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Startup Due Diligence for a Venture Capitalist

Startup Due Diligence for a Venture Capitalist

What is Venture Capitalism?:
Learn why startups fail so often
How can we identify future failures?
Step One - Filter out the terrible products:
Specific product details
Must-have or nice-to-have?
Rate of growth
Market size
Market share
Location of startup
Plans for future products
SWOT analysis
Step Two - The Founding Team:
Ability as a team leader
Learns from mistakes
A solid business plan
Number of employees
Employee salary and benefits
Team chemistry
Unified mission and direction
Relationship to founder
Step Three - Financial Viability:
Current debt
Cash flow
Check Income statements
Quarterly projections
Calculate net gains and losses
Exit strategy
Step Four - Evaluate the Competition:
Know exact competition
Growth stage of competition
Reputation of competition
Realistic market share projection assuming competition survive
SWOT analysis
Step Five - Legal:
Past lawsuits
Last Words:

What is Venture Capitalism?:

Venture capitalism is the investing of money in unproven startup companies.

A successful venture capitalist has the ability to recognize one epic idea among a hundred good ones and a thousand terrible ones. While the selection process requires a lot of luck and can be almost compared to gambling, it can be made a lot safer if you take the right precautions. 

Timing is everything. If you travelled to the past and had the opportunity to invest in Microsoft when it was still a startup, you’d be crazy if you didn’t. If you bought 100 shares at $21 each back in 1985, you’d turn $2100 into over $750,000 – a growth of over 35,000 percent. This is the dream for venture capitalists.

Are you willing to make a big investment in someone else’s dream? If you make the right call, you could be the next Bill Gates. If not, you’ll join the ranks of countless others who lose big on the venture capital lottery.

Statistics are disputed, but the most sources agree that around 75 percent of startups fail. The 25 per cent that succeed all have things in common that can be identified before anything is invested. Defending against bad investments and identifying common traits of past successes is all part of the due-diligence procedure that helps you steer clear of that wide 75 percent trap.

Be the 25 percent. In Atul Gawande’s The Checklist Manifesto, a surgeon and researcher interviews a group of successful venture capitalists to find out how it’s done. Unsurprisingly, the secret is no more complex than a checklist. I’d like to think that a good checklist can avoid almost 100 percent of human error – the information is out there, it just needs to be applied properly, in a way that eliminates the oh-so-common issue of fallibility. We’re all human, after all.

Learn why startups fail so often

CNInsights.com: The 20 Reasons Startups Fail

Thankfully for researchers, entrepreneurs are generally honest about their failure. Examining 101 Startup Post-Mortems, CNInsights.com aggregated the data to summarize the 20 most popular reasons for failure.

As reported in Forbes, many startups fail because they make a product no one actually wants. The majority of businesses are started to satisfy the needs of the entrepreneur and don’t take widespread appeal into consideration.

In Richard E. Gerber’s book, E-Myth, he theorizes that most entrepreneurs think they can get by with just doing the technical work (programming, baking, writing) and don’t realize they need to be managers and entrepreneurs, all in equal doses.

A large crowd-sourced pool of data published by Inc. using answers from Quora reports that market saturation is one of the biggest issues. There are more failed products in the world now than ever before because startups try to be 0.5% of a 50 billion dollar market instead of 50% of a 100 million dollar market.

Entrepreneur criticizes the majority of startups for their business plans, claiming they rely on a black box labelled ‘???’ in the space between ‘idea’ and ‘success’.

Read 101 Startup Post-Mortems and hear straight from the founders how it all went wrong.

How can we identify future failures?

Atul Gawande in The Checklist Manifesto

Simply put, due-diligence in venture capitalism is doing enough research and preparation to avoid investing in a startup that is doomed to fail. Stay on the safer side of one of the riskier practices in business with this comprehensive checklist.

Step One – Filter out the terrible products:

Investing in great companies means giving entrepreneurs the means to meet an urgent need their potential customers have. If a product is useless, no one will buy it. It’s as simple as that.

