#20 - Diligence Basics Part 1: Initial Screening

An introduction to the first phase of due diligence.

Dec 01, 2021

Welcome back StartOP family! I am extremely excited to kick off this series about conducting basic due diligence on startups. Make sure to check out the opportunities to join the StartOP team in our LAST ARTICLE and apply HERE(applications due tomorrow at 11:59pm EST). Subscribe below to get future editions of the StartOP newsletter!

What really is due diligence?

Due diligence is often considered one of the most important parts of venture capital and is ultimately responsible for deciding if it’s worthwhile to invest in a specific startup. The due diligence process often begins with a venture analyst or associate screening ventures to see if they fit the fund’s investment thesis. Once a startup appears to match the VC fund’s thesis, the team would begin conducting further evaluations before potentially negotiating an investment. Now we are going to dive into the first part of due diligence, the “initial screening”.

Initial Screening, Importance of First Impressions!

The initial screening is a startup’s chance to impress investors and make them want to learn more about your venture. A large portion of prospective startups are often filtered out at this stage with only about 10-15% of sourced startups moving to the next stage of the investment process. During the initial screening, prospective startups are evaluated in five main areas to see if they’re a match with a VC firm.

1. Team

The first part of the initial screening is all about whether the founding team contains the best people to solve a given problem. The founding team is ultimately responsible for guiding the venture and the venture’s ultimate success or failure. An investment into an early stage startup is looked at by many venture capitalists as an investment into the founding team of that company.

2. Product

It is imperative that a startup’s product, or initial product concept, improves dramatically on an existing problem or solves a problem that has not previously been tackled. The product itself must also have the potential to be profitable when scaled, which often is more straightforward for software products, but can get complex when dealing with hardware products. A product can also evolve as the founders conduct market research to evaluate if the need for their product actually exists.

3. Market

Market size is another key component of the initial screening process as a small market (often viewed at below $1 billion) will not allow a VC firm to get a sufficient return on their investment. VC firms typically look for large markets with the potential to support the startup reaching 10X, or greater, growth. If a startup is in an emerging market, venture capitalists often must conduct a significant amount of research to support the company's market hypothesis.

4. Fit

Venture capitalists often focus on specific sectors or industries that align with their background and experience. Many VC firms, especially those founded recently, also invest based on a thesis of how an industry will evolve in the future. An investment thesis could also revolve around certain social issues including: environmental preservation, serving the underserved, rebuilding countries and creating opportunity for global advancement, along with many other initiatives.

5. Stage

VC firms often focus on investing in startups at specific stages, though some are stage agnostic. As startups grow, there are different aspects of the due diligence process that carry higher weight including ARR (annual recurring revenue), CAC (customer acquisition cost) and an overall more in-depth dive into a company’s finances. To learn more about startup stages, check out a past StartOP article HERE.

The Recap

Due diligence is often a long and research-intensive process that every fund and venture must go through on their way to making an investment. The process is kicked off by an initial screening, which focuses on evaluating the venture’s “fit” with the fund’s platform and investment thesis. Though each VC fund has different screening methods, prospective ventures will often start by being analyzed on 5 fronts: team, product, market, fit and stage. Stay tuned for our next newsletter to learn about the second phase in the due diligence process!

Diving Deep

Check out these articles for additional insight on the first stage of due diligence:

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