Before diving into the main topic that is due diligence in venture capital, we must first understand venture capital commonly known as the VC. Let us understand this with the help of an example. A group of friends think of starting a new business. They go to the bank to ask for a loan and explain the bank their idea of the start-up. However, banks reject their loan application as it does not provide loan only for ideas. Hence, this is where Venture capital’s role comes into play. Venture capital is a funding team who invests in such start-ups. The start-ups only have to satisfy the venture capital that there is no harm in investing in their business.
Understanding Due Diligence in Venture Capital
Due Diligence is the process which is followed by the venture capitals. Due diligence in venture capital is done to see whether the start-ups which they are investing in, are worth investing or not. It helps them know everything about the start-up. They get knowledge of the capital, assets, liabilities etc. of the start-up company. They also get to know how the members of the start-up company manage it. This process helps the funding team clear all doubts regarding the start-ups. They come to know if there is any kind of risk while investing in them. Once, the venture capital is satisfied that the start-up business can grow in the future, then they invest in it.
Importance of Due Diligence in Venture Capital
A VC does not invest in just any business with closed eyes. It determines if the business will flourish in the near future or not. For this it has done some research about the start-up. This is where due- diligence process plays an important role. It prevents the venture capital from investing in the wrong company. Every funding team has the right to know each and every detail of the business they plan to invest in. Due diligence in Venture Capital process offers them this chance to investigate the start-up. Every venture capital company follows a different due diligence process. If this process was not there, then it would have become very difficult for the VC to decide in which business to invest.
Areas of Business under Due Diligence in Venture Capital
Every Venture capital follows a different due diligence process. The process varies according to their needs. However, there are some areas which every venture capital focuses on during the process. They are given below:
Legal Due Diligence
Here, the Venture capital needs to know if the business they are investing in is being made by following all legal procedures or not. It is very essential for the start-ups to have no Intellectual Property issue while they are making and selling their product. This can be checked by the due diligence process. Venture capital assures that the business follows all the laws. As non-compliance will lead to major loss to the company.
Financial Due Diligence
Venture Capital needs to know the financial position of the business. It needs to know the income, bank accounts, other investors, contracts, money required for products, profits or losses etc. They ask the company to bring all the documents describing all these things. Whatever, the business has like the accounts, ledgers, tax receipts etc. have to be shown to the venture capital.
Product Due Diligence
VC has to know everything about the product that the business is selling. The product must be developed properly for buyers to buy it. The quality as well as the quantity sold matters here. If the Product is good, then only business can compete in the market. Therefore, selling the right product is very important.
Management Due Diligence
It is very important for the management of the company to be cooperative. If there are no fights in the management, then only the business can expand. So, if there are any conflicts, then VC does not prefer to invest. So, VC’s collect information regarding the management of the business.
Stages of Due Diligence in Venture Capital
It is a very lengthy process. There are 3 stages of this process which are given below:
Screening
There are many start-ups for the venture capital in India to fund or invest in. But, it cannot sit looking deep into all of them. Therefore, only selected businesses are studied deeply by the funding team. Due diligence in venture capital process is only applied to the companies who have passed the screening test. Hence it is really important to complete the very first stage of the due diligence in venture capital that is screening.
Business Stage
Only after passing the 1st stage, VC moves on to the second stage. The second stage is the business stage. Here, VC studies the product, market in which it is sold, work of the management team etc. of the business. Only when these things satisfy them, they move to the next stage, not before that.
Legal Checks
After passing the first two stages, the legal stage appears. Now, VC calls up a lawyer to advise it. VC along with the lawyer discuss the risk and profits of the transaction in detail with its legal perspective. Only when this is done and the lawyer says that there are no risks, then investment is made not before that. This is because nobody wants to enter into a risky transaction. In order to succeed in the business world it is really important to enter into the transaction with the calculated risks not blindly.
Making More Informed and Data Driven Investments
The Due diligence process does not only benefit the VC, but also the start-up. Below are both the benefits, discussed in detail:
Benefit for Venture Capital
Making investment in a company is a big thing. Therefore, a Venture capital cannot make investments with closed eyes without proper research. It has a right to study the business before investing in it. Following the due- diligence process saves the Venture Capital from loss and investing in wrong company.
Benefit for Company
If you see the positive side to this, the due diligence also benefits the company. Even if a business is rejected in the due diligence process, it helps a company to know the reasons for its rejection. The company must concentrate on these reasons and must improve itself. This process helps the company find out its faults. Now after knowing the flaws, it can work harder and try best to be selected in the next due diligence process by another VC. Now, the company need not recollect the documents again for the next due diligence process.
Conclusion
“Precaution is better than cure”, this saying entirely suits the due diligence in venture capital process. It is better to know the company entirely before making investment and facing loss. The VC takes a 3 staged test, to check the company. Only after it is satisfied and all conditions are fulfilled, it makes the investments. This avoids VC from facing loss. It also allows the company to know its weak points and work on it.