"Investors want to invest in great products and services with a competitive edge that is long lasting. They look for a solution to a real, burning problem that hasn’t been solved before by other companies in the marketplace. They look for products and services that customers can’t do without – because it’s so much better or because it’s so much cheaper than anything else in the market." – Ben McClure

The first step of due diligence is to filter out almost every idea you see until you find one that meets the critieria for success.

Specific product details

Gather as much information about a product as you can. Find out who owns it, see if there’s a prototype or pre-beta release. Record the details of the most attractive product in the form fields below.

StartupLi.st provides information about the product as well as links to the founder’s Twitter, Facebook, LinkedIn and more. 

Angel.co goes a step further, providing onsite bios and information about everyone involved in the project so far, also the number of applicants and other data that gives a good indication of how popular the product is.

OneVest provides information about startups including funding goals and progress, current customers patent status and more.

Kickstarter is a great place to get in on the ground level with new innovations. While firms are using the platform to seed their idea through customer pledges, the founders can be contacted through the site with investment proposals. 

Must-have or nice-to-have?

Next, you need to consider whether the product is a must-have or just nice-to-have. Record your thoughts on this using the dropdown field below.

To get an idea of whether a product is a must-have or just nice to have, have a look through these points.

Questions to consider:

Are there similar products out there? If so, what makes this one the best?
Does it save a significant amount of time or money?
Is it a logical evolution of a trending idea? (Walkman to iPod)

Warning signs:

You can’t imagine yourself or others needing to use it
There are better solutions
It seems outdated or not forward-thinking enough.

Rate of growth

According to Neil Patel, angel investor and co-founder of Crazy Egg, Hello Bar and KISSmetrics, "Rapid growth early on is a sure sign of future success".

"Growth — fast growth — is what entrepreneurs crave, investors need, and markets want. Rapid growth is the sign of a great idea in a hot market."

While growth usually refers to revenue, revenue can rely heavily on other indications. Some key growth metrics for early stage companies include:

  • Customer Acquisition Cost –  According to KISSmetrics, to calculate CAC cost, divide sales and marketing costs, including overhead expenses in these departments, for a given period by the number of customers picked up during that period.
  • Customer Retention – How many customers have stayed on? Are they active or occasional users?
  • Customer Churn/Attrition – How many customer have stopped paying for the product?
  • Customer Life Time Value – How much do you expect the startup to earn from a single customer?
  •  Viral Coefficient – This takes into account social shares, accepted invites and other social media factors to determine the company’s buzz.
  • Revenue – What’s the total income of the firm?
  • Activation – The conversion rate between prospect to active customer
  • Referral – What percentage of customers choose to refer the company or product to others?
  • Profit – Are they making more than they’re spending?

Market size

A huge market size with a gap is a great opportunity for startups and investors, but it is more likely that startups will succeed by filling a gap in a small market, according to Auren Hoffman, CEO of LiveRamp. 

"Many start-ups try to be 0.1% of a fifty-billion dollar market rather than 50% of a $100 million dollar market.  Of course, both numbers equal $50 million in revenue but the company that has 50% market share turns out to be much more valuable because it is much more important to its industry."

Market size is essentially "How many customers want this product, how much will they pay and how many times a year will they buy it?".

An example of the market size of productivity tools can be found on Quora, here.

Market share

Market share is calculated after market size. For example, if you and 4 other realtors in your local town serve 650 customers and you personally serve 325 of them, your market share is 50%. A lot of data will need to be gathered from the startup you’re considering to evaluate this information. It should be compared again other metrics to determine potential size of business and to project future growth.

Location of startup

"Startups located in Silicon Valley are 60 percent more likely to experience growth compared with companies based in other areas of California"

While much of business is now done over the internet and location has historically been all about local competition, now business location is about image. Serious technology startups go to Silicon Valley, is the assumption (backed up by quite a bit of data). New York has the largest ratio of small businesses in the U.S and yet the lowest user engagement on Facebook. Craft breweries have experienced immense success in the small city of Asheville, North Carolina, but is the market too saturated?

Plans for future products

Where will your money go in the future? Are there upgrades planned? Are there projections for the effect of these upgrades on growth?

