How does due diligence work in venture capital?

We explain what due diligence actually means in VC, and how startups can prepare for it.

So, you pitched your startup idea to a VC, met the investment team, got a green light, and received a term sheet – time to celebrate? Not quite yet. There’s still due diligence – DD – between the funds and your company’s bank account.

What is due diligence? According to the Oxford Dictionary, it is “a comprehensive appraisal of a business undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential”. Briefly, the point of due diligence is to get a full understanding of a business and uncover possible critical aspects before making an investment.

In venture capital, there’s also another side to that; we have our own investors (i.e. pension insurance companies and family offices), with whom we’ve agreed to go through specific topics before making investments. EU and Finnish legislation also require us to check certain details.

“The purpose of due diligence is to deepen the understanding of the target company, to ensure that there are no obstacles for the investment and to identify the issues that need to be fixed in order to have a strong foundation for growth.” – Ville Heikkinen, Partner at Butterfly Ventures

Due diligence process at Butterfly Ventures

We follow a specific investment strategy in Butterfly Ventures; our average ticket size is around €300k but usually, we start with a small initial investment and do follow-on investment(s) once certain milestones are reached. Due diligence is conducted before each investment, and when we’re doing it for the first time, it’s pretty detailed and thorough.

The first DD starts with signing a term sheet and ends in a money transfer. In between, it’s filled with a bulk of documents, which the startup sends to us. It can also include meetings, visits to the company’s premises, and customer reference calls. The process is collaborative; often, we help entrepreneurs to find the best solutions, solve issues, renegotiate agreements, etc. during the DD. The process can take anything from a couple of weeks to several months. In subsequent investments, we focus more on specific, important subjects found.

Often, investors involve external consultants in the process, but we rarely do that at Butterfly Ventures. Thus, our process doesn’t incur remarkable costs for startups. We believe that in early-stage cases – which we focus on – money creates more value in the startup. As we’re often the first VC, we want to get to know the company thoroughly – that’s also another reason why we like to conduct DD by ourselves.

Generally, Butterfly’s due diligence process was very straightforward, light, and well instructed. However, delivering documents and finalizing details took surprisingly long, mainly because we had been running our company informally and our documentation was insufficient.” – Tuomo Nissinen, Co-founder and CEO of 3AWater

Material delivery for due diligence

When a startup signs a term sheet, we provide them a guide and a checklist. The guide is a 7-page file explaining the process step-by-step, and it contains a list of all required documents. We also create a shared Dropbox folder for material delivery. The folder is divided into three subfolders: FinancialLegal, and Business planning & other. Each of them has up to five subsections.

For example, subfolder Financial has subsections 1 Financial reports and plans, 2 Assets and liabilities, and 3 Financing. After the startup has delivered all requested files, subsection 1 should contain the following material:

  • All approved financial statements or year-end statements
  • Latest available financial statement
  • Yearly tax statement extracts from the register on floating charges
  • Yearly balance sheets
  • Latest balance sheet
  • Yearly profit & loss statements
  • Latest profit & loss statement
  • Financial budget including sales estimations, breakeven, salaries, expenses, etc.
  • 12 months cash flow plan

Every time the startup uploads files on Dropbox, they mark them on the checklist. That way it’s easy for them to keep track of what’s delivered. Usually, delivering materials takes from a week up to a month. Once the startup has delivered all (or most) materials, we start reviewing the files.

The process was pleasant overall, I really liked the checklist provided, it made the process transparent and easy to follow. Understanding ahead of time all the documents required made it easy to get everything together and communicate with Butterfly Ventures.” – Christof Neuman, Co-founder and Director of Business Development at IPDx

Issues arising in material review

During the review process, we read and analyze the material. We bring up considerations, tasks, questions, and other findings by adding comments on the checklist or discussing with the startup. Then, based on the feedback, the startup might have to make some corrections, explain unclear topics, or deliver additional files. Then again, we go through the documents. If the quality of the material is high and the files are delivered in an orderly manner, the process is pretty fast.

It was our first DD. The process forced us to make the necessary actions to tidy, to organize, to capture. The communication with Butterfly was really good, we never felt negatively reviewed or confronted in any way at all. Really only that Butterfly wanted to know and see that we had all legal and financial and tech in order, that we had what is needed to run our company.” – Monica Vaksdal, Co-founder and CEO of Think Outside

Some examples of common issues that arise during this phase:

No employment, manager, or service agreements
All employees and founders should have sufficient agreements in place. In case the startup doesn’t have them, we can provide templates.

