When raising venture capital (VC), founders often focus on pitching their vision. And while this is certainly the hook that gets investors excited, investors also care about risk. Before committing funds, VCs conduct extensive venture capital due diligence, asking tough questions to evaluate whether a startup has the right foundation for growth.
A common framework investors use is the 5 Ts of VC due diligence—Team, Technology, Traction, Total Addressable Market (TAM), and Terms—which guide their questions in key areas:
From corporate structure to customer contracts, VCs dive deep to uncover potential red flags before investing. In this guide, we’ll explore the most important VC due diligence questions, how to prepare for them, and what investors look for in a VC due diligence checklist.
VC firms are less risk-averse than banks and offer a solution to funding needs for startups. It is estimated that for every 10 projects they fund, VCs only see one early stage startup succeed—and that’s acceptable as long as this one success is really big.
However, that is not to say that VCs are ready to invest in a potential investment opportunity without a thorough risk assessment, just because they like an idea. Pitching TV shows have created the idea that if you pitch well, you can impress the VC. If you handle their tough questions with wit and courage, you might get funding in under thirty minutes.
Nothing can be further from reality. Even if you attract attention during the pitch and get an initial thumbs-up, the hard work has just begun.
Venture Capital firms follow a strict due diligence process before they reach the decision to fund a business. This process includes intense scrutiny of all parts of your business. They will want to see proof that you have a product or service. They will also look for technology, a market, a business plan, and a strong management team.
Conducting due diligence looks at the main risks of the venture. It checks if the business has taken steps to reduce these risks or if it should take action.
The due diligence process generally includes two aspects:
Legal due diligence is done to make sure all legal issues are fully addressed (or at least sufficiently addressed for the stage of the company and inline with industry best practice). It also considers business factors. This process helps ensure there are no material legal problems that could stop the deal.
The business due diligence process is usually led by the VC firms, as well as specialists retained by the VC firms. They have the financial and management skills to evaluate the deal. Lawyers also help with the legal due diligence mentioned above. The VC’s attorneys will work together with the company’s attorneys to complete the legal due diligence.
As a general rule of thumb, VCs are comfortable taking a significant risk on new business models and technology, but are less inclined to take risks on legal documentation. The best way for a startup to get VC funding is to use experienced startup lawyers. They can help guide the process and negotiate for you. It is never a good idea to handle any of this on your own. This is a legacy of your professionalism and telling of how serious you are about the deal.
It all starts with an idea: an innovative product, a pioneering service, or a ground-breaking technology. VCs will assess your idea in-depth and try to understand both the problem you are trying to solve and what your competitive edge is.
VCs will also try to assess any red flags. Is there anything about it that could end the venture before it starts, or limit the company’s lifecycle?
On the legal due diligence side, the VC team will examine how your business and product are legally compliant with federal and state regulations. Most importantly, they will investigate the legal status of your innovation.
Do you have registered patents or trademarks (if those protections are important for the business)? Is your technology protected by IP agreements and contracts that prove your ownership? Do you have non-disclosure agreements with your executives and employees to protect your IP?
Can your IP be legally challenged? Can new competitors enter the market and easily replicate your technology?
Risks associated with the above issues may make your product unsustainable to the venture capitalist. For example, no investor wants to lock their capital in long litigation over intellectual property rights and trademarks. Sound answers to related legal issues are necessary to proceed with the investment.
There needs to be product market fit. Showing that the business aims for a large, growing market (Total Addressable Market) is important for investors. This suggests they could get a good return on investment and make the investment worth it.
Venture capitalists expect a detailed market analysis, which may include credible third-party estimates from market research reports. Knowing your market is critical since it is a key data point for VCs. For them, an ideal market is a fast-growing, large one, where the candidate company can be an early entrant into the market.
You need to provide accurate estimates of market size and growth rate for now and in five or more years.
They will also want to understand how your product could impact the market. They will look at how your product or service and the market could change over time.
Venture capital firms’ due diligence will also seek to estimate customer acquisition strategies and costs. Is the market mature enough for your product or does it need to be educated—and convinced? What time, cost, and effort does it take to reach a critical mass of customers? Is there a reasonable profit margin after deducting the customer acquisition costs, or will marketing suck in all revenues?
The VC team will typically check all agreements you have with customers and vendors. This includes anything that might affect your sales and market segment. They will look at joint ventures, marketing partnerships, channel and distribution agreements, licensing agreements, and other commercial agreements.
Are your partners reputable and trustworthy? What are the company’s obligations to these third parties, and what can you legally expect in return? Have you inadvertently put your IP at risk, allowing the other party to claim any rights to your IP?
