What exactly is Steam doing when it says, "Preparing to Launch <GAME NAME HERE>"?

I'm guessing:

1. Verifying the game is legit (DRM).
2. Verifying the game is up-to-date.
3. Verifying the requirements for the game (e.g. directx) are still met.

Although (3) should theoretically only be checked on the first run, I'm pretty sure it's actually checked on every run - I saw a few games that always show a brief "installing directx" line even after the first run. Maybe it is done to verify no hardware or software changes were made to the system that can break the game.

This is just a guess, though... if you want to know for sure, I suppose you can monitor the Steam process at the moment it is launched (e.g. with a network analyzer and some process monitor such as sysinternals).