Due Diligence in Investing: A Crucial Step in Evaluating Startups and Venture Capital
- Published August 23, 2023 4:57AM UTC
- Publisher Cecile Bon
In the world of investing, there’s an age-old adage: “Do not put your money in something you do not understand.” This wisdom is particularly significant when considering investments in startups or venture capital (VC). These investment opportunities are often fraught with high levels of risk and uncertainty. So, how do you mitigate these risks? The answer lies in the practice of due diligence.
Unpacking Due Diligence
At its most basic, due diligence is the process of thoroughly researching and understanding an investment before committing any money. This ‘homework’ involves a deep dive into the minutiae of the startup or venture in question, with the aim of understanding what you’re buying into, what the risks are, and how you can expect to see a return on your investment.
Due diligence can be divided into two major components:
Industry due diligence is about understanding the big picture. It delves into the industry landscape, identifying key players, potential competitors, the startup’s unique selling propositions, and the probability of success.
Legal and corporate due diligence is a microscopic investigation into the startup, founders, legal contracts, corporate structure, product, compliance, and more. It verifies the credibility of the startup’s claims, ensuring that they are who they say they are and can deliver what they’ve promised.
The Importance of Due Diligence
Due diligence is akin to a comprehensive health check for an investment opportunity. Its primary goal is to minimize the risk of you losing your money. It can help you avoid overpaying for an investment, increase your chances of seeing a return, and prevent you from making a potentially bad investment. Nevertheless, it’s important to remember that even the most thorough due diligence cannot guarantee that an investment won’t fail or that you won’t experience a total loss of principal.
The Due Diligence Process in Venture Capital
In the VC landscape, due diligence refers to the investor’s process of evaluating a potential investment opportunity. It seeks to select potential winners, identify key risks associated with the investment, and develop a risk mitigation plan.
The due diligence process in VC typically consists of three stages:
Screening due diligence: At this stage, the potential investments are filtered according to predefined criteria. Those fitting the criteria are marked for further evaluation.
Business due diligence: Once an opportunity passes the screening stage, the viability of the deal is thoroughly evaluated. This involves reviewing aspects like the management team, market potential, the product/service, and the business model.
Legal due diligence: At this stage, legal professionals review the opportunity to ascertain the legal aspects of the deal. It’s essential for the startups to have their lawyers prepared to address the investors’ questions.
The due diligence process is time-consuming and can be costly due to the involvement of consultants, advisors, lawyers, accountants, and the investor’s own time. However, the cost of skipping due diligence can be far greater, as the infamous case of Theranos demonstrates. Theranos, a biotech company that raised over $700m in investments based on fraudulent claims, ultimately collapsed, leading to significant losses for investors.
Preparing Startups for Due Diligence
To navigate the due diligence process effectively, startups should:
- Prepare due diligence binders: These should contain all pertinent information and be regularly updated.
- Consider due diligence as their process too: This will help them to assess potential long-term partnerships with investors.
- Assign a point person for communications: This ensures consistent messaging.
- Answer investor’s questions thoroughly: This aids in maintaining investor interest.
- Use feedback with other investors: Feedback from one investor can be used to address concerns that may arise with others.
- Build trust with investors: Establishing a solid relationship is just as important as securing the investment itself.
Check out our other blog. This comprehensive guide takes you through the due diligence process, highlighting key strategies and considerations to mitigate risks and increase the chances of a successful investment in technically-oriented startups.
In conclusion, due diligence is a crucial and necessary step in investing, especially when dealing with startups and venture capital. While it can’t eliminate risks entirely, it significantly reduces the potential of making an ill-informed decision, thereby helping to safeguard your investment. Whether you’re an experienced investor or just dipping your toes into the investment world, due diligence should always be a priority.