2021 was one of the biggest years for startup investments. Over $600 billion was raised worldwide, with United States investments accounting for almost half of the sum. Startup founders that raised funds in this period, not only boasted of innovative technology products but were also able to successfully navigate the investment due diligence process.
Investment due diligence, a necessary and at times tedious process, is the “make or break” for startups seeking investment, particularly when seeking investment from institutional investors (e.g., venture capital funds). Shubh Karman Singh, a California-based investment due diligence consultant, and angel investor understands the process all too well.
Singh conducts investment due diligence on companies ranging from early-stage startups with no revenue to large organizations worth hundreds of millions of dollars across a broad range of functional areas/industries (e.g., fintech, healthcare, cybersecurity, cloud computing) and geographies (e.g., U.S., Canada, Europe, China). His firm’s clients include many of the largest and most impactful venture capital and private equity funds in the world.
One area he wants to stress to startups who are planning their fundraising is the importance of preparation.
“Founders should begin early and identify the funds that could potentially be a good fit. There are hundreds of VC funds in the U.S. but most have a specific investment thesis. The culture and process can vary too. Understanding these elements is critical to making the process sustainable and successful in the long run”
Investment due diligence falls into three primary categories: screening, business evaluation, and deal terms / legal due diligence.
Screening is the first step. If your product or service is not what the VC is looking for and lacks the initial hook, quite likely there will be no moving to the next step.
“A key part of passing the screening stage is understanding the investment thesis of the fund. If the investors are healthcare-focused, and the startup is focused on cybersecurity, then it will be highly unlikely for the deal to move past screening. In other instances, the fund might be looking to invest in post-revenue startups or at Series A / B stage only, while the startup might just be starting out. To improve odds, it is important to ensure the startup’s value proposition aligns with what the investors are looking for”.
If the startup successfully passes through the screening stage, then in the next stage (business evaluation), the potential profitability and viability of the startup’s business model is evaluated – could it become the next unicorn? Even if the company does not have unicorn qualities currently, this, of course, does not mean a deal will not close, but it may take time for investors to determine the ultimate value proposition of the investment.
The biggest problem startups have at this point is: ”not just having a viable business plan, but also being able to communicate it effectively. Noting that the target market is worth billions of dollars in the business plan is helpful, but investors want to understand what piece of that billion-dollar pie is the startup targeting and is in fact, well-positioned to capture. Similarly, clearly articulating customer needs, potential competition, etc. are key to demonstrating that the founders understand the market well and are planning ahead for both potential opportunities and threats”.
Finally, if the deal is a good fit and investors are ready to move forward, a term sheet is typically presented to the founders. Negotiation over deal terms is pretty common and once there is mutual consensus, it is time to lawyer up for both sides and get through the legal due diligence process. This phase by far requires the most documentation and can be the most time-consuming, taking anywhere from a few weeks to several months depending on the size and stage of the deal.
Singh believes it is important to get the deal terms and legal due diligence right to ensure the interests of founders and investors are protected. “The deal terms should ideally make sure that the investors are able to get a meaningful return on their investment, but at the same time protect equity stakes of founders in both current and future rounds from significant dilution. Thorough legal due diligence can also save from any potential curveballs arising from deal terms from prior rounds”
Deal volume and size in 2022 will likely remain high, providing opportunities for founders looking to raise capital. So, for startups ready to take the leap and raise their next round, preparation and understanding the investment due diligence process will remain key.