Getting Venture Capital isn’t as easy as you think; duediligence
May 29, 2015 by Emmanuel Sibanda
As an entrepreneur you may have considered looking for Venture Capital to take your venture to the next level. It is common to forget however, that VC is not for all businesses. Generally, most VC’s prefer to invest in a business that has proven its potential through market traction (proof of concept). According to studies carried out the average age of a venture at VC funding level was about 4 years- ascertain whether you fit into this moulf before looking for venture capital.
From a purely statistical perspective investing in early-stage businesses carries quite a significant risk, with nearly 90% of start-up companies failing within 3 years. Most entrepreneurs tend to be over-optimistic and over hype their business models when pitching to VC’s or Angel Invesors. In order to evaluate the validity of the business model, the actual size of the targeted market and how safe the business is (legally), VC’s carry out what is known as a due diligence on your business.
The due diligence process is a rigorous process that will determine whether or not your business will get venture capital. Each VC firm will have a particular criteria they follow based on the types of investments they find attractive. However, as a general rule we can divide the due diligence process into 3 stages; the screening stage, the business evaluation stage and the legal due diligence.
Under scrutiny from the Venture Capital Firms
Screening Process
VC’s receive hundreds, if not thousands of business opportunities, because VC’s want to be profitable and do not have unlimited capital, only a few of those opportunities can be funded. The intention of the screening process is to eliminate business proposals that do not fit into the criteria that the VC deems necessary for profitable success. Very few applications are reviewed thoroughly (because time literally is money in the VCs eyes), as few as 10-15% of businesses manage to pass this process.
Before applying to a VC, you can help yourself and probably help the VC by first reading up on the VC you are interested in. Look at the types of investments they have made, the stages they normally invest in, the size of investments they normally make and the industries they are interested in and ask yourself whether your business would be a fit for the VC. Be honest with yourself, you are not doing yourself any favours by wasting time applying to every single VC firm you come across online. You also need to be aware that certain funds will only review opportunities that have been referred to them by a trusted source.
Business Evaluation
Once your business passes the screening process, the next thing the VC will look at is the potential of your business. Is it a viable investment? Generally the VC will look first at the credibility of the leadership. In any business you have to have capable leader(s). The VC will try and evaluate how the founders met (assuming there is more than 1 founder), what qualifications you have, or what experiences you bring to the table (have they started other businesses?)- if you know that you are inexperienced get a few experienced mentors who will advise you and help build your credibility, how well you with your co-founders, and how it would be like to work with you (can you be trusted, do you live up to your word and why you started the business). Understand that if the VC’s do not feel comfortable working with you and they sense a slight scent of a lack of integrity VCs will probably not want to deal with your business.
The VC will then evaluate your target market. VC’s are generally looking for investments that will offer a 10X return on the investment they make (at-least), therefore your market has to be large, high growth market. Your business has to fit into this category and you have to be able to clearly articulate why your business will experience high growth in the particular market. This means you have to understand who your competitors are (saying you have no competitors is more often than not a sign that you have not researched your market space thoroughly enough) and what they key metricsare – do thorough research on your competitors, you also have to understand and clearly articulate your competitive advantage.
The next thing the VC will look at is your product, or the service you are offering. The first question you would need to address as an entrepreneur is what problem is your product/service solving, is it a ‘vitamin pill’ (nice-to-have) or a ‘pain-killer’ (must-have). Every entrepreneur believes their product/service is a must have, but ask yourself from an objective perspective, ask yourself the 5 why’s?, get to the core problem you are trying to solve and whether there is a connection between that problem and the solution you are offering.
The next thing a VC will then look at is your business model. The issue here is whether your business plan tells a convincing story. You have to ask question pertaining your monetization strategy, your distribution plan, the risks you foresee (risk assessment) and solutions you have for those perceived risks.
Business Due-Diligence
In the Due-Diligence process investors will try and ascertain whether they are getting what they agreed to pay for, this is when VCs test how robust your business is and how true the assumptions you have made are. During this process the VCs will again ask questions pertaining your credibility, your market, your product/service and your business model in even greater detail.
As a founder, leader and manager you have to be able to adapt to changes. As your business scales, competitors adapt, new laws that affect your business and industry are passed and customer’s tastes and demands change, will you as the leader be able to adapt to the added pressures that come along with that change? You have to be able to show that you have the ability to put out a sustained effort towards ensuring the success of your business.
The VCs will want you to show that you can identify who your target market is, you have to be specific the answer ‘everyone’ will not suffice. You need to understand your market in detail, why is the market growing, what is making your market grow, how will you handle your competitors or competitors who arise in that space (if your business achieves financial success you are guaranteed more competitors will emerge- how will you deal with those competitors?). You also have to understand whether your market is fragmented and whether that works to your advantage or disadvantage. Other questions include; what are your barriers of entry? How will you distribute your product/service? And is your distribution strategy feasible?
You, as the entrepreneur, would then have to describe what value your product/service offers to customers and potential customers. Is there anything unique about your product/service, what makes it superior to its competitors, is the product truly scalable (can it achieve high growth while maintaining its profit margins- these must be high profit margins for it to be regarded as a scalable business). The VC will then look at your business model; what is your exit strategy (is it feasible), are there more monetization models you can adopt and what traction have you made so far (this involves monitoring your key metrics).
Legal Due Diligence
There are quite a number of issues the VCs will look at. If the VC you are approaching does not have an in-house legal counsel, you may to make sure you pick the right layer to complete a legal review of your business, your lawyer must be prepared and capable of answering the questions that the VCs will ask. Questions asked will include questions pertaining; i.) Corporate Matters (this includes looking at your articles of incorporation, your shareholder’s agreement, whether your company is qualified to business in all countries you intend the business to operate in and all the stock transfer your business has undertaken), ii.) Financial Matters (this includes your financial statements and your bank accounts- make sure you have a business bank account separate from your personal bank account, pay yourself a salary and do not use your business bank account for personal transactions.), iii.) Management and Operations (internal management policies, management contracts, contracts between your business and other partners it works with, Intellectual property protection and partnership agreements where applicable.), iv.) Employee Matters (labour contracts, your hiring policies and whether you are in adherence with labour laws), v.) Insurance (covering both you and the business), vi.) Real Estate, if applicable, vii.) Legislation you need to comply with (licences, permits and authorizations needed) and viii.) Any pending litigation claims against your business.
Once your business survives this due diligence, the VC will then determine whether or not they will invest in your company and finalize the transfer of those funds. If the VC acts as a lead investor in a syndicate they will most likely share the outcome of their due diligence with other potential investors. Now you are ready to scale your business to great heights.
UPDATE: Tools such as YueDiligence have been created to help entrepreneurs assess whether their ventures are ready to be VC funded or not
Category : Entrepreneur
Tags : due diligence, venture capital
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