SWOT analysis

Discuss the Strengths, Weaknesses, Opportunities and Threats involved in the investment. A worksheet geared towards investors is available here.

Step Two – The Founding Team:

Venture capitalists screen hundreds of startups when looking for that one elusive company that shows real potential for growth. According to 1000ventures.com, just 6 in 1000 startups pass this first stage of screening and move through to the next. Some of these stages rely on you being a good judge of character, while some rely on the hard analysis of facts and figures. 


Passion is a vital part of a successful business. According to Investopedia, you should be grading whether your prospects would agree with these statements:

  • Is this something that you can work on over and over again, without getting bored?
  • Is this something that keeps you awake because you have not finished it yet?
  • Is this something that you have built and want to continue to improve upon, again and again?
  • Is this something that you enjoy the most and want to continue doing for the rest of your life?

Data presented by 1000ventures.com states that the top three factors that are of the highest importance to venture capitalists all relate to the attitude of the entrepreneur, with actual financial gain being less important. 

The growth of a company depends on the founder’s motivation as much as any other factors – "Personal qualities and their correct demonstration with the right stakeholders are the determining factors for success or failure as an entrepreneur." – Investopedia


So, the entrepreneur truly loves what he or she is pitching and you can see they a real passion for their idea. The next thing to consider is trust. This covers both intentional deception and potential ineptitude to determine whether or not the entrepreneur is lying to you or maybe doesn’t realize they can’t meet their goals. 

Are they able to do what they say they can? The dissertation Pitching Trustworthiness: Cues for Trust in Early-Stage Investment Decision-Making by Lakshmi Balachandra addresses this exact issue:

"Trust has been defined as a condition where “the willingness of a party to be vulnerable to the actions of another party based on the expectation that the other will perform a particular action important to the trustor, irrespective of the ability to monitor and control that other party”.

Early-stage investors enter such a relationship with an entrepreneur once they decide to invest in the company; investors must determine if the entrepreneur is trustworthy or not before they invest, which requires an interpersonal analysis."

Determining whether you can trust an entrepreneur is an art as much as it is a science. That being said, there are a few things you can look at.

  • 1

    Projected growth: Do they meet their targets? If the targets were too high, perhaps they are talking above their game.
  • 2

    Complete and utter honesty: Have they been 100% honest about every little thing they said? 
  • 3

    Are they reliable? Were they late to meetings? Did they remember all the materials for their pitch? These early warning signs can help you to make broader assumptions about a person’s character that might pay off in the long-run.


Do they know what they’re talking about?

Points to consider include: 

  • 1

    What is their exact niche?
  • 2

    How long have they been in the industry
  • 3

    Educational qualification
  • 4

    Success of past projects
  • 5

    Employment history

Ability as a team leader

How do you recognize a great team leader?

From past experience it should be obvious whether someone has the ability to lead or not. If the startup already has an office you can go and see the leadership in action. This article on Entrepreneur weighs in on the 10 most important qualities for a good team leader.

Some of the most successful firms in history have been led by entrepreneurial leaders, such as Apple, Microsoft, Facebook and Virgin. Forbes cites ‘dissatisfaction with the present’ as one of the five most important qualities for an entrepreneurial leader, as well as someone who knows how to point out and exploit the firm’s unfair advantages. 

Learns from mistakes

Studies have shown that serial entrepreneurs have a higher success rate than first-timers, and that’s no surprise. Should data in the set that doesn’t support this conclusion either be chalked up to bad luck or a stubborn entrepreneur that refuses to learn from the past? The Harvard Business Review says the data is irrelevant. In the end, there’s no foolproof criteria for every individual startup, as shown by the conflicting opinions. More evidence to support the success of serial entrepreneurs can be found on Quora.

A solid business plan

A solid business plan should align goals with time-frames and be based on comprehensive research along with the data sources for easy reference. Question the founder about the flexibility of the plan. What happens if sales are 10% lower than predicted? What if customer attrition is 30% higher?

