Due Diligence: A VC’s Guide to Vetting Investment Opportunities

For venture capitalists, investing in innovative startups with intellectual property (IP) often proves to be a pivotal strategy that leads to differentiation and growth.

With the right acquisitions, thousands of VCs have a decades-long competitive edge. Investing in startups with strong IP portfolios, in particular, is a lucrative and effective strategy that paves more paths for greater financial returns, product innovation, and industry dominance.

Thanks to constant developments in the field of IP, venture capitalists continue to understand the role of assets like patents and trademarks in choosing which startups to invest in. Those who’ve maintained their position ahead of the curve—such as Alphabet, Tesla, and META—now enjoy near-irrefutable positions in their industries because of this particular frame of mind (and the approach it bears).

For any venture capitalist looking to grow their portfolio tenfold (at the very least), investing in firms with strong IP portfolios and potential is a crucial strategy to adopt. Before one follows suit and hops on the opportunity to generate high returns on investment, however, there’s one critical practice any VC needs to know about before using the strategy in question:

Due Diligence.

Any venture capitalist needs to know that not all startups with intellectual property are successful. Investing—which makes it even more important to vet carefully.

By conducting due diligence, VCs can use a comprehensive and systematic process. As difficult as this process may seem, it’s relatively straightforward once all the details and necessary steps are laid out.

Here’s a thorough guide on due diligence and how venture capitalists can use it to vet investment opportunities better:

First of All, What Is Due Diligence?

Simply put, due diligence is a systematic process of investigation, research, and analysis that venture capitalists can use to evaluate the potential risks and opportunities associated with investment opportunities. It generally involves a comprehensive review of a startup's financial, legal, technical, and market status that provides insight into whether it aligns with the investor's investment criteria and goals.

This fundamental concept is essential in the venture capital investment process because it provides crucial details that lead to more informed investment decisions. By conducting due diligence, VCs can identify potential red flags, assess a startup's growth potential, and negotiate better terms for their investment.

The 5 Types of Due Diligence

There are five different types of due diligence that VCs can conduct to gain a more comprehensive understanding of their investment opportunities (and their accompanying IP portfolios):

1. Financial Due Diligence: This form of due diligence revolves around reviewing a startup's financial statements, projections, and accounting practices to evaluate its financial health and identify any potential financial risks.
   
   
2. Legal Due Diligence: In this form of due diligence, VCs are required to conduct a thorough review of a startup's legal documentation, contracts, and regulatory compliance to assess the legal risks associated with an investment.
   
   
3. Technical Due Diligence: This form of due diligence encompasses thoroughly reviewing a startup's technology and infrastructure—such as software, hardware, and intellectual property to evaluate its technical capabilities—while identifying any potential technological risks.
   
   
4. Market Due Diligence: This form of due diligence involves VCs analyzing market trends, customer behavior, and the competitive landscape to assess a startup's potential for growth and success.
   
   
5. Intellectual Property Due Diligence: When investing in startups with IP portfolios, VCs are required to conduct intellectual property due diligence by reviewing a firm’s patents, trademarks, copyrights, and trade secrets and checking them for validity, potential and possible applications.

Key Considerations to Account for When Carrying Out Due Diligence

Venture capitalists must be aware of several critical considerations before conducting due diligence when vetting potential investment opportunities. By considering these details, it becomes easier to ensure profitable investments and streamline the process of finding them.

While the list of key considerations continues to grow each year with new developments and trends emerging, there are eight main factors—or “must-haves,” in layman’s terms—that need to be prioritized when doing due diligence:

1. Employing the Assistance of Experts

One vital—yet commonly overlooked—aspect of due diligence VCs need to know is that it requires expertise in different areas, such as finance, intellectual property, technology, and marketing, to be effective.

Venture capitalists should involve domain experts with specialized knowledge and experience in each area when conducting a comprehensive and accurate assessment of an investment opportunity. This ensures that all insights and information accounted for when forming a final investment decision are accurate, reliable, future-proofed, and free of bias or influence from external actors.

2. An Awareness of the Challenges That May Arise

Conducting due diligence can be a time-consuming process for VCs—especially when challenges come up along the way.

One of the biggest challenges is generally accessing reliable and accurate information about the startup. This is a pervasive case for VCs investing in early-stage startups with limited financial and legal documentation.

Another common due diligence-related challenge for venture capitalists is managing the process efficiently and effectively—even more so when involving multiple domain experts with different schedules and priorities. This challenge can lead to missed opportunities, merger and acquisition delays, and investor trust loss.

By being more aware of challenges like these, VCs can adequately prepare their processes and approaches to circumvent them more efficiently and effectively from start to finish.

3. Thorough Reviews of Financial Statements and Projections

According to an article by Ernst & Young, the majority of successful VCs consider financial due diligence to be the most critical aspect of the due diligence process.

By assessing the startup's financial health, VCs can accurately gauge the potential investment risk while uncovering any red flags and points of improvement that may influence their decisions. Typically, there are numerous ways for investors to quickly and safely do this—such as:

• Reviewing a start-up’s financial statements;

• Thoroughly analyzing an investment opportunity’s financial projections (and cross-checking to see if they line up with market analysis) and

• Employing various accounting practices to identify potential risks—such as cash flow problems, debt obligations, or unrealistic revenue projections.

4. Objective Team and Leadership Evaluations

While investment decisions usually revolve around a company’s financial statements, industry standing, and growth potential, there’s another part of the equation that must come into play during the due diligence process:

A deep dive into the people behind it—specifically, its team members and leaders.

The team and its leadership are crucial factors in determining the success of a startup because they are two of the biggest influencing factors on a company’s performance year in and year out. This means that to carry out effective due diligence processes, VCs should also be able to thoroughly evaluate a company’s team and leaders based on key factors like:

• Skills;
• Experience, and;

• Track records

Incorporating a team-and-leader check into the due diligence process will make it easier for a VC to gauge a potential investment’s ability to execute business plans and achieve set targets. Considering this key consideration during the vetting process makes even more sense, considering that 23 percent of startups fail because of poor management.

More Due Diligence = Better Investment Decisions for VCs

With thousands of startups emerging each year, venture capitalists now have a growing pool of investments to tap into when building their portfolios. Picking the right ones to invest in, however, is easier said than done because of all the possibilities and precautions involved.

However, incorporating the habit of practicing due diligence lightens the load.

Through constant due diligence, venture capitalists can improve how they vet investment opportunities. This minimizes risk while uncovering valuable and decision-influencing insights. The key considerations and details above can help improve the same process even further, making the acquisition process more efficient, effective, and profitable!