Venture Capital | Part 4/7: Due Diligence
After we have met you a few times, we as a group have a decent amount of conviction around your idea. Now, we need the big boys to tell us the same thing.
This means we move the opportunity to due diligence. The end result of DD is an investment paper on the opportunity, mapping in great detail the potential of the investment and where it is going, according to us.
Due diligence has a few different parts to it —
1. Market DD
In step 1, we want to know the deep nature of the market. Is it lucrative, is it growing? In general, we need to know 3 things:
- Market size — How large is the market? We check verified publications (Statista, CBInsights, etc.) and compare their individual market size assessments to come to a final number in our mind of how large the market currently is
- Competitive landscape — Who are the players in the market currently, and how mature is it? Is it competitive, fragmented, or one dominant player?
- Market maturity — Markets go through different cycles. We need to know — Is the marketing the initial stages of market growth or is it slowing down now?
- Market growth trends — What is the CAGR (Compounded Average Growth Rate) of the market, and how does it compare to other industries and markets? This is key because its important to be part of a moving river. I’ve heard people say growing industries are like a fountain — they push up with force and take who’s on it with them.
- Regulatory — We need to understand the current and future risks in the market. This also includes an angle on lobbying power.
- Timing — Are the dominant players in the market already established? Have companies “crossed the chasm” already with a sustainable moat, or are companies still fighting to grab the top position.
2. Business DD
This involves analysing the internal business model and structure of the company, as well as going to meet customers to hear firsthand reviews.
This involves a few things —
We look at key product metrics like product pricing (how is the pricing developed and how healthy it is relative to the market), Product margins (what % we keep and how that compares to the market), MAU/DAU (how many users are looking at our product) and activation rate (how many people are being converted).
One of the largest risks of a startup is operational. It’s important as an investor to track sales, materials contracts, inventory, customer contracts and invoices, leases and the entire end-to-end cycle to get a sense of operational health.
We do a strong background check on all the people involved— previous jobs, university degree, company history, and more.
3. Financial DD
Then we look into the financial details of the company. This comes from the dataroom a company keeps (explained earlier). We look at 2 things — past performance and forecasting into the future.
All this information comes ideally from the 3 statements of the company:
- Income statement
- Cash flow statement
- Balance sheet
Now, keep in mind that in early-stage companies there is relatively little historical data. But there are a few key metrics that matter —
Customer Acquisition Costs (CAC)
(This comes under unit economics)
Customer acquisition costs are the amount of money your business needs to spend in order to acquire a new unit customer. This metric is important because it allows you to track how efficient your marketing and sales efforts are. If your CAC is too high, it means that you’re spending too much money to acquire new customers. And if it’s too low, it could mean that you’re not spending enough to reach new customers.
Churn rate is the % of customers who cancel their subscription or stop using a service within a given time period (usually annual). It’s a key metric for businesses that rely on recurring revenue, such as subscription-based businesses and software-as-a-service (SaaS) companies. A high churn rate can have a significant impact on a business, as it can lead to lost revenue and decreased growth — and signals that the product is not as sustainably desirable to the customer, a cause for concern in the VC space.
Average Order Value
The average order size is the average amount of money that your customers spend when they make a purchase from your business. This metric is important because it allows you to track the health of your business. If your average order size is too low, it could mean that you’re not generating enough revenue per customer.
Monthly Recurring Revenue (MRR)
Your monthly recurring revenue is the amount of money that you can expect to generate from your customers on a monthly basis. This metric is important because it allows you to track your growth and predict your future revenue.
Annual Run Rate (ARR)
Your annual run rate is the amount of money that you can expect to generate from your customers on an annual basis. This metric is important because it allows you to track your growth and predict your future revenue.
Your cash runway is the amount of time that you have to achieve profitability before your startup runs out of money. This metric is important because it allows you to track your progress and make sure that you’re on track to achieve profitability.
Your burn rate is the rate at which your startup is spending money. This metric is important because it allows you to track your progress and make sure that you’re on track to achieve profitability. (This is used to calculate cash runway)
Virality is the key to any startup's success. If we look at a project as a model that turns an influx of people into revenue, virality allows us to get money from users without spending anything on acquisition. Plus, strong virality can help a project take over its market in just a few months: one active user invites several friends, each of whom invites a couple more friends, and so on.
Your k-factor is the rate at which your startup is growing organically by word of mouth. This metric is important because it allows you to track your progress and make sure that you’re on track to achieve profitability.
The gross sales are the total amount of revenue that your startup generates. This metric is important because it allows you to track your progress and make sure that you’re on track to achieve profitability.
Monthly active users (MAU)
Your monthly active users are the number of people who use your product or service on a monthly basis. This metric is important because it allows you to track your progress and make sure that you’re on track to achieve profitability.
NPS/Product market fit
Your NPS (Net Promoter Score) is a measure of how likely your customers are to recommend your product or service to their friends or family. This metric is important because it allows you to track your progress and make sure that you’re on track to achieve virality and that your customers are willing to pay for what you are selling
Customer lifetime value
Customer lifetime value (CLV, or CLTV) is a metric that indicates the total revenue a business can reasonably expect from a single customer account throughout the business relationship. The metric considers a customer’s revenue value and compares that number to the company’s predicted customer lifespan. The longer a customer continues to purchase from a company, the greater their lifetime value becomes.
Gross Merchendise Value
In a startup, GMV is the gross merchandise revenue: the total revenue that a company generates through the sale of its goods or services. It is important that GMV is measured in conjunction with net sales, which takes into account deductions.
Gross Merchandise Value (GMV) vs. Gross Transaction Value (GTV): While GMV can be defined as the total dollar value of everything sold through a marketplace in a given period of time, gross transaction value (GTV) is a calculation of the revenue in relation to commissions. GTV is equal to the number of items sold multiplied by the price collected.
- Accounts Receivable — The risk of default in customers is different for different businesses, and it’s important for us to know this.
- Schedule of bad debt and/or write-offs — This tells us how financially healthy the company is, and if there will be debt issues in the future.
4. Technology DD
This section is often outsourced to companies that specialise in technology, as VC firms are unlikely to have the expertise in-house. Here, we track technology, its replicability, potential patents, competitive traction in development, long-term viability and more.
5. Legal DD
Legal due diligence is often outsourced as well. Here, we look for any red flags that may indicate a mismatch between the startup’s legal standing and what they have reported to the VC firm.
The lawyer will complete a legal review including an overview on articles of incorporation, list of shareholders (including angel investors) and percentages owned, bylaws and amendments, annual reports, compliance with state and federal laws, any legal claims against the company, any outstanding liabilities, taxes, and more.
This draft is part of a 7-piece series focusing on the inside of the VC industry. It is told by a current VC associate, to help entrepreneurs lift the curtain. The goal is to learn to raise better by speaking the language and giving VCs what they look for. It will include —
- Sourcing | Where good founders like to work, play, rest
- Pitch Deck | What we look for in Ideas
- Initial Meeting | What do we look for in People? On Founder Market Fit
- Due Diligence | How Heavy is the Past? — Data in VC, Financial analysis of VC firms
- IC | The Art of Making Good Decisions
- Deploy | Term sheets
- Exit | Ways to do it