Before you approach an investor, a board member, or a lender for funding your startup business, it’s essential that you effectively prepare your business plan and valuation.
This is because potential investors, board members, and lenders will ask you specific due diligence questions about your business plan to determine whether investing their money in your company is worth it.
venture capitalists tend to have high standards when it comes to businesses they consider backing. They need to be confident that their money will be used efficiently and strategically to reach their investment objective within the time frame outlined in the documents submitted with their application.
Their concern makes sense because many venture backed startups fail as we explain in this blog post.
They also need to be certain that the new capital they’re committing won’t result in more dilution of their equity stake in the company or a substantial dilution of its value if they were to walk away from it before the end of the fundraising process.
Let’s first look at the due diligence process and the importance of preparation for due diligence questions.
Due diligence process and due diligence questions
Due diligence process: What is it? The process of conducting due diligence on a potential investment is a way to ensure that both investor and startup are comfortable with the level of risk involved with partnering together.
It’s an important part of the process that every investor and board member should go through before deciding on whether or not they choose to invest in your company.
Every investment raises red flags of some sort like the fact that your team doesn’t have the experience to lead their project and it’s a huge risk. Or the fact that your business model doesn’t make sense since it relies on some unknown factor that the market is not yet ready to accept one way or the other.
But what is due diligence?
Due diligence is a search for facts to help investors and board members identify the risks and determine if the potential reward of partnering with your company is worth the level of risk.
Top venture capitalists usually have a checklist for their due diligence where they typically go through for each investment decision.
The checklist includes several important dimensions of which a number of questions are to be asked to startups. Some questions are straightforward to answer but there are several due diligence questions that are tricky and require you to prepare well given their decisiveness.
Below we explain the most critical due diligence questions you should be ready to answer.
1. What differentiates you from your main competitors?
This question is more of a qualitative question where an investor and/or board member wants to understand the essence of the company, what’s unique about the product or the service, and why it’s different than the competition.
This is also a question to figure out if your business idea is good or not and if it has a good chance of succeeding in the market.
If, for example, you’re raising money to help farmers or provide fresh produce at affordable prices, then it’s important to present a direct, quantifiable value proposition that shows how your solution will help farmers reduce their production costs, increase their profits, and improve their quality of life.
And it’s also important to show how your solution is different from all other existing solutions on the market.
In this blog post, we explain how Airbnb distinguished itself from its competitors in the pitch deck. You can do even better by creating a Power Grid highlighting the benefits of your product compared to those of your competitors in one snapshot.
2. What strategic challenges do you foresee in the coming years?
This question is important to assess if you’re raising money from an investor or a venture capital firm. What are the risks associated with your business and how can you manage them?
Many startups focus on day-to-day operations and product development in the short-term. This question helps investors assess whether you are thinking strategically about the long-term growth path of your startup and whether you are aware of future issues or not.
Another good question to ask is what challenges you foresee will face in the next 1, 3, and 5 years. What obstacles and challenges need to be overcome for your business to succeed in the long run?
If your startup involves the selling of vitamins and supplements, for example, then it’s important to let the venture capitalists know if there’s been a recent regulatory change or if a government agency has come out with new guidelines that would affect your business.
This is indeed one of the best due diligence questions and prepare you to look beyond your startup and think of micro environment (such as customer preferences, competition) and macro environment (such as technological and societal changes).
3. What is the monthly recurring revenue?
This question is important to let investors know how the company makes money. Do you offer a subscription-based model? Are you charging a one-time fee for your product or service? Are your customers paying upfront for a one-time use or a recurring use?
Investors and boards usually want to know how the company makes money and if there’s enough recurring revenue to support the level of capital being requested.
The trick is the “recurring” part because it can show how satisfied your customers are that they come back. Moreover, it is an indicator to show to what extent you can grow organically without incurring marketing costs.
Certain startups have unique business models that can succeed in the market but it’s not necessarily common knowledge like Uber, Airbnb, or Amazon. If your business model or idea is radically new, this due diligence question is an opportunity to show the investors the potential of your startup.
If you’re raising money from venture capitalists, it’s also important to let the VC know if you have any patents or if you have any unique business models that have not been tried before by other companies.
4. Are there any antitrust or regulatory concerns?
Investors or board members would like to know if they’re investing in a company that has any potential antitrust or regulatory concerns. There are certain industries where there is a lot of competition and potential for regulatory changes.
With Uber being a great example, investors and board members want to know if any issues may arise with their business model if they were to be successful in the market. In the case of Uber, there were a lot of uncertainties about regulations and whether municipalities would allow them to run taxis and how the taxi associations and unions of drivers might respond.
This is one of the due diligence questions that you can prepare very well to respond by doing desk research and by taking to legal and business experts in the field.
If you’re raising money from investors, you need to let them know if your business has any potential issues with foreign competition. Transparency and honesty should be prioritized and you should think about possible remedies.
5. What pain points would exist if the team size tripled in the next month?
This is a question to assess if your business can support the level of funding that you’re seeking or if any issues would require the company to slow down or shut down if the team was to grow quickly.
These are just a few of the questions that investors and board members might ask to determine the level of risk that is associated with partnering with your company.
Since you have shown your growth ambitions, venture capitalists need to make sure that you have thought and planned for various aspects of growth, particularly growing your team. It also helps them to assess your leadership and managerial skills when there is growth pressure on your startup.
They might ask these follow-up questions:
- Which department will experience most work pressure and need urgent attention because of growth pains?
- How do you plan your hiring process when under pressure?
- Do you provide extra incentives for employees to work longer hours? What incentives?
- How do you try to normalize the pressure such that it does not harm your growth?
It’s important to remember that investors and board members have high standards and they want to know that their money is being invested in a company that has a good chance of succeeding in the long run.
Bottom line
Creating a business plan and valuation is only one part of the fundraising process. Investors will want to see that you have taken the necessary steps to educate them about your company and answer their questions.
During the fundraising process, investors will want to see that you have properly prepared for meetings and conversations about your business. This will help you obtain more funding for your startups and bring your business closer to its ultimate goal.
Due diligence questions that we discuss in this blog post are important but not the only questions investors ask you in the process. Make sure to read more about their possible questions and prepare well. Good luck!
