Risk And Rewards: Due Diligence In Venture Capital

A lot has already been said about the various corporate misgovernance and window-dressing practices that have been identified within the growth and late-stage startups of the country, and what it means for investors and founders alike. 

This spotlight on malpractices underscores the paramount importance of conducting due diligence before making any investment commitments. 

For those unfamiliar with the intricacies of the venture capital and private equity landscape, due diligence entails a comprehensive examination aimed at verifying the accuracy of all historical and current information provided. 

Its primary objective is to unearth any potential red flags or hidden pitfalls that could adversely impact investors in the future. Initiation of the due diligence exercise indicates that the only thing stopping investment from coming into a company is red flags. 

Types Of Due Diligence

The thoroughness of due diligence (DD) exercise may vary depending on the stage of the  investment and the specific sector involved, yet it essentially encompasses four primary categories: 

Financial Due Diligence (FDD)

FDD delves deep into gauging the financial health of the organisation. This involves turning the accounting books of the company inside out and identifying trends and patterns that could serve as indicators of its future performance. 

By scrutinising the accounting books, FDD  not only validates past claims but also assesses future projections and profitability goals. Through this exercise, investors gain insights into the entity’s accounting practices, understanding their potential impact on future management Information System (MIS) and Key Performance Indicator (KPI) tracking. 

Legal & Compliance Due Diligence (LDD)

This is an essential “skeletons in the closet” check. This process involves a comprehensive review of all agreements and contracts that the company has entered into,  encompassing a wide spectrum such as agreements with shareholders, vendors, customers,  employees, founders, banks, financial institutions, and related parties, among others. 

The essence of LDD lies in uncovering nuances beyond the surface, acknowledging that “there is more than meets  the eye.” 

Usually spearheaded by a lawyer, the LDD is the single largest red flag generator and what most indemnity clauses are linked to. The outcome of LDDs often involves specific call-outs to the company’s past practices, their potential ramifications in the future, and proactive measures investors can take to shield themselves from potential litigations or lawsuits. 

Unless the findings prove to be a deal breaker, LDD plays a pivotal role in ensuring investors are well-informed and protected in the legal and compliance landscape. 

Technical Due Diligence (TDD) 

It assumes paramount significance, particularly in businesses where growth hinges on technology’s inherent capacity to differentiate from competitors. In sectors like deeptech and biotech, characterised by a demand for domain expertise, TDD emerges as a pivotal exercise, often orchestrated by funds in tandem with highly specialised tech experts. 

In both tech and non-tech domains, the nature of the check may vary, with some being more focused on standard practices. However, a company not passing the TDD with flying colours is most likely not getting funded, as a technology gap is a harder pill to swallow than delayed filings. 

Founder Diligence

It is the most crucial of all, especially in the early stages. Identifying the founders’ skill sets,  mindset, and goals is paramount since they essentially constitute the driving force behind the company’s trajectory for an extended period. 

The ability to analyse founders and assess their capacity to scale and navigate challenges in a highly dynamic environment is integral. In essence, if an investor conducts an inaccurate analysis of the founder, no amount of green or red flags can salvage the investment. 

Conclusion

All the above diligence forms are an essential part of the pre-investment exercise by investors.  However, this does not draw away from the importance of maintaining a constant check on all factors. 

In many instances, late-stage investors may extend the benefit of the doubt to the diligence  

performed by previous investors. Nevertheless, recent times have taught us one thing for certain:  nothing can be taken for granted.

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.