Anyone who’s run venture capital investment due diligence on a potential investment knows that it’s not an exact science. Digging through ledgers and financial statements ought to be fairly straightforward, but that’s only if they’re well-maintained and up to date, which they rarely are. This means that the team involved also has to be able to do some financial sleuthing to really get to the nitty-gritty of the risk involved in an investment. On top of that, they need to weigh various other factors that don’t have a price tag associated with them.

If it sounds like a lot, that’s because it is – and many young venture capitalists end up only doing the minimal financial due diligence required and rely more on their gut on investment decisions – often to their chagrin.

Any venture capital acquisition is going to involve risk, but proper risk assessment and mitigation is the name of the game when it comes to being a savvy investment fund. The amount of research and time involved in proper due diligence justifies the decision to employ a part-time CFO.

Why Bring in a Fractional CFO For Due Diligence?

The simple answer to why you should onboard an outsourced CFO is this: strategic financial insight and due diligence that leads to smarter investment, without the need to pay a full-time CFO salary. But you probably want a little more detail than that.

A CFO with a strong venture capital resume will bring their experience working with dozens of firms to assist with your financial strategy and conduct thorough due diligence. They approach every assessment of a target company with a rigid screening process that allows for the management team to make a proper decision. The benefit of their experience allows them to identify and analyze less obvious business health factors that can make or break a potential investment.

At a high level, these are the factors a CFO will look into when performing due diligence:

  • Strong Financials: Does the company already exhibit strong YoY growth and steady cash flow? How confident are they (and you) in their business projections?

  • Market Considerations: How in-demand are the company’s products or services? How big is the market size? And how large are both projected to be in the short and long term future?

  • Company Culture: Does the company have a well-defined vision and mission and employees at all levels who are committed to seeing it develop?

  • Competitive Advantage: Does the company’s business model offer a significant competitive edge over others in the same sector?

The other obvious benefit of bringing in a CFO you trust for due diligence is that they save you from having to spend time on it yourself so you can focus on relationships, portfolio management, and building your deal pipeline.

Let’s look a little more in-depth at the steps required in due diligence and the benefits a fractional CFO can bring to the process.

Steps to Exercise Due Diligence and The Role of a CFO

1. Information Requesting

A comprehensive due diligence assessment requires documents. A lot of documents. CFOs tend to employ due diligence checklists that they provide to startups to make the information gathering process easier.

Due diligence is both qualitative and quantitative. Financial statements are an obvious component of the process, but just as important are less tangible factors such as the leadership style of management and company morale. Seasoned CFOs are a great fit for this process as they are used to working at the leadership level and know the ins and outs of what makes a successful business.

Examples of information that will be requested to run proper due diligence include:

  • Investor Pitch Documents

  • Organizational / Incorporation Documents

  • Full List and Breakdown of Products and Services

  • Company Structure Outline

  • Management Bios and Resumes

  • Board of Directors Bios and Contact Information

  • Intellectual Property Documents (Patents, Trademarks, Copyright etc.)

  • Development Plan

  • Legal Information (Opinions, Pending Litigation, Permits etc.)

  • Financial Information:

    • Financial Statements

    • Balance Sheets

    • State and Local Taxes

    • Insurance Policies

    • Liabilities

    • Accounting Methodologies

These documents will then form a due diligence binder that acts as your bible for the entire process.

2. Site Visits

Site visits not only allow you to confirm that a business does indeed exist (a very important consideration), but also allows the auditor to assess the company’s build, processes, and forge a personal relationship. A CFO will take the time to get the full tour of different operating units and get to know people at different levels across the entire organization.

Site visits are important to the review process to see if the picture that has been painted for you matches the reality.

3. Management Interviews

Having a CFO conduct management interviews can ask the right questions to uncover any anecdotal information that can be salient to making a smart investment decision. This is particularly true of a CFO who has a lot of experience working with venture capital and also startups directly.

