Venture capital, is generally a kind of finance where money is being invested in a company, a startup, or a small business in exchange for equity in the company. In raising funds from various investors, VCs invest these funds in various companies. Their general partners go out and raise the funds from these investors referred to as limited partners. In this case, if the company performs well, the GP’s firm benefits, so does the LP. Companies use capital invested in their businesses to hire out their team, broaden their offerings, or reach a profitability milestone. VC is part of a much broader and more complex branch of the financial system known as private markets.
Venture capital firms are investment firms that finance and guide startup companies and other young businesses. Like PE firms, VC firms invest the money contributed by limited partners in private companies with promise. Unlike PE firms, however, VC firms typically acquire a minority equity position—50% or less ownership—when they back companies. A firm’s portfolio consists of the companies it has invested in and the companies themselves are referred to as portfolio companies.
Venture capital is the epicenter of growing startups and small companies, but before an investment, a venture capitalist goes through a rigid scrutiny known as due diligence. Venture capitalists do due diligence before making any investment decision because in this it do a thorough examinations of company’s business model, its management team, what are the market opportunities, and their compliance with law. This procedure ensures venture capitalist that whether the decision they will take about the investment that is to what extent they must invest and what are the calculated risk and probable returns.
Venture capitalists do due diligence so that they may not take decisions in a rush to invest in a business. They study all the angles of a business before deciding whether that business holds any possibility of success and growth. Due diligence helps them know some of the problems a business may face and how it may overcome those problems.
The due diligence process involved in venture capital often takes time and complexity. However, it is very important for both venture capitalists and the businesses seeking investment. For venture capitalists, it reduces the risk that can be taken when investing. For the businesses, it gives the opportunity to explain their potential for growth and profitability.
IMPORTANCE OF DUE DILIGENCE IN VENTURE CAPITAL INVESTMENTS
Lack of history & Volatile growth
Most of the ventures financed by venture capital firms are relatively less historic, meaning there is very little information to help make an informed decision.
While the conventional assumption is that starts-ups tend to function in explosive mode, in short term reality, growth turns out to be much more volatile, which makes long-term growth predictions much more uncertain.Risk mitigation
Venture capital investments (VC) are inherently risky as most start-ups collapse. Due diligence by VC firms can unearth and minimize risks associated with the company’s business model, market environment, technology, and team. It helps in getting out the hidden issues that may have an influence on the working of a start-up or bring legal and financial troubles in the future.
A close examination of the legal agreements, ownership of IPs, compliance with the relevant regulations, and the lawsuits can help avoid risks that may jeopardize VCs.
This financial health, cash flow, and liability assessment can be very useful to understand if a profitability level can be achieved or if more funding is necessary.
An assessment which is done for knowing financial health, cash flows, and liabilities will help understand the potential capability to achieve profitability or whether any additional funding is necessary or not.
Valuation and Investment Decisions
Due diligence would be necessary to establish the fair value of a startup, while financial statements, revenue forecasts, and market analysis would most likely constitute the tools whereby a VC could measure relative growth prospects about the startup. If due diligence were not strictly conducted on the work of the entrepreneurs, VCs would pay too much for equity that would restrict their gaining’s.
It depends solely on the accuracy of financial projections made by the startup of relative growth against the valuation.
VCs can even evaluate whether the startup had an executable market opportunity by understanding the landscape of competition and the demand in the market.
Business Operations
Other crucial aspects of due diligence include the business model, supply chain, and operations process requirements-one needs to understand how the company works, its scalability, and resources required to scale up.
VCs need to assess whether the product or service is ready for the market or significant development.
Operational Efficiency Inquiries regarding how the company manages the costs of doing business, how supply chains are managed, and how the customer’s relationship is maintained are pursued to conclude whether or not the startup can scale efficiently.Exit Strategy
Usually, VCs strategize the exit much earlier to make the most of the return. In the due diligence process, VCs study and assess possible exit opportunities depending on the possible acquisition or merger and possible IPO. Their knowledge about the growth curve and the company’s positioning in the market helps estimate the timeline of the probable exit as well as the probable return on investment.
Due Diligence helps the venture capital firms predict the performance of the startup over time and identify optimal opportunities for an optimal exit.
CONCLUSION:
Since venture capital investments can be strategic, it would, therefore, form the foundation for informed, risk-adjusted, and good venture capital investment. Venture capitalists mitigate risks better through due diligence to make value-enhancing investment decisions and maximize their returns. Unless a VC does proper due diligence on every aspect of a startup before committing an investment, he is bound to suffer financial losses, legal troubles, and the loss of reputation.