While there’s definitely room for more input and conversation there, we were prompted to hear from the other side about how investors view their own due diligence. This is generally known as the process of reducing risk by verifying what is being said by the entrepreneur, and the underlying facts about them and their business opportunity as its positioned.
Hear what four different reputable Minnesota tech VCs have to say about due diligence:
At what stage in the process do you start your diligence?
Greg Beaufait (GB): There’s two types of seed diligence in our minds — The first is market and team diligence, which is continually ongoing from the first pitch, as we learn more about the market, technology, competition, and team. The next, more formal aspect is legal diligence, which is discovery and fact-checking to make sure there aren’t any red flags in the business structure, capitalization, major customer agreements, technology licenses, etc. That part happens next, after we’ve generally decided to move forward with an investment opportunity. Red flags that haven’t come up prior, or inconsistencies found at this stage, can derail what would otherwise be a deal everyone wants to get done. So don’t hide any skeletons in your closet.
Cathy Connett (CC): The Sofia Fund believes in due diligence on all of our deals because we know that due diligence leads to better investment decisions. We start researching a deal from the time a company applies to us but true due diligence starts after a company has presented to us and a decision has been made to consider a possible investment.
Ryan Broshar (RB): I like to think there are two stages to the due diligence process. The informal and formal. Informal due diligence begins after the first conversation and continues through the term sheet. This is the basic fact finding and relationship building part of the process. Questions would include asking for references for stats/charts/trends/etc, checking with existing investors, mentors, or peers, and consistency of founder story. Formal due diligence starts starts slightly before a term sheet is handed out and will continue til funding.
Patrick Meenan (PM): We bucket diligence into two categories – business and legal. If there is mutual interest between us and the entrepreneur(s), we start business diligence after the initial pitch all the way to term sheet. In almost all cases, our business due diligence is completed before term sheet signing. If that isn’t the case, our specific pending business diligence items will be listed in our term sheet. The only times we have to do this is when the entrepreneur(s) desire for customer calls to be completed post term sheet signing. Once the term sheet is signed, we focus purely on legal diligence / documentation of the investment.
Do you have a standardized approach, what do you look for? What are some red flags?
GB: We don’t have a standard approach, as it all depends on the opportunity we are investing in. If it’s really early-stage, with no or few customers, it comes down mostly to talking to potential customers, acquirers, competitors, and people who have been around the team in prior roles. If it’s later, and we are investing more around the traction of the business to date, we’ll dig in on the customer agreements, customer engagement, are they using it more over time and paying more for it, etc. The legal stuff is a standard checklist we have, but the focus depends more on where we see current potholes in the company structure / organization or potential future ones. Common red flags are “paying customers” that are actually getting the product for free or much cheaper than implied, and may or may not be using it, as well as cap table issues where the founders don’t own enough of the company; sometimes the structure of prior investments, and prior investors wishes, are too flawed / complicated for later-stage investors to get excited about cleaning up. Generally, anything you don’t want to come up in diligence you should try and get out in front of a couple of conversations in when an investor starts showing interest.
CC: Due diligence can take many forms but the questions we are trying to answer for ourselves relate to the risks associated with that particular deal. Our due diligence team is interested in assessing the business and financial risks associated with the company and its leadership team. The company’s position on these issues is important, thus we need information from the company, but we are also interested in our own independent assessment. All investments have risks… we simply want to go in with eyes wide open and also with a focus on the value we might bring to mitigate some of the inherent risks. Our due diligence will affect our decision to invest as well as potentially the terms that are acceptable to us.
RB: Yes, we have a standardized approach. However, since we typically do not lead rounds we will request the due diligence conducted by the lead investor and then do our own review. Most requests will be around seeing cap tables, incorporation docs, employee or customer contracts, and following up on referrals. Major red flags would be anything that would that would give me a sense your hiding something…no matter how minuscule. At the end of the day, the due diligence process is about building trust and confidence in making an investment. This process should help solidify this bond, not shake it.
