5 Ways Entrepreneurs Can Ace the Due Diligence Process
When venture capitalists invest in entrepreneurs and startup companies, they understand that they are taking a risk. Due diligence is the process investors use to assess, with first-hand confidence, what those risks are.
The goal of due diligence is to prepare your company to raise capital. Investors seek proof that the business plan is based on extensive market and customer validation. They want to know how the intellectual property is protected. They seek evidence that the financials are sound, and that the founding team executes with excellence and integrity. The responsibility for answering these questions and for proving the caliber of the founding team always falls to the entrepreneur.
Preparing for Due Diligence is Preparing for Success
Savvy entrepreneurs anticipate due diligence and begin developing their process for due diligence long before they ever start talking with investors—from the moment they sign the startup’s first legal agreement. The scope of due diligence expands with the first cap table (whether financing is from friends and family, a bank, or angel investors), validates markets and customers, and commercializes intellectual property.
- Create an online, virtual data room for due diligence that provides scalable storage capacity and allows for data sharing. There are many secure, cloud-based tools available for storing and accessing company sensitive and confidential data. Consider ease of use, accessibility, and cost.
- Intuitively organize your materials in a way that is intuitive. Create data naming and a data room checklist. Done correctly in the early days, it will be straightforward to add and update data and documents as your company grows. Data room sections will include strategic planning, corporate matters, financial matters, management, board, vendors, market and competition, product/service, value proposition, and customers and sales pipeline.
- Develop due diligence discipline. Make an organized and repetitive approach part of your company’s due diligence process until it becomes automatic. Venture and angel investors provide due diligence guides and best practices. Your founding team will benefit, and this sends a positive message to investors that you know what you are doing and will be prepared for formal due diligence when it starts.
Due Diligence in Real-time – Red Flags Checklist
Not only do you want to anticipate investor’s questions, but you also want to identify and resolve any red flags. By red flags, I mean anything that could prevent an investor from moving forward with an investment. Many “red flags” can be addressed and resolved. Others turn out to be roadblocks that stop a deal. Then, some concerns add to the overall risk of the situation but may be risks an investor may be willing to tolerate.
Founder and team concerns: Investors invest in people ahead of business plans. Due diligence places the founder and team’s personalities, values, and management style under a microscope. Investors want their trust level to increase with each interaction they have with the CEO and management team. They want to feel good about working with you and forming a long-lasting relationship. When it comes to the founder and team, their questions/concerns may include:
- Does the team lack relevant experience and expertise?
- Is the entrepreneur challenging to work with?
- Does the entrepreneur share the investor’s vision?
- Is there evidence of poor decision making/ judgment in business or personal matters? Does the background check reveal missteps (g.arrests, bankruptcy, personal financial issues, civil litigation, IRS concerns)? If there is something in your background, bring it up yourself?
- Are there spouses or other immediate family members or other relatives on the founding team?
- Are the founders and management team eligible to work in the U.S.?
- Are the compensation expectations of founders and team aligned with the expectations of investors?
Company and business plan considerations: Investors tend to gravitate towards companies that can prove out markets and validate customer interest with low levels of capital.
- Is the company in an industry with institutional venture funding?
- Is the business model scalable with a credible and viable revenue model. Is the expense structure feasible, given the investment?
- Is the intellectual property owned or securely licensed by the company?
- Are the founders willing to accept a realistic valuation, terms, and management structure, as well as Board structure and control?
- Are there concerns about company Board structure/ control?
- Do the round size and use of funds correspond to the stage of the company. Do projected milestones match the capital?
- Are there issues with the Capital Table or financing history?
For entrepreneurs, due diligence is a matter of getting prepared, asking for help when you need it, and answering questions—kind of like a final exam where you know all the questions ahead of time, and you can bring the answers in with you into the test.
For investors, due diligence is the time to make absolutely certain that the founders and management team have the skill and integrity to build a great company with the culture and drive to scale and create great returns.