Performing due diligence on an early-stage startup is a critical step for investors or potential partners to assess the viability and risks of the company. The degree of due diligence can vary depending on the specific industry, startup stage, and level of investment or partnership. It’s crucial to carefully review and assess all relevant information, ask questions, and seek professional advice to make informed decisions.
Here are some steps to conduct due diligence on an early-stage startup:
➡️ Assess Management Team: Evaluate the startup’s management team, including their experience, previous exits, skills, track record, and roles (did the founding team work together in the past?). Assess if the team has the expertise and capabilities to execute the business plan and navigate challenges. Early-stage startups may be more reliant on the founders’ vision and execution capabilities, so you may want to closely evaluate the team’s ability to drive the startup’s growth. Basically, this is the least tangible part of the due diligence. Still, for me, it’s the most critical component thank can indicate the company’s success already at the very early stage. Sometimes, or many times it’s all about people, and even if the product is not ready yet but the team is passionate, has unique synergy, apparent grit, and complementary skillsets, they will make it happen and find a way to bring the product to the market (given all other factors like market, demand, etc. exist)!
➡️ Review the Business Plan/Financial Model: Carefully review the startup’s business plan to understand its product or service, target market, revenue projections, and growth strategy. Assess if the plan is realistic and well-thought-out. The total 5-year projections may not be available if the startup is in the very early stage, and the numbers may not be that helpful but the strategy should be appropriately defined and GTM clearly established.
➡️ Evaluate the Market Opportunity: Research and assess the market opportunity for the startup’s product or service. Consider the size of the market (Antler has excellent materials about TAM, SAM, and SOM), competition, customer demand (does the problem exist?), and trends (is it a long-term demand or a single-event generated hype?). Evaluate the startup’s competitive advantage and potential for growth.
➡️ Review Financials: Review the startup’s financial statements, including balance sheets, income statements, and cash flow statements. Assess the startup’s financial health, revenue streams, expenses, and profitability. Look for any red flags, inconsistencies, overspending, or areas you could potentially help and advise.
➡️ Review Intellectual Property: Assess the startup’s intellectual property (IP), including patents, trademarks, copyrights, or other proprietary assets. Verify if the startup has legal ownership of the IP and if it is protected. It’s helpful to clarify the competitive edge and eliminate or delay upcoming competitive solutions.
➡️ Conduct Market and Customer Validation (so-called reference calls): Seek feedback from potential and existing customers or partners to validate the startup’s product or service, market demand, and customer satisfaction. Consider testimonials, case studies, or customer references. Connect with independent industry experts who have no financial/personal incentive to endorse the product or the company.
➡️ Assess Legal and Compliance Issues: Review the startup’s legal and compliance documents, including contracts, licenses, permits, and regulatory compliance. Assess if the startup is compliant with applicable laws and regulations. Also, review the cap table that shows existing investors owning some percentage of the company. Are they experienced in this space, did they successfully invest in this market before, what is the composition of their portfolio?
➡️ Conduct Background Checks: Conduct background checks on the startup’s founders, key executives, and major stakeholders. Look for history or conflicts of interest that may impact the startup’s operations or reputation int he future.
➡️ Review Risks and Mitigation Strategies: Identify and assess potential risks and challenges the startup may face, such as market competition, technological changes, regulatory changes, or financial risks. Evaluate the startup’s mitigation strategies and contingency plans and also ask founders how they see the risk and what the plan is to face upcoming challenges. They will know best how to respond to the risks and probably already have some examples of dealing with certain issues from the past.
➡️ Seek Professional Advice: Consider seeking professional advice from experienced investors, attorneys, accountants, or industry experts to conduct a thorough due diligence process in case you have limited knowledge of the technology, market, or geography.
The due diligence process differs between early-stage and growth-stage startups due to their varying stages of development, operational complexities, data availability, and risk profiles but the above points apply to both early-stage and later-stage startups.
Here are however some additional checks to be added while you are working with growth-stage company. Some key differences are as follows:
🚀 Focus on Business Model and Traction: Early-stage startups often have limited or no revenue and may still be refining their business model. Due diligence for early-stage startups may focus more on assessing the startup’s market opportunity, product or service viability. Here you can easily do the customer validation and review traction. You should look for evidence of customer demand (retention, burn rate), the potential for scalability (local vs global), and validation of the startup’s value proposition and potential road map with additional features or offerings.
🚀 Financial Projections and Scalability: While financials are relatively important for early-stage startups, they may not have an extensive financial track record. Due diligence for growth-stage startups should involve assessing the startup’s financial projections, including revenue forecasts, expense projections, and cash flow management for the next 3 to 5 years. Evaluate the startup’s scalability potential, growth rate and ability to achieve profitability and become cash flow positive.
🚀 Management Team and Execution Capabilities: Due diligence for early-stage startups focuses on evaluating the management team’s capabilities and track record. Investors may assess the founders’ experience, skills, and ability to execute the business plan. For the later-stage companies, you already have at least 2–3 years to analyze and see how the management team has executed the projections, how they collaborated, how hiring and employee retention looked like, and how sales, customer success, and marketing teams supported the growth of the company. While on the early stage of development, you can only guess how the team will work together, now, for growth-stage company you will have a lot of data points to verify if the team is executing according to the plan or needs some support. This si also your board’s responsibility (if you have this role as an investor) to identify weak points and offer help, bring experts, and advisors, support hiring efforts and leverage your network.
🚀 Intellectual Property and Legal Considerations: Intellectual property (IP) may be a key area of due diligence for early-stage startups, especially if the startup’s value proposition is based on proprietary technology or innovation including patents, trademarks, copyrights, and trade secrets. Legal considerations, such as contracts, licenses, permits, and regulatory compliance, may also be assessed during due diligence. In the later stage of development, it’s good to come back to this point and research if the competition is developing similar technology if there are some patents that may introduce alternative solutions to the problem the startup you consider investing in is addressing.
🚀 Market Size and Competitive Landscape: Due diligence for growth-stage startups may focus on the startup’s position within the market and its ability to compete. Growth-stage startups will have more established revenue streams, customer base, and market presence, so investors may assess the startup’s market share, competitive landscape, and potential for further growth.
🚀 Financial Performance and Operational Metrics: Growth-stage startups are expected to have a more established financial track record, and investors should thoroughly review the startup’s financial performance, including revenue growth, profitability, and operational metrics. Check if the business model and pricing are well-established, as they may need some updates. Investors will also assess the startup’s operational efficiencies, scalability, and ability to meet market demand. A16z published excellent resources about how to analyze Growth Metrics.
🚀 Expansion Plans and Risk Mitigation: Due diligence for growth-stage startups should involve evaluating the startup’s expansion plans, including market entry strategies, product diversification, and geographic expansion. Investors may also assess the startup’s risk mitigation strategies, including contingency plans, regulatory compliance, and potential risks associated with the startup’s growth plans. If you are not sure if the startup is ready for series A which is commonly defined as ‘ready for growth’, you may find helpful the scorecard for series A developed by Initialized Capital that indicates what metrics ‘series A startup’ should demonstrate.
All in all, you should tailor the due diligence approach based on the unique characteristics and risks of the startup being evaluated. Conducting thorough due diligence always helps make informed decisions but after all it’s about your conviction, the way you see the future market, and what potential you see in the team.