PM: We do not have a long standard check list as we acknowledge that every opportunity is unique. One thing that is universal is that in all cases we spend a material amount of time on customer calls. It not only helps us evaluate the company, but also more impactful board members as we have a better appreciation for the customer voice. Outside of that, diligence varies based on the opportunity. To illustrate the uniqueness of opportunities, lets look at two local examples. When we invested in Total Expert, there were not a lot of customers, data was limited, and they were selling into specific segment (loan officers). In that case we spent less time analyzing metrics and more time understanding the health of customers, why they bought the product, doing a market size analysis, etc. When we invested in WhenIWork there was over 3,000 paying customers, lots of data, and you intuitively knew the market was massive (businesses with hourly employees). In that case we focused much more on metrics like LTV / CAC, churn rate, etc. that sizing the market. It takes a lot to shock us, so nothing stands out there. The most consistent issue we come across is cap table management. We are big believers in the importance of understanding the incentives of interested parties and understanding who stands to benefit in a material positive outcome. Our favorite scenario is when the founders and employees own 80%+ of a business before we invest. Motivations are pure, incentives are aligned, and the people doing the real work (entrepreneurs) tend to benefit the most. When we see situations where other VCs/angel investors/advisors/former founders own 50%+ of a business before we invest, it calls into question a lot of things and will only get more complicated over time.
How do your findings affect the terms or the entrepreneurs ask?
GB: The major terms are typically set and agreed upon by the time we are doing a super deep dive, but if we find something we are concerned about in diligence, but not enough to deter us from making an investment, we’ll look at putting something specific in the financing terms to protect us. We’re more likely to back out of a deal entirely than look to change terms if we see major red flags during deep diligence that were not disclosed in any prior conversation, as it brings up concerns over what else is being hidden.
RB: I typically don’t see it effect the terms of the deal. Moreso, it would just kill the deal. If something major is uncovered in the process, this would shake the confidence of the investor to make the investment.
PM: Seems like an obvious statement, but the smaller the investment and the more reasonable the terms the more leniency there is for diligence issues. The larger the investment and the less reasonable the terms the less leniency. We have seen cases where founders price their round for perfection, but the diligence doesn’t support it.
For entrepreneurs: what do do/not to do to be setup for success when it comes to the diligence?
GB: The biggest things entrepreneurs can do is be prepared for diligence at every financing round of a company and eventually M&A, and prepare a diligence folder prior to the fundraise, so you can pre-emptively send an investor 95% of what they are looking for. This will especially save you time when dealing with multiple investors and multiple requests, it will speed up an investment process too as you keep the ball in the investor’s court, and shows you are prepared and know what it takes to close a financing. Find a good lawyer that has taken startups through multiple financings and get out in front of what you’ll need to close a financing months before it happens, rather than trying to play catchup or react to investor requests.
RB: Best thing you can do is be overly transparent. Make sure you cap table is up to date and have a projected cap table for post-investment. Before the process begins, create an online folder that includes all the business documents related to your business. When requested by investor, just send over link to folder. This makes it seem like your are responsible and willing to be transparent about your company…further building trust and confidence.
PM: General advice, not specific to Arthur Ventures. If you are going to run a true process, control the dialogue by getting ahead of things. If there are certain things you want to highlight about your business – like low churn, or great customer expansion, or momentum within your market – do it. Don’t wait for someone to ask. Low churn example – if someone asks for your revenue growth only, send it but also highlight that you have essentially no churn. Customer expansion example – if someone asks for a customer list, send it but highlight the path for certain customers that have grown over time. Market momentum example – if someone asks for your analysis of the market size, send it but also highlight recent developments that are about to dramatically increase the size of the market. Too many entrepreneur(s) wait for the question they want to get asked when with a little prep they can move the dialogue to where they want it to go.
CC: In terms of what an entrepreneur can do to make the process fast/smoother, one suggestion would be preparation. It’s easy for an entrepreneur to get a list of “standard” due diligence items investors will want to review. To the extent the company can assemble the supporting documents and materials in Dropbox or a shared folder even prior to a presentation, the more investor-ready they appear and the more likely the process will be faster.