An Investor’s Guide to Due Diligence in Early-Stage Startups
- Published August 31, 2023 5:17AM UTC
- Publisher Cecile Bon
Venture capital investments, especially in early-stage startups, require meticulous research and due diligence. An investor’s responsibility is to unearth the essential facets of the target company that could either boost its value or potentially jeopardize the deal. The process can be even more complex when considering investments in technically-oriented businesses where understanding potential issues calls for substantial expertise.
In this article, we will guide you through the comprehensive due diligence process, focusing on seed stage and Series A rounds, during which startups are typically seeking funds to fuel their growth and expansion efforts.
Understanding Due Diligence
The purpose of due diligence is to illuminate potential roadblocks and unseen issues within a startup. These problems may range from legal hurdles to financial discrepancies or operational inefficiencies. Conducting due diligence ensures you, as an investor, understand precisely what you’re investing in, the potential risks involved, and the likely returns on your investment.
The Due Diligence Checklist
Let’s delve into a systematic approach to due diligence, touching upon the fundamental areas you need to explore while assessing potential investment opportunities.
1. Structure and General Organization
The first step involves gathering essential information about the target company: its registration details, ownership structure, publicity, and marketing materials. The purpose is to ensure the legitimacy of the business and the individuals involved.
Here are some key questions to ask:
- In which jurisdictions is the company registered?
- Who holds equity in the company?
- What are the key marketing strategies employed by the company?
- Are there any secondary or conflicting interests among the owners or employees?
2. Strategic Assessment
This phase entails assessing the strategic value of the company and the market it operates in. Your aim is to evaluate the competitive landscape and determine if the startup is uniquely positioned for success.
- What differentiates the startup from its competitors?
- What is the total addressable market?
- What are the potential growth opportunities in the market?
- What strategic challenges could the company face?
Porter’s Five Forces model is an essential tool for analyzing the competitive dynamics within an industry. It provides a detailed perspective on how different factors can affect a startup’s potential for profitability.
- Threat of New Entrants
In some industries, the barriers to entry are low, making it easy for new competitors to enter the market. If the startup you’re evaluating is in such an industry, this could be a significant risk. Look for protective measures that the startup may have in place, such as patents, exclusive contracts, or a unique business model, to mitigate this threat.
- Bargaining Power of Suppliers
If there are only a few suppliers or if the cost of switching suppliers is high, this can give suppliers significant power. This could lead to higher costs for the startup and potentially lower margins. Try to evaluate the startup’s relationships with its suppliers and its plans for managing supply chain risks.
- Bargaining Power of Buyers
Similarly, if a few large buyers dominate the market, they can exert significant pressure on the startup, potentially driving down prices. Understand the startup’s customer base and how it plans to maintain strong relationships with its key customers.
- Threat of Substitute Products or Services
Evaluate the uniqueness of the startup’s product or service. If there are readily available substitutes, this can limit the startup’s ability to increase prices and impact its potential profitability. It’s essential to understand the startup’s value proposition and how it differentiates itself in the market.
- Competitive Rivalry
A highly competitive market can make it difficult for a startup to establish a strong market position. Consider the number and strength of competitors, as well as the startup’s strategy for dealing with competition.
By analyzing these five forces, you can gain a more profound understanding of the industry dynamics that the startup operates in and how they can influence its growth and profitability. Include the insights from this analysis in your overall due diligence report to provide a comprehensive view of the startup’s potential for success.
3. Assets and Financials
At this stage, you need to delve into the company’s financial health. Detailed scrutiny of financial reports, balance sheets, and profit & loss statements will give you a clearer picture of the company’s fiscal stability.
Key questions include:
- What physical assets does the company own?
- What are the company’s revenue streams?
- What financial liabilities does the company have?
- What is the monthly recurring revenue?
4. Legal and Risks
Evaluate potential legal issues and regulatory requirements that the company needs to comply with. Understand the types and scope of the company’s insurance coverage and any existing or potential litigation.
