Introduction

Each year, thousands of startups prepare to pitch their ideas to venture capitalists for a chance at funding their dreams.

While there are currently more than 54,000 VC-backed startups in the U.S., fewer than 1% of startups receive VC funding, Forbes reported. Clearly, the series funding process is challenging, and startups need to be prepared to show more than just a good product idea in order to wow investors.

VCs perform a thorough due diligence process to weed out riskier investments, instead focusing on startups with solid business plans, clear product demand, and a calculated strategy to scale well into the future.

In order for startups to clench the coveted VC funding, founders will need to understand how to meet the expectations of the venture capital due diligence process.

Venture capital due diligence: How it’s changed over the years 

Before investing in a startup, a venture capitalist needs to perform due diligence, or the process of evaluating the risks, viability, foundation, and scalability of the company. In short, the VC wants to ensure the startup they are considering has a detailed business plan and a good chance of providing a return on the investment.

VC investments and the ways VCs conduct due diligence have changed frequently over the years. Whether it’s the industries that get the most VC attention or the business aspects VCs are inspecting during the due diligence process, there are many changes and trends for startups to be aware of before they start pitching investors.

Following 2020, when the COVID-19 pandemic hit and disrupted businesses worldwide, VC investments saw a major increase in 2021. As reported by Forbes, VCs in the U.S. raised $128.3B, up 1.5 times the amount raised in 2020. According to Statista, VCs invested about $345B that same year, a record high.

But by 2023, VC deals reached a low not seen since pre-pandemic times. VentureBeat reported that VCs raised $66.9B, and investments reached $170.6B, about half the amount invested in 2021. 

In an interview with HubSpot for Startups, Naman Jain, senior manager of the Startup Program at Startup Grind, shared what he has seen in terms of changes in investing trends in recent years. Today, Jain says AI, climate tech, and EV companies are seeing more investments because of their potential.

“I think the two major revolutions that will happen in the next couple of decades are artificial intelligence and energy transition,” Jain said. “From what I've seen, these are the two hottest industries that VCs invest in because they're going to grow so much over the next couple of years and have the biggest revolutions for the next couple of decades.”

In fact, AI is performing so well that it is driving an increase in VC investments. As EY reported, investments in AI comprised 37% of the $42.9B of VC investments in Q2 2024.

But it’s not just specific industries that are trending in the VC space. Jain is also seeing shifts in how VCs are investing their money, particularly in startups that have strong, detailed business plans.

“Fundraising, in general, has become conservative. That's because a lot of VCs have lost money investing in startups over the last 10 years, and it's been very hard for many of these VC firms to get exits.” Jain explained. “One of the biggest trends we're seeing is VCs focusing more on businesses that care about unit economics and profit. Obviously, the vision has to be there. They have to burn money when they have to. But the business model should be very clear.”

Steps in the VC due diligence process 

Now that you know the trends in venture capital due diligence, it’s time to learn the process to better understand what investors are looking for when considering startups for investments.

Here’s how VCs conduct the due diligence process to source the most promising startups.

Initial appraisal 

As soon as you begin talks with a VC firm, investors will be evaluating your startup to determine whether it’s worth the time to do further research and investigation into the company.

To start, they will want to know more about the basics of your business, including your business plan, the team you have in place, and how your business fits into the target market. The focus will be more on the big picture at this stage rather than detailed business figures, but you will need to show that the team has the expertise to run a successful business and that there is a need for your product or service within the target market.

Market analysis 

If the initial appraisal goes well and the investor feels that there is potential for your startup, they will start diving into a deeper investigation of your business. The VC needs to confirm that your startup makes sense in its target market, especially considering that 35% of startups fail because of a lack of market need, according to CBInsights.

At this stage, the VC will explore top competitors to the startup to make sure the startup is different and provides a unique value that will have a leg up on the competition. After all, CBInsights found that 20% of startups fail because they can’t compete with other businesses, which presents a risk to investors.

However, market fit and competitors aren’t the only market risks to a business, and investors will want to thoroughly explore any potential challenges that could come up down the road. External risks don’t mean VCs won’t invest, but they will expect startup leaders to have plans to adapt to risks. Some of these risks can include regulatory changes and emerging technology.

Financial review 

One of the most important steps in venture capital due diligence is a financial review. Sure, startups may not have a ton of sales and revenue on the books right away, but there are still plenty of financial details a VC can analyze. 

The VC will want to see how the business is spending money and how sales are projected to grow in the future. Some of the financial statements and metrics the VC will look at include balance sheets, accounts payable, leases, debts, inventory, customer invoices, revenue, revenue growth, customer acquisition costs, and customer churn rate.

With cash flow issues being one of the top reasons startups fail, VCs want to ensure the startup they invest in isn’t at risk of facing serious financial problems over time.

Legal due diligence 

Businesses need to meet several standards and have appropriate licenses and registrations to operate. These standards can vary based on the type of business and what it sells, but VCs need to make sure the company is legally sound and doesn’t risk losing the investor’s money if it’s shut down for improper operations.

According to Exploding Topics, around 2% of startups fail because of legal trouble. Startups should take extra care to make sure they are meeting local, state, and federal obligations before pitching to VCs.

Evaluating the management team 

Securing VC funding also means founders are entering a type of partnership with the investor. As such, investors will want to make sure the management team is a good fit both in terms of skills and personalities. 

