly rather than slowly. Other VC firms won’t wait around if they spot the opportunity.
All of the above contributes to risk reduction: Risks that the company fails to spot red flags in the startup’s business model, financial results, or documentation, risks not observed in the startup founder’s character, and the risk of losing a great deal.
Additionally, at FirmRoom, we have created an importable due diligence checklist, incorporating all of the necessary steps and information needed to move forward.
Here are five tips we believe we stand startups in good stead when preparing for due diligence:
You’re expected to mess up; you’re also expected to be honest. VC companies generally maintain a policy of dropping a company, regardless of how promising, if the startup founders have been dishonest in their dealings.
You already know several of the documents that VC companies will look for, so don’t wait to be asked for them. Retrieve them in advance and ensure that they’re well marked (Incorporation.pdf, client list.xls, etc.)
As mentioned above, VC investors typically work with startup founders on the basis of their ideas, not their organizational skills. But nobody wants to work with somebody they think will be a disaster, so be as organized as possible.
All of the above calls for a VDR. In addition to fulfilling these goals, it will enable you to keep deals on track, to analyze individual investor activity and the most commonly accessed files and documents, and enable/disable viewers, among other benefits.
There are a vast number of risks in a due diligence process for both the VC company and the startup founder, among them:
Even with contracts that cover issues around good faith, the startup founder can provide misleading information that could potentially end up destroying value for the VC company.
Unless the VC company is armed with a structured approach to due diligence, it’s more likely than not that a piece of relevant information that would otherwise change the nature of the deal could slip through the net.
Once a startup founder has sent information to a VC company, unless it’s been kept behind a watermark on the virtual data room, how can they guarantee that the concept or information won’t be stolen?
Our advice to startup founders is to be transparent. Whatever the risks in your business, it’s highly unlikely that they haven’t seen them before.
Remember that two of the biggest recipients of VC money in the past decade have been cannabis-related businesses (which can’t even hold bank accounts) and cryptocurrency-related businesses.
Both are exceptionally high risk, and yet both have raised hundreds of millions of dollars in VC funding.
For a due diligence process to be effective and efficient, above all, it needs to be organized.
This is where a strong virtual data room platform enters the fray. Whether on the VC investor side of the startup founder side, there are huge benefits to be gained from sharing information in a secure and structured manner.
For the VC company, it streamlines the investment process, which can involve several companies at once; for the startup founder, it shows the VC investor that you’re not going to be the disaster to work with that many startup founders show themselves to be early on.
Learn more about using FirmRoom data room through demo and tutorials in a free 14-day trial. We promise to significantly enhance your due diligence process.
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