Do these agreements support the company’s competitive advantage with specific sales channels or segments? What part of the projected sales do they represent? What are the consequences of terminating any of these agreements?
This due diligence is crucial to determine if any existing contracts have inherent risks, or if they constitute a competitive advantage. The market size and sales are important for the VC’s return on investment. Answering these questions well is key to getting the VC to fund your business.
Assessing the Management Team
While many startup founders see themselves as managers, VCs are adamant that a professional management team is essential. Although many VCs are willing to provide mentoring on top of funds and can accept the startup founders as “green” managers, a lack of effective management skills is a major red flag. Put simply, VCs see a ton of interesting ideas but they need to be comfortable that the management team in place is the right team to succeed with executing the idea.
VCs will look for experienced managers who can execute the business plan and yield high returns. VCs will ask for each management member’s background to assess whether they have the skill set required to scale the startup. Demonstrating to VCs that your team members have relevant educational and/or professional experience can go a long way in convincing the VC that your team can succeed.
VCs will also consider any current hiring efforts. They will examine your compensation plans and future hiring plans. The goal is to determine that your business is and will remain able to recruit qualified managers.
The VC team will also look into how the current owners work with management. They will consider what might happen if there are disagreements. They will try to assess possible risks from poor relations between shareholders, or between shareholders and management, as well as risks related to poor management.
In legal due diligence, several important documents are reviewed closely. These include incorporation documents and proof of current ownership. You would be surprised how often we see companies come to us seemingly ready to raise funds but they have not yet properly issued stock to anyone (and this can have significant tax impacts).
Additionally, it is important to review contracts with executives and key employees. This includes compensation plans and equity incentive plans, as well as confidentiality agreements and invention assignment contracts.
As competent management is one of the top VC requirements, it is vital to have qualified lawyers help you with hiring, contracts, and agreements from the get-go.
Assessing the Business Plan
Your business plan will get a thorough examination in order to evaluate the financial potential of the business idea, the business model, and the veracity of the business plan’s underlying assumptions.
A critical aspect that the VC will assess is your capacity to update it. A business plan dated from 12 months ago won’t cut it, as this will suggest to the VC that the business is unable to incorporate recent achievements, issues, risks, or events to its planning. The business plan should change as the company grows. It must include updated figures and address new risks.
A second key factor in assessing your business plan is how you reached your market potential and revenue estimations. The inclusion of trustworthy external sources, market reports, and analyses is a sign that you base your estimates on more than wishful thinking and doubtful extrapolation. It is crucial that your break-even points in terms of profitability and cash flow are based on sound estimates.
The venture capital team will also assess your plan for growing the business. How do you plan to use the VC funds for that purpose?
The primary purpose a VC will invest in a startup is growth—their funds are not supposed to be used for debt payments, luxury purchases, or as an injection of cash flow to the company. Therefore, the question is, what will you do to grow your company fast? Create new product lines? Hire specialists? Prepare a milestones chart with what you plan to achieve once you get the funding and explain how every cent will be spent.
It goes without saying that the VC will assess in detail your financials and taxes, including financial statements, cash flow, financial projections, assets, debt and debt securities, bank statements, etc.
From a legal diligence perspective, this means showing all your financial data. This includes assets, contracts, and other documents. You should include loan and securities contracts, shareholder equity agreements, and contracts with customers and suppliers.
Also, provide board decisions and minutes. A qualified lawyer will offer invaluable support to the due diligence process at this stage, in conjunction with accountants and financial counselors.
Getting a venture capital firm to invest in your company is forming a partnership. As such, you should also do your due diligence on potential VCs to ensure there are no unpleasant surprises around the corner.
Assessing a potential VC partner includes doing the necessary background checks and evaluating their portfolio companies, successes and failures, and mission-alignment. It can include contacting portfolio companies to get information about how the relationship unfolded. It is also a good idea to look into what other valuable resources the VC can offer in addition to funding, such as subject-matter expertise or network-building.
Most VCs will appreciate that you are thoroughly investigating a potential relationship with them because it shows that you do not enter into partnerships lightly and that you are intentional and methodical about scaling your business.
When you are seeking funds from a VC, attracting attention with your pitch is just the first step. As the fundraising process unfolds with VCs, the due diligence process heats up.
Hiring an experienced attorney to help you with the fundraising and due diligence process is essential.
SPZ’s experienced team of startup lawyers will stand by your side at all stages of your business. With our thorough knowledge of the fundraising process, we will help you interact with the VC, draft and review the necessary legal documents with your best interests in mind, and provide valuable counsel throughout the process.
DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute attorney advertising under applicable state laws.