Questions to ask include:
- What licenses and permits does the company hold?
- Are there any ongoing or potential lawsuits?
- Are there any antitrust or regulatory concerns?
- What significant contracts does the company have with customers, partners, vendors, and service providers?
5. Operational Assessment
Assessing the startup’s operations helps you understand how the company works internally and if it has a sustainable business model.
Team and Leadership
Get a sense of the company culture and understand how well the team functions.
- What is the team structure?
- Can the team efficiently collaborate remotely?
- How often is structured feedback given?
Scrutinize the processes that enable the team to work efficiently and whether they can scale as the company grows.
- What procedures are in place for new hires?
- How often is code deployed to production?
- What would be the pain points if the team size triples in the next month?
Written Communication and Documentation
The company’s documentation policies reveal how effectively knowledge is shared and preserved.
- Is there a glossary of terms related to the work they do?
- Who is responsible for writing technical documentation?
- How often is the technical documentation updated?
Problem and Solution
Identify whether the company’s product or service is effectively addressing a market need.
- Do they conduct formal interviews with end users and customers?
- How do they validate their ideas?
- What assumptions and hypotheses have been tested with experimentation and prototyping?
Evaluate the technical soundness and scalability of the product.
- Are the company’s backups tested and regularly restored?
- Do they use containerization such as Docker or Kubernetes?
- What would break if the customer base increased by 100 times overnight?
While this checklist serves as a comprehensive guide, remember that due diligence is not a one-size-fits-all process. Each startup is unique, and your due diligence approach should adapt to the specific context and dynamics of the target company.
Post-Investment Due Diligence
While pre-investment due diligence forms the foundation of your investment decision, it’s essential to note that due diligence doesn’t end once the investment is made. Post-investment due diligence is a continuation of the process to monitor and manage your investment, safeguarding it from potential risks and ensuring the startup continues to perform as expected.
1. Monitor Financial Performance
After the investment, keep an eye on the company’s financial performance. Regularly review financial reports and check if the company is meeting its targets. Some key financial metrics to track include revenue, costs, profit margins, and cash flow.
2. Track Key Performance Indicators (KPIs)
KPIs vary depending on the industry and the specific company. For a tech startup, KPIs might include monthly active users, customer acquisition costs, and churn rates. For a manufacturing firm, they might include production efficiency, order accuracy, and delivery times. Make sure you understand the KPIs that matter most for the startup you’ve invested in and monitor these regularly.
3. Participate in Investor Updates
Most startups provide regular updates to their investors, usually on a quarterly or biannual basis. These updates typically include information about the company’s financial performance, progress towards goals, significant developments, and challenges faced. Participating in these updates will help you stay informed about the company’s status and progress.
4. Conduct Regular Check-ins
Arrange periodic meetings with the startup’s management team. This will give you an opportunity to discuss any issues or concerns and get an understanding of the startup’s strategic direction. Remember, as an investor, you’re a partner in the business, and your input can be valuable to the management team.
5. Legal Compliance
Ensure the company stays compliant with all relevant laws and regulations. Changes in the regulatory landscape can have significant impacts on a startup’s operations, so it’s crucial to ensure the company is prepared to adapt as needed.
Investing in early-stage startups offers the potential for significant returns, but it also carries substantial risk. Conducting thorough due diligence can help mitigate some of this risk and increase your chances of a successful investment.
Due diligence isn’t just about ticking boxes; it’s a way to understand a startup’s potential from every angle. It allows you to identify opportunities and risks that might not be immediately apparent and make informed decisions based on a comprehensive understanding of the business.
Remember that the best outcomes often come from partnerships where both parties—the startup and the investor—are fully committed to the business’s success. So, beyond just performing due diligence, strive to become a supportive and active participant in the startup’s journey. Your investment isn’t just financial; it’s also an investment of your time, expertise, and network. Make it count!