While directed at entrepreneurs, you could use this article to find potential holes in a business plan and ask all the right questions. These are the eight things business plans should be able to tell you about:

  • 1

    Executive Summary
  • 2

    Market Analysis 
  • 3

    Company Description
  • 4

    Organization and Management
  • 5

    Marketing and Sales Strategies
  • 6

    Service and/or Product Line
  • 7

    Funding Requirements
  • 8


Number of employees

Angel investor and Brisk.io CEO Hampus Jakobsson breaks down the necessary investment for an ideal theoretical startup over the course of 18 months, taking into account the addition of one additional employee every six months to compensate for growth. Team size can be used as another way to calculate the worth of a company so far: revenue per employee.

"You will need cash for 4 people x 6 months + 5 people x 6 months + 6p x 6m = 90 man months. With minimal salaries this means $3000 /m * 90 m = $270k. So an angel round of $300k is what you need"

Simon Olson, New Business Development at Google Brazil, examines some of the implications of team size in this Quora post. 

  • Large teams could indicate a high burn rate.
  • Large teams indicate an aggressive business strategy that aims to generate enough revenue to compensate the high cost of salaries
  • A small team could indicate a problem with employee retention
  • A small team could mean an efficiency or slow growth

Employee salary and benefits

Find out exactly what kind of remuneration the employees get and decide whether this could be high enough to be a burn risk or low enough to incite workplace dissatisfaction. PayScale is a great place to find out the average salary for employees in all kinds of industries at differing levels of seniority. 

Team chemistry

Identify future risks by looking for potential conflicts in the make-up of the team.

  • A husband and wife team without experience working together
  • Founders who have never held one job long-term
  • A mixture of part and full-time staff
  • Salary inequality
  • Favoritism

Unified mission and direction

Mission statements lay the foundation for the future of any company. While most commonly viewed as being written for public eyes, the mission statement is a company’s internal reference point to stick to at all times. 

Both employees and founders need to be reminded of why they are working. Whether or not the employees work in the spirit of the company mission is a good indication of whether they share the founder’s passion and are in it for the long-haul. Like the entrepreneur, employees too should be enthusiastic, trustworthy and experts in their field.

Relationship to founder

Employees who are personal friends with the founder can either be an asset or a huge risk to productivity. Their long-term relationship could mean effortless collaboration and that they are on the same wavelength but it could also be a distraction or intimidating for employees who are not as close.

Step Three – Financial Viability:

Although arguably the most important aspect of due-diligence, this can’t be evaluated until the product, founder and team have been screened. Without a solid foundation, indications of financial viability will be an illusion at best. By assessing the key elements of the company (steps one – three) you will be able to determine whether it is worth taking on a firm that has a capacity for future growth but not obvious results right away.

Current debt

The current level of debt a company has is a good way of measuring its stability. If it is already in debt and isn’t generating enough profit to pay that back, scaling the issue up by providing more money may not be a wise choice. 

Cash flow

According to Entrepreneur, over 90% of small business failures are caused by poor cash flow. Ensure the founder has compensated for:

  • Seasonal sales fluctuations
  • Emergency expense
  • Late payments
  • Unexpected growth/shrinkage
  • Rent
  • Insurance
  • Outgoing bills date vs incoming cash date

Check Income statements

Quarterly projections

If the firm you’re screening hasn’t got any projections to present you can conduct this part yourself if you have the following information:

Fixed Costs/Overhead

  • Rent
  • Utility bills
  • Phone bills/communication costs
  • Accounting/bookkeeping
  • Legal/insurance/licensing fees
  • Postage
  • Technology
  • Advertising & marketing
  • Salaries

Variable Costs

  • Cost of Goods Sold
  • Materials and supplies
  • Packaging
  • Direct Labor Costs
  • Customer service
  • Direct sales
  • Direct marketing

Entrepreneur recommends to always double the estimates for marketing, triple for legal and insurance. Create two forecasts for both an aggressive plan and a conservative one. 

Business Model Forecast is an online tool that offers itself as software for startups to create projections. There’s nothing stopping you using it to attempt to predict a firm’s financial future.

Calculate net gains and losses

Now you need to calculate the net gains and losses of the company. Record them using the forms fields below.