As Harvard Business Review reported, about 60% of new companies may fail because of internal team issues, which can be a big risk to investors. Startup founders need to not only have the skills and experience to run the business successfully, but they also need to get along and work well together. In a study, Harvard Business Review found that a balance of technical skills and soft skills, like passion and shared vision, helped leaders better run their startups.

If your startup has already started hiring employees outside of the founding team, investors will also evaluate these employees. They will want to ensure the team works efficiently and communicates clearly and that the company’s organizational structure makes sense.

Technology assessment 

Does your startup have the right technology to run the business? Investors need to confirm that your company has a reliable technology stack, or tech stack, that provides a user-friendly experience to both customers and employees. They will want to review the startup’s product development process to make sure it’s efficient yet not too expensive with excess or costly tools that aren’t really necessary.

If you have a tech startup, investors will want to review any proprietary technologies that can help your company stand out from competitors.

Other factors VC firms consider  

Different VC firms may have varying criteria for what to check during the due diligence process. While most VCs will need to review financials, perform legal due diligence, and analyze market fit, some may have additional factors they want to see, like a product with traction, a loyal customer base, exit strategies for founders, and more.

In a recent interview with HubSpot for Startups, Olivia O’Sullivan, partner at Forum Ventures, shared advice on what investors are looking for in startups today.

“What an investor is willing to see at that inflection point is, that you have a product that's live and you have demonstrated that your engineering team can build a product and iterate quickly,” O’Sullivan said. “And you've demonstrated, in some capacity, the ability to be able to recruit a strong team, whether it's your co-founders, or maybe you have a few employees.”

Outside of product development and recruitment, here are other factors VCs may investigate while doing due diligence.

Customer and reference checks 

Investors want to see that a startup has traction, meaning that the startup is gaining attention and momentum among its target audience. To do so, they may review customer feedback and customer satisfaction metrics, such as net promoter scores (NPS) and customer retention rates.

“From an attraction standpoint, after the pre-seed round, you want to prove that some subset of your customers are rabid users of your product, where you have rave reviews and there are signs of stickiness and strong engagement and some meaningful early traction,” O’Sullivan said.

The VC may also require references to validate startup leadership, and they may have conversations with former colleagues of the founders or industry experts to confirm the leaders have the skills and experience outlined in their resumes.

Exit strategy 

Ultimately, the investor’s goal is to make a significant return on their investment and exit the company by selling their equity or share of the startup.

“Obviously, this is assuming there's a large and growing market, an investor needs to believe that there's the potential for your business to make $100M in revenue to have a meaningful exit,” O’Sullivan said.

However, investors also want to make sure that not only do they have a path to exit but also that founders have a plan should they decide they want to leave the company down the line.

Investors typically look for at least 10x, but usually more along the lines of 50x to 100x, in their initial investment. They will want to know that your business has a path to scale revenue and that the business leaders have considered exit strategies. 

Startup founders should build an exit strategy into their business plan, which will prepare the business if the company wants to pursue an initial public offering (IPO), a founder wants to leave, a company merges with or acquires the startup, or an investor wants to exit.

How startup founders can prepare for the due diligence process 

The due diligence process may seem intimidating, but it’s a great opportunity for startups to fully flesh out and refine their business plans and processes. 

The due diligence process protects investors from riskier business investments, and it can build more trust in the startup when founders are communicative and transparent. 

In preparing for the process, startup founders become more organized and prepared for future investor meetings. Even if one investor says no, the due diligence process can better prepare startups for future investor meetings while also improving the way the startup does business. 

Here are ways that founders can prepare for VC due diligence.

Have a comprehensive business plan 

Investors want to see a detailed business plan that documents how the startup fits into the industry and target market, how finances are projected to grow, why this business stands out from competitors and offers unique value to users, and what goals the business has for the future. 

You’ll also want to include information about the founders and leadership team so investors can see that your team is well-suited to running the business.

A strong business plan not only shows the investor that the startup has been thoroughly thought out and is more than just an idea, but it also helps set the startup up for success.

Document your processes 

Startup founders should have documents that explain how the various processes within the company work. Investors will have questions about different aspects of the business as they complete their due diligence, and documenting processes upfront better prepares founders to answer any questions.

This process can also ease the mind of investors as they do their legal due diligence. They will want to check that all the paperwork, such as legal agreements and intellectual property filings, is complete. Keep these documents in a secure, centralized place within your tech stack.

Maintain open lines of communication 

Investors are looking for a startup with the potential to make far more money in revenue than their investment, but they also want to make sure they connect with and trust the founders. 

Prioritize investor communications and be transparent throughout the VC due diligence process. First, make sure one founder or leader within the startup is the main point of contact for the VC. This person should be able to respond to any questions or requests as quickly as possible.

Business challenges or risks aren’t necessarily going to scare off an investor but be upfront about any concerns you have for the business. To go the extra mile, prepare steps the business is taking to mitigate any risks to show the investor you can be proactive in the face of challenges.

Secure funding by preparing for VC due diligence

As a startup enters the due diligence process, it can be an intimidating time. Will the investor find huge red flags and walk away? Startup founders should look at the venture capital due diligence process as an opportunity to map out their business, organize their important documents, and improve the company overall.

By preparing for VC due diligence, startups are setting up their startup for success. The detailed business plan, proven traction, cleared legal paperwork, and additional data can all help the startup improve its operations. Even if one investor says no, the due diligence process sets a startup in a better position for a yes from the next investor.

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