Dear Abby for Tech: due diligence

I’ve recently started writing a series of posts for Women 2.0. Instead of picking a topic each week, we’ve been soliciting questions from the community to get at the areas that people feel most uncertain about. We kicked off the new column with a question about diligence:

How do you (and the early-stage VC community in general) like to conduct due diligence on the companies you are interested in funding?

The purpose of diligence is to answer Who, What, When, Where, and Why questions about a prospective deal. At a seed-stage fund, this typically involves four things: market research, competitive research, customer feedback, and founder reference checks. Taken together, these present an investor with as comprehensive a view of a deal as possible. A fifth element, much more common in later stage investing, is an examination of financials.

MARKET RESEARCH

Market research involves looking into trends in a given sector. This type of research is often done well in advance of a specific opportunity coming in, for the purpose of understanding a hot market or with an eye toward crafting an investment strategy. This is because it’s time-consuming, and may be rushed if done reactively around a particular deal. However, sometimes it does happen in conjunction with diligencing a particular deal. Some common questions that investors try to answer include:

  • What are the drivers in that segment of the economy?
  • Is the addressable market of customers growing or shrinking?
  • Is there an underlying regulatory framework that dictates rates, prices, or behavior?
  • Are there changes happening that make this market particularly prone to disruption in the near future?

COMPETITIVE RESEARCH

Competitive landscape research involves examining a sector to determine who the component players are. The first step is to identify the large incumbents – the 800-lb gorillas who serve the majority of customer needs in the space. Then, there is a survey of smaller players and other startups. Who has entered the space recently? Are those startups funded or showing evidence of traction? Is this a “land grab” situation, where dozens of startups are trying to differentiate with highly-specific niche features, or are there few entrants (few entrants isn’t necessarily more ideal; that may mean there’s no real demand)? The competitive companies are then compared to the startup under consideration, typically on pricing, the offering, and/or the technology.

Read the rest here. And if you’d like to send in a question, contact askavc@women2.com