Exit strategy

Smart entrepreneurs have an exit strategy for years down the line. In short, build a business to be tremendously profitable, sell it for millions and have enough personal wealth to last a lifetime. 

Find out what the exit plan is for any founder you invest in.

Step Four – Evaluate the Competition:

Know exact competition

Taking stock of the competitors is similar to calculating market share, but takes a more analytical approach. There are services out there that can do the work for you, but the founder should have a pretty good idea what they’re up against if they’re knowledgeable about their field. 

Software firms likely created their product to address customer needs that a similar service could not; they know who they’re trying to get customers from. 

Be wary about highly competitive markets – going back to the point about market size and share, these are the more risky places to invest without a great deal of prior knowledge. This article on Platformed compares the approaches competing businesses took and who came out on top. There are some valuable lessons to be learned from other people’s mistakes.

Youtube vs Vimeo

"A great counter-example of a product that didn’t try to copy and paste features form competition and continued to carve its own unique value proposition is Vimeo. In it’s initial days, YouTube’s hosting and bandwidth infrastructure coupled with its flash-based in-browser embeddable player formed a compelling value proposition for content creators. As YouTube gained traction among content creators, the focus of the platform moved from improving video hosting infrastructure (as a value proposition to creators) to improving match-making of videos with consumers (focusing on video search, and a video feed).

Vimeo decided, instead, to focus its platform on the content creators and provide them with superior video infrastructure (HD player, a netter embeddable player for bloggers). This has helped Vimeo steadily gain popularity as a video-hosting infrastructure despite the YouTube’s dominance as a video network." – Source.

Growth stage of competition

In the eternal words of ancient Chinese military philosopher, Sun Tzu: know your enemy

To know the best direction forward and to advise your investment where the money should go, you need to know what else is out there and, more importantly, how significant it is. A great example of transparency in the murky world of investment is Angel.co, a site where you can find out which round the competing startups are in, how much backing they have and who the founders are. 

A quick look at trending startups on the front page of the site and you’ll see what I mean. Level, for example, at the time of writing, has a $120,000 seed from one investor. It’s also worth noting the founder is a serial entrepreneur who raised $8.5 million for a games firm that went on to be acquired by Zynga (Facebook). 

It’s this sort of information that can give you the edge, either when you’re already making the investment or when you are deciding whether the startup has any future in its target market.

Reputation of competition

There’s obviously a big difference between competing against a multinational corporation and against a startup. As part of working out the market share, realizing the competition’s reputation is essential to making sense of the data.

Is there a large, innovative company that could make the same idea big first? A case study on this not-so-rare situation comes in the form of Instagram vs Hipstamatic.

Launching almost a year before Instagram, Hipstamatic got everything right from the get-go. It was essentially out-competed by Instagram. It panicked, releasing a slew of unfinished features and products, before admitting defeat shortly after Instagram got the ultimate seal of approval; acquisition from Facebook. 

Realistic market share projection assuming competition survive

Take note of any very new companies and monitor their growth stage and reputation as it happens.

SWOT analysis

Discuss the strengths, weaknesses, opportunities and threats that the competition has. Strategic partnerships are an obvious opportunity, while the threats are being made irrelevant by a startup more growth-focused. As before, a worksheet to make this easier is available here.


Your prospective investment should take care of providing you with a list of authorized or pending patents. Make sure they match up exactly to the product they plan on putting out.


Is the product or company name already taken? If the startup is in the early stages, advise the trademarking of ideas to ensure the most effective one is available.


Is there proper insurance in place for every concievable eventuality? Making sure you check this personally could be the one thing that saves you your entire investment. An uninsured company is certain to go under in times of disaster. 

Past lawsuits

Everything else is in order? Get a good idea of the founding team’s historical involvement with the law. Maybe there has been a dispute over trademarking in the past? You need to get a good idea of what happened in the past so you can plan for the worst in the future.

Last Words:

If you’ve got this far it looks like you’re erring on the side of caution. If you’re part of an investment group, don’t hesitate to have the other members run this checklist on the startup – keep in mind Gawande’s above quote from The Checklist Manifesto.

Good luck with the investment!

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