No full control of IP
In some cases licensing is fine, but often it seems that IP transfer agreements don’t fully transfer the ownership of the IP. For example, they might restrain the way the IP can be used, have loopholes, or limit exit strategies. In such cases, companies need to renegotiate the agreements, which is often the most time-consuming part of the due diligence process.

Complicated company structure
Sometimes founders set up different companies and merge with other companies, which leads to complicated company structures. In these cases, they need to deliver an overview chart and additional information (e.g. financial statements) about each firm, until we reach the entity which owns everything.

Arising issues can be divided into different categories; some can be marked as post-investment tasks (not super urgent), some need immediate attention. Finally, when all (urgent) issues are resolved, the startup can sign the checklist which becomes the minutes of the due diligence.

Shareholder agreement negotiations

The next step of the process is to negotiate a shareholder agreement. Often, negotiations run parallel while some of the open issues are still being resolved. Negotiations usually last from a week up to a month, partly depending on co-investors and external advisors. After the startup has signed the shareholder agreement, we take a final review of the due diligence material and sign the agreement as well.

Finally, it’s time to transfer money and close the process.

The benefits of due diligence

Even though the main purpose of due diligence is to confirm the viability of an investment, it also offers benefits for startups. DD is a great assessment tool, which helps to uncover the strengths and weaknesses of a company. The more investor knows about a startup, the better help and advice they can offer.

Sometimes, early-stage startups don’t have sufficient business and cash flow plans, and their cap tables might be skewed. In the DD process, they get help to put everything in order, which benefits all parties. As mentioned earlier, due diligence can also reveal remarkable threats, which no one has realized before. Spotting a loophole in an IP transfer agreement is an unpleasant and time-consuming surprise but for sure, a very beneficial finding for the startup.

It is hectic, all-consuming. All hands on deck. But also a great opportunity to tidy, to revisit our processes, our work, our documentation. It is also a great period to get all team members on the same plate; do all think we do what we do (or do some think we do something slightly different).” – Monica Vaksdal, Co-founder and CEO of Think Outside

When due diligence is properly conducted once, future investment rounds are much easier. Many of the collected files don’t need to be submitted again – a “light due diligence” will do in the following rounds.

“Due diligence really helps to get everything together and sets the framework to understand how we should always keep our documents. This greatly helps in general administration. It has proven beneficial in future investments to have everything ready instead of searching for all needed documents.” – Christof Neuman, Co-founder and Director of Business Development at IPDx

Due diligence tips for startups

If you’re running a startup and planning to raise money, there’s a chance that you’ll face due diligence at some point. By following these tips, you can ease the process beforehand.

An investor wants to see signed contracts. Thus, creating written agreements – even simple ones – is always better than forming deals verbally. If you have existing, written contracts with managers, employees, service providers, and other parties you cooperate with, the due diligence process is faster.

Start early. Move from ad hoc, chaotic start period of the company to a structured shape. Be upfront prepared, before you enter into a DD process, that simplifies the DD. Organize all; finances, tech, documentations and reports. Have structured methodologies for everything one does, so it is easy for new, fresh eyes to understand what and who you as a company, team are.” – Monica Vaksdal, Co-founder and CEO of Think Outside

The same applies here; having your decisions in black and white simplifies things later on.

Whether it’s IP, committed founder team, access to proprietary technology, partnerships… better have it documented.

Keep ALL essential files organized
Create a folder system or data room as early as possible, and store all important documents there: articles of association, year-end statements, loan agreements, balance sheets, shareholder agreements, etc. When there comes time for due diligence, the process goes much smoother when you don’t need to chase each file from a different place. Also, remember to keep the materials updated!

Have all your documents in order. There was nothing out of the ordinary asked, basically everything you think the investor will ask for they will… all legal, administrative, and financial documents should be ready.” – Christof Neuman, Co-founder and Director of Business Development at IPDx

It’s rare to complete the due diligence process in less than a month; it might happen but usually, it takes longer. Thus, take the fluctuating time estimates into account when planning your upcoming weeks and milestones; receiving money might take a while.

Startups should also keep in mind that the process might take 1-2 months depending on the situation.” – Tuomo Nissinen, Co-founder and CEO of 3AWater

Due diligence might seem like a boring burden that needs to be done to the detriment of more important things. Keep your team informed and explain why certain things are required and need to be done.

Allocate work/tasks and responsibilities. Founders can’t and shouldn’t do all alone. It’s also a good opportunity to revisit the past; how did we get here and now? What steps have we taken to get here? What did we learn on the way and how was learning incorporated? Is all of this well documented, and not the least; how can we communicate? – Monica Vaksdal, Co-founder and CEO of Think Outside