What questions will venture capitalists ask during the due diligence process?

There are many occurrences when a business, be it a startup or an established company scaling up, may seek to raise funds from venture capital (VC) investors rather than bank loans. Such occurrences are usually attached to projects bearing increased degrees of risk, which banks may not intend to undertake, such as an innovative product, service, or technology, or the creation of a new market.

Legal Due Diligence for Startups Seeking Venture Capital Investments

VCs are generally less risk-averse than banks and may offer a solution to such funding needs. It is estimated that for every 10 projects they fund, VCs only see one 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 without a thorough risk assessment, just because they like an idea. Pitching TV shows have contributed to the impression that if you get the pitching right, and if you can navigate with wit and courage the tricky questions the VC will ask during the VC interview, you could get funds in less than 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.

Beyond Pitching: the Due Diligence Process

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, technology, a market, a business plan, and a management team worthy of their investment.

The due diligence process aims at assessing the key risks inherent to the project and verifying that the business has taken or should / could take countermeasures to mitigate them.

The due diligence process generally includes two aspects:

• The business diligence, during which the VC will look at whether the startup is a good fit, includes scrutinizing the startup’s management team, business model, financials, and more.
• The legal diligence, during which investors will review a slew of legal documentation, including the company’s:
  • corporate records, including the charter, bylaws, and other corporate documents including board and shareholder meeting minutes and consents;
  • agreements relating to capital stock and issuance thereof, including equity incentive plans, stock grants, option grants, etc.
  • commercial agreements;
  • capitalization table and pro forma;
  • documents relating to the intellectual property of the company, including agreements assigning intellectual property rights;
  • confidentiality agreements;
  • employment agreements, and more.

Legal due diligence is performed to ensure that all legal matters have been addressed in-depth, on top of business considerations, and that there is no legal concern that could result in a derailment of the deal.
The due diligence process is usually led by members of the VC who have the financial and management expertise to properly evaluate the deal, as well as lawyers to help manage the legal due diligence summarized above. The VC’s attorneys will work together with the company’s attorneys to complete the legal due diligence.

The best way to go through the process if you are a startup seeking VC funding is to use experienced startup attorneys to help guide the process and negotiate on your behalf. 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.

Assessing Your Technology

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 own patents or trademarks? 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.

Assessing the Market

Demonstrating that the business targets a large, growing market is important for investors and venture capital firms because it is an indication that they could achieve the necessary ROI and make the investment worthwhile.

Venture capitalists expect a detailed market analysis, including third-party estimates from market research reports. Knowing your market is critical since it is a key data point for VCs. They typically look for markets that can generate from $500 million to $1 billion of revenues. For them, an ideal market is a fast-growing, large one, where the candidate company can be the first (or second) player.

Besides from dependable estimates about market size and market growth rate now and after a five years period, they will also seek to understand how your product might influence and shape the market, and how both your product or service and the market could evolve in 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 deducing the customer acquisition costs, or will marketing suck in all revenues?

On the legal due diligence side, the VC team will review all agreements you have with customers and vendors, including anything that could affect your sales and market segment, such as joint ventures, marketing partnerships, channel and distribution agreements, licensing agreements, and any other type of commercial agreement. Are these arrangements profitable or do they represent a liability for the investment? 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 guarantee the company a 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. Since the market size and sales relate directly to the VC’s ROI, answering these questions satisfactorily is crucial to convincing the VC to fund your business.

Assessing the Management Team

While many startups 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.

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.

During the due diligence process, VCs will carefully examine the profile of current employees and managers, your hiring strategy and background check process, any hiring that you have underway, compensation schemes, your plan for future hires, etc. The goal is to determine that your business is and will remain able to recruit qualified managers.

The VC team will also try to determine the involvement of the current ownership with management, and what would happen in case of 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.

On the legal due diligence side, the due diligence will focus on incorporation documents, documents establishing the current ownership and conflict resolution between shareholders, contracts with executives and key employees, compensation schemes, equity incentive plans, confidentiality and invention assignment contracts, and any other document that may imply risks or, on the contrary, prove that you have taken sound risk mitigation precautions.

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 evolve with the company, include recalculation of figures, and provide for evolving risk assessment and mitigation.

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? Will you do more research and development? 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.

Finally, one of the most important things in your business plan is the exit scenario. A VC usually plans to get their investment back within a period of five years. This is not usually possible unless you can achieve an outsized exit to a large company or an IPO. “Outsized” is key, as VCs aim at an ROI between 25-50% and therefore will not settle for a small-scale exit scenario. Your exit value (including share value) and exit strategy are, therefore, vital aspects of your business plan.

Assessing Finances and Taxes

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 point of view, this means presenting all your financial data, including assets, contracts and other documentation, loan and securities contracts, shareholder equity agreements, contracts with customers and suppliers, board decisions and minutes, etc. A qualified lawyer will offer invaluable support to the due diligence process at this stage, in conjunction with accountants and financial counselors

Do Your Own Counter-Due Diligence

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 Since it shows that you do not enter into partnerships lightly and that you are intentional and methodical about scaling your business.

Conclusion

When you are seeking funds from a VC, attracting attention with your pitch is just the first step. As the fundraising process unfurls with VCs, many founders find that a critical step in is the due diligence process. Although the due diligence process naturally focuses on the product or service, business model, and financial health, an important part of it will be to gather and evaluate all legal data that can support the above.

Hiring an experienced attorney to help you with the fundraising 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.