What is Venture Capital due diligence and why is it so important?
This is a multi-part series on Venture Capital Due Diligence. Throughout this series we cover the basics of deal flow screening, management due diligence, and financial analysis.
First, What is Venture Capital?
Venture Capitalists (“VCs”) are financial intermediaries who raise funds from investors, known as limited partners (“LPs”), and make equity investments directly into a portfolio of private companies. In addition to investment capital, VCs also invest their time and other resources to help the management team and company grow and become successful — with the ultimate goal of an exit event such as a public offering (IPO) or acquisition. These proceeds are shared with the investors in, and managers of, the venture capital fund, and can be reinvested into new opportunities. This cycle represents the flow of funds in venture capital.
Scott Kupor, in his book Secrets of Sand Hill Road, cites a 2015 study by Ilya Strebulaev of Stanford University and Will Gornall of the University of British Columbia that states since 1974, 42 percent of all US company IPOs were venture capital-backed entities, which accounts for 63% of the total market capitalization (i.e. value) of public companies created since that time. Venture capital is a big industry.
What VCs Do
To many an opaque industry that most only know through episodes of Shark Tank or scenes in The Social Network, the Venture Capital industry plays an important role in the development of businesses across the world. This series is about the processes venture capitalist perform to find such opportunities and make investment decisions.
Startups often need money in order to build a team, develop a product, and bring it to market. While some founding teams can fund these steps themselves, known as bootstrapping, many require raising capital from investors to achieve these goals. Enter venture capital. For companies seeking investment, raising capital from these institutional investors is often a daunting task, with the odds stacked against them when looking at the data:
As you can see in the above graphic, not only is it challenging to build a successful company, but it is nearly as hard to raise money from venture capitalists. This is partially due to the asymmetry between the two: entrepreneurs have only so many opportunities to build a scale a successful company while VCs, on the other hand, have the advantage of being able to decide among potentially thousands of opportunities. The due diligence process serves not only as a function to better understand companies, but also to quickly screen out those that may not be successful or fit within the fund guidelines.
VCs are often compared to angel investors (“angels”). Angels, like VCs, make investments in private companies, but invest their own personal wealth (or pool it together and invest as a group), whereas VCs are investing the funds provided by others. These investors are wealthy individuals who are generally the first round of investors in a startup. Angels can range from friends and family members investing based on a relationship to sophisticated investors with strong business backgrounds. In the latter case, the angels look very much like VCs, but due to the fact they are investing their personal funds and do not have the same benchmarks and economics, meaning they can invest smaller amounts in earlier-stage companies, unlike typical VC investments.
As previously mentioned, VCs and other private equity investors do not have the benefit of investors in the public sphere because key information about the company are not as easily accessible. This creates challenges during the due diligence process unique to private markets, of which we will discuss in more detail in coming posts, and often necessitates a VC’s more active role in the company. VCs often take a board seat upon capital investment, which allows them to provide guidance at the highest level of the company. VCs can also leverage their past experiences, networks, and knowledge to provide direct resources to management and founding teams. These are all value-add “capital” that goes beyond its cash contribution.
Defining Due Diligence
Venture Capital investing requires not only the process of choosing opportunities in which to invest, but also requires the monitoring and eventually exiting of those investments. In this series we will focus on investing activities: prospecting for new opportunities and performing the analysis of every critical component of the company.
The phrase due diligence is one commonly known to analysts and investors in publicly traded securities, who benefit from publicly available documents, professional analyst opinions, and endless streams of relevant data. On the other private side of the investing world, especially at early stages, due diligence for VCs can take on a different meaning.
Due diligence is the process of informing an investor about a potential investment opportunity to enable an investment decision. For venture capitalists, this is both a very critical step and a challenging one, because the thorough investigation across a founding team, market, business, products, and financials involves lots of assumptions and often few reliable signals.
VCs can set themselves apart by developing consistent and methodological approaches to due diligence that create better means of sourcing and evaluating investment opportunities. Good VCs do much more than write checks, they work with the portfolio companies to carve our marketing channels, identify and hire top talent, bring products to existing networks — actively increasing the probability of success with support. It starts, however, with due diligence and this series covers these essential steps.
Stay tuned as we dive into the first stage of due diligence: the screening process.
Don’t miss out! Subscribe to our newsletter to stay up to date on research, insights, job opportunities, and more.