Here are some examples of questions that will help you learn more about a company’s structure, outlook, competition, and market share:

  1. How long has the management team been employed by the company?
  2. What critical skills and backgrounds are present in the company for the development, production, and distribution of the company’s products/services?
  3. Describe the company’s strengths, weaknesses, opportunities, and threats.
  4. What are the most important things you plan to accomplish over the next 5 years?
  5. What is the expected annual growth over the next five years?
  6. What is the biggest risk to achieving the projected financial results?
  7. Describe your products/services and the sales and gross profit produced by each.
  8. What are the advantages and disadvantages of the products/services versus its competitors?
  9. Why do customers select your company instead of others?
  10. What patents, technology, or expertise prevent other companies from replicating their products or services?
  11. What are the company plans for future products/services?
  12. What R&D is the company running or planning?

4. Internal Communication and Interim Discussion

During and after the initial audit, the CFO will be providing updates to the partners in charge of weighing the investment. If any potential red flags are identified, you can collaborate on whether any of the issues identified are complete non-starters.

Key questions that arise during the audit include:

  • Are the company’s process and infrastructure refined? And if there are issues, would it be easy enough to provide guidance to course correct?

  • Based on the financial outlook and market landscape, is the company poised to make a splash in the industry sector?

  • Based on all the current evidence, does the company fit into the investment philosophy, vision, and mission of the venture capital fund?

5. Due Diligence Reports Preparation

If the company has passed the initial assessment, the CFO will then compile both a comprehensive report and a shorter summary report for all the stakeholders to be able to assess both the finances and company overview.

A CFO brings their knowledge of investor relations to the table, so they are able to leave out the fluff and summarize all the salient points stakeholders need to make a strategic decision.

  • Investment Thesis: High-level summary of the logic for the investment;

    • Why the company is capable of disrupting the market.

    • Why customers will find their product or service essential.

    • How the company is capable of building traction based on the size of the proposed funding round.

    • Overview of the management team and their capability to achieve success.

  • Failure Risk: A full risk analysis with mitigation considerations.

  • Leadership Assessment: Do the CEO and other leaders have the experience and qualities to succeed?

  • Technology, IP, and Product Roadmap: A full assessment of the technology and products, and the potential impact on the market.

  • Customer Need and Go-To-Market Plan: A full analysis of customer needs, assumptions, and sales pipeline.

  • Uniqueness and Competition: How well the company is positioned with respect to current and future competition.

  • Market Size and Market Opportunity: Are market share projections reasonable?

  • Financial Projections and Funding Strategy: Discussion of the financial plan and capital-raising strategy.

  • Exit Strategy: Discuss the assessment of likely exit strategies.

  • Deal Terms and Payoff: Is this a low valuation, high-risk deal, or a high valuation, low-risk deal?

This report may also be converted into a presentation that the CFO or partners would present to LPs and other key stakeholders to earn their buy-in.

6. Valuation and Final Negotiation

Once everyone has weighed in and decided it’s worth going ahead, the CFO can then help negotiate the valuation and terms of the investment.

Common valuation techniques are:

  • A comparison of positive cashflow influx with risk-free investments such as government bonds or R&D credits.

  • Comparison with other similar companies and their valuations.

  • An opportunity cost analysis to determine likely profitability.

The final negotiation with the company would involve how much equity the VC fund will hold in the company, and the exit strategy for investors.

A Final Word on The Value of a CFO to VC Firms

At the end of the day, it’s worth remembering that 90% of all startups fail. There is so much competition in the VC space, that grabbing up lucrative investment opportunities at a reasonable level of investment can be tricky at the best of times.

At Greenough Group, our CFO leadership collectively has many years of experience working full-time with leading VC firms such as 500 Startups and Oceanshore Ventures. More than 200 Venture Capital Firms have found that our strategic financial services save them time and money by providing the high-level executive due diligence they demand but don’t require a full-time executive for.

If you’re looking for support in managing the finances or due diligence processes at your venture capital fund, reach out to our VC consulting services specialists and we’ll get right back to you.