How, When & Why VCs Do “Due Diligence” Pre and Post Term Sheet

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Due Diligence is the process that Venture Capitalists (VCs) use to vet a startup company before investing in it.

The process consists of various procedures that involve assessing the startup’s team, product, and market.

VCs use this process to reduce the amount of risk they take by investing in a startup company.

Disclaimer: The information shared here is based on my experience and not on any official data or study from any legal/financial/accounting institution. It is solely meant to help Startup Founders, Entrepreneurs, and VCs understand each other better and be useful for them to have a better experience while interacting with each other!

Also, I am not a lawyer or an accountant, so do not take this article as any advice or information.

If you are running your business or planning to run your business, talk to experts who can guide you better!

How does Due Diligence Work?

How long does it take? What does it cost?

How do I get VC Funding?

These are some common questions asked by Startup Founders who want to raise funding from Venture Capitalists (VCs).

To answer these questions and help Startup Founders understand how they can go about raising funding from VCs, I’ll be covering the following topics:

What is Due Diligence (DD)?

I have already mentioned that Due Diligence is a process VCs use to vet startups before investing in them.

In other words, it is a process used by VCs to determine if the startup they want to invest in is worth investing in or not. This process can be broken down into 5 steps.

Step 1 — Preparation

This step involves preparing all necessary documents and data for the DD process. Documents like Business plans, Financial Projections, Product Specification Documents, Team profiles, etc., are prepared during this step.

Step 2 — Startup Review

The next step involves meeting with the founders of the startup and reviewing their business plan, product, and market to see if any major issues will affect their business or if any gaps will cause issues later on.

Step 3 — Technical & Legal Review

Once the above two steps are completed, it’s time for a startup company’s legal and technical review.

Here, lawyers and accountants hired by VC firms scrutinize all documents prepared by founders and review their financial projections and product specifications.

This step aims to ensure that there are no legal or financial issues that can cause a problem in the future.

Step 4 — Data Collection

During this step, data about the startup company is collected by hiring specialized third-party agencies to help collect it.

This data is collected on various aspects like the team, product, and market of the startup.

Step 5 — Post-DD

Once all the above steps have been completed, VCs make their investment decisions based on their data.

If they are satisfied with what they find, then they offer to fund the startup company.

If not, then there can be a few reasons like issues with the startup company’s product or market or with one or more members of its founding team, etc.

This happens when due diligence has not been done before investing in a startup company.

How Does Due Diligence Take Place?

There are 2 ways in which VCs conduct due diligence on a startup company:

Pre & Post Term Sheet DD

Due Diligence occurs both pre and post-term sheets (pre-funding and post-funding).

Before deciding to fund a startup, VCs conduct pre-term sheet due diligence to ensure that the startup is worth investing.

Post-term sheet due diligence is conducted when VCs have already decided to invest in a startup and are ready to sign a term sheet with the startup.

Pre & Post Investment DD

This is a new approach that has been adopted by some VCs recently. In this process, VCs conduct DD pre-investment to understand if they want to invest in the startup or not sign a term sheet with them.

If they do, then they will sign an investment agreement and invest in the startup company. If not, then they will refuse to fund the company.

This approach has become popular because it saves time for both parties -startup founders and VCs-and reduces the risk for both of them.

Duration of Due Diligence

The duration of due diligence is usually around 5–6 weeks but can vary from 1–3 months depending on the amount of data and information available about the company and how quickly it can be collected by hiring specialized third-party agencies etc.

A lot depends on how quickly a founder can prepare all documents needed for due diligence, which is usually 2 weeks before the actual start date of DD.

Cost of Due Diligence

The cost of due diligence depends on various factors like the amount of data that needs to be collected, the number of specialized third-party agencies hired, and the number of VC firms involved.

The average cost is anywhere between SGD5,000 to SGD30,000.

Why Do Venture Capitalists Conduct Due Diligence?

VC firms conduct due diligence to reduce the amount of risk they take while investing in a startup company.

By conducting due diligence, they can assess the team, product, and market of a startup company and if any issues can affect their business or if any gaps will cause issues later on.

How Does Due Diligence Help?

Due diligence helps VCs in 2 ways:

1. It gives VCs the information they need to make an informed decision about whether to invest in a startup company or not. This helps them avoid investing in startups with a low chance of succeeding and thus avoid losing their money.

2. It saves time for both parties involved — VCs and startup founders. By conducting due diligence, VCs can assess if a startup is worth investing in or not without having to sign term sheets with them, which saves their time and the startup founders’ time.

Do you think VCs should conduct DD? Let me know by posting a comment below.

About the Author

I am the Founder of Cudy Technologies (www.cudy.co), a full-stack EdTech startup helping teachers and students learn better. I am also a mentor and angel investor in other Startups of my other interests (Proptech, Fintech, HRtech, Ride-hailing, C2C marketplaces, and SaaS). You can also find me on Cudy for early-stage Startup Founder mentorship and advice.

You can connect with me on Linkedin (https://www.linkedin.com/in/alexanderlhk) and let me know that you are a reader of my Medium posts in your invitation message.

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Founder of Cudy Technologies (www.cudy.co), a full-stack EdTech startup helping teachers and students teach and learn better. I am also a mentor and investor.

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Alexander Lim

Alexander Lim

Founder of Cudy Technologies (www.cudy.co), a full-stack EdTech startup helping teachers and students teach and learn better. I am also a mentor and investor.

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