In a new weekly column, a VC answers our community’s most pressing questions. It’s Dear Abby for startup founders. 

By Renee DiResta (Principal, O’Reilly AlphaTech Ventures)

How do you (and the early-stage VC community in general) like to conduct due diligence on the companies you are interested in funding?

– Aspiring Founder in San Francisco

The purpose of diligence is to answer Who, What, When, Where, and Why questions about a prospective deal. At a seed-stage fund, this typically involves four things: market research, competitive research, customer feedback, and founder reference checks. Taken together, these present an investor with as comprehensive a view of a deal as possible. A fifth element, much more common in later stage investing, is an examination of financials.

Market Research

Market research involves looking into trends in a given sector. This type of research is often done well in advance of a specific opportunity coming in, for the purpose of understanding a hot market or with an eye toward crafting an investment strategy. This is because it’s time-consuming, and may be rushed if done reactively around a particular deal. However, sometimes it does happen in conjunction with diligencing a particular deal. Some common questions that investors try to answer include:

  • What are the drivers in that segment of the economy?
  • Is the addressable market of customers growing or shrinking?
  • Is there an underlying regulatory framework that dictates rates, prices, or behavior?
  • Are there changes happening that make this market particularly prone to disruption in the near future?

Competitive Research

Competitive landscape research involves examining a sector to determine who the component players are. The first step is to identify the large incumbents – the 800-lb gorillas who serve the majority of customer needs in the space. Then, there is a survey of smaller players and other startups. Who has entered the space recently? Are those startups funded or showing evidence of traction? Is this a “land grab” situation, where dozens of startups are trying to differentiate with highly-specific niche features, or are there few entrants (few entrants isn’t necessarily more ideal; that may mean there’s no real demand)? The competitive companies are then compared to the startup under consideration, typically on pricing, the offering, and/or the technology.

Customer Feedback

Customer feedback involves getting on the phone with users of the product and asking them why they are using it. We try to ascertain willingness to pay (or, verify that the customers are paying), and investigate the likelihood that early customers are going to evangelize for the product to other potential customers. There are usually some questions about differentiation – why this specific app? How does it compare to whatever the customer was doing to solve the problem before the startup came along?  The VC will obviously try out the product as well, and may connect the startup with potential new customers to see if they can close a deal, or to get feedback from an objective new source.

Founder Reference Checks

Checking out the founding team is pretty self-explanatory. It’s done primarily to gauge trustworthiness, work ethic, technical competence, and to hear about what it’s like to work closely with the founder. Usually these calls take the form of founder-provided references to start, and then some extended-network validation. We will often connect founders with members of our network who have deep domain expertise in a relevant area, and then get feedback from them.

For a full understanding of the diligence process around financials, I’d suggest going to a business textbook or Quora. At any stage, the VC has a look at the cap table; while it’s up to the founders to determine their split, a hugely disproportionate equity arrangement can be a red flag. We also sanity-check basic financial models to verify that the founders have made reasonable estimates around growth, sales, revenue, etc. At later stages, financial due diligence is a highly involved process that includes validating income statements, balance sheets, and cash flows from the previous few years, looking at financial reports, the cap table, revenue models, potential legal/liability issues, and much more.

Each VC firm has their own spin on the process, so it’s perfectly reasonable to ask an investor what their specific diligence process entails during your pitch meeting. Good luck!

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picAbout the guest blogger: Renee DiResta is currently the Principal at O’Reilly AlphaTech Ventures, where she researches emerging technology trends and supports portfolio companies. Prior to OATV, she spent six and a half years as a trader at Jane Street Capital, a quantitative proprietary trading firm. Follow her on Twitter at @noupside.