Due diligence is yet another one of those confusing, and opaque things in venture.
When VCs say they are going to do the diligence, the founders don’t really know what to expect. The process varies from firm to firm.
Typically, most of the due diligence is done by so-called Lead Investor. The Lead Investor conducts the diligence and issues you a term sheet. Other investors often rely on the Lead Investor to do the due diligence work.
You can think about Venture Due Diligence as a Walkthrough Check List when you are buying a house. Things you notice go on the list, some things maybe addressed and some things might not be. It is not standardized for all houses and is somewhat open-ended.
Similarly, Venture Due Diligence is a non-standard, an open-ended process that ends when an investor (and lawyers) are satisfied with the information they’ve seen.
Most of the due diligence, especially in the early stage companies, happens BEFORE the term sheet. In the later stage financing, a lot of the due diligence happens AFTER the term sheet. This is because later stage companies have more business, legal and financial things that need to be reviewed.
Here are the common things you can expect to happen during the early stage due diligence process.
1. Financial Model (before the Term Sheet)
Here are the things investors will check:
- Financial Model: Do you even have one ? <= For realz 🙂
- Milestones: Do your Milestones make sense ?
- Runway: Do you have long enough Runway ?
- Silly things: Is there anything obviously off ?
If you are a later stage company, the investor will dig into your CAC/LTV, marketing spend, growth assumptions, hiring plan and much more. Effectively, financial model gives investors an opportunity to evaluate the past performance, and the future plan for your business all in once place.
2. Market (before the Term Sheet)
Here are the things investors will check:
- Competition: Who are the competitors, and do you know them well ?
- Size: How big is the market you are after ?
- Moat and Dominance: What is your Moat and path to Dominance ?
When looking at the market investors want to understand if it is big enough, and if you can dominate it, or own a significant chunk of it. Small markets continue to be a turn off for most institutional investors. Usually, if the market is obviously small the investors would pass right away without taking a meeting.
Sometimes things get uncovered during the diligence that make investors think the market is too small. This typically happens during the customer calls when investors realize that customers prefer a competitors, or won’t pay for your product as much.
Competition could be a very serious reason why investors would not invest. During the diligence VCs gather the list of competitors, and try to understand how you are different, and why you do you win.
Lastly, a lot of larger firms would want to understand how you can dominate the market. That is, not just have a piece of it but become effectively a monopoly. With that they will also dig into your moat, and why the business would be a lasting business.
3. Customers (before the Term Sheet)
Here are the things investors will check:
- Pain point: What is the customer need ?
- Product: Does your product solve this pain point ?
- Satisfaction: How happy are the customers with you ?
- Competition: Why did they choose your product ?
- Stickiness: What would make the customers switch ?
Institutional investors will rarely invest without talking to your customers. The point of the calls is to establish if you product solves a big problem and if the customers are prepared to spend the money with you. In addition to calling your customers, expect investors to also call potential customers that they are connected to through their network.
Similarly, a lot of VCs would find industry experts through their network and ask for their opinion. A lot of times this might happen even before VCs would take a meeting. Again the goal is to validate whether there is even an opportunity, and how interesting it is from the venture perspective.
4. References (After the Term Sheet)
Investors would typically ask for 3 professional references for each founder. They would conduct routine reference checks, but would likely focus on the traits important to win in the startup game such as vision, ability to inspire, resilience, capital efficiency, etc.
In addition to the references that the founders provide, VCs look for people in their network who worked with the founders to give them an independent opinion.
Anything that comes back as a negative on the founder through these references could become a deal breaker.
Lastly, some, especially later stage firms would run a background check on all the founders.
5. Other investors (before the Term Sheet)
Investors often want to talk to other investors. If you already had investors prior to this round, it is highly likely that new investor would want to talk to them.
In addition, investors want to talk to other investors who are coming into the same round. The dynamic really varies, but in general, if you have the lead investor, they may have a strong opinion on who should and should not be in the round.
On the other hand, investors that are following the lead, often ask to talk to the lead investor to understand their perspective, and likely, ask them to share the diligence they already did.
6. Legal (after the Term Sheet)
Here are the things investors will check:
- Capitalization: Conduct review of your Cap Table and previous financings
- Formation Documents: Making sure your initial documents are in order.
- Financing Documents: If you raised capital before, review those documents.
- Contracts: If you have substantial business contracts those will be reviewed.
- Board Minutes and Corporate Books: If you’ve been around you need to have them.
- Reps and Warranties: Long list of stuff
Legal is the broad due diligence that takes place after you sign the term sheet. This typically takes 2-8 weeks, with 4-6 being the average for larger rounds.
During this part, lawyers are translating the Term Sheet into what is called Definitive Documents that actually spell out all the details of the financing. These documents can get quite long – easily over 100 pages.
This is where you really need to get a solid law firm on your side, because it is impossible to do this well without a lawyer.
The key thing to know and pay attention to. Lawyers will do all the cap table calculations for you. The Cap Table itself is not a legal document, but instead gets mapped onto the Stock Purchase Agreement and translated into issuance of shares and price per share.
The second thing thats really important is that legal questionnaire could be incredibly long and intimidating. For early stage company, the answer to most questions is N/A – or not applicable. This is a perfectly acceptable response, and it is on the opposing lawyers to come back if for whatever reason they are not happy.
In a way, you can’t really read about this part of the process on the internet, you have to experience it once to understand. In spirit, it makes sense, as you are striking a serious business deal. In reality it can quickly get tedious, confusing, and frustrating because of the level of details and time that it takes.
Be sure to also pair up with a trusted investor or another CEO who can help you get through the process, pay attention to things that really matter and leave the rest of the process up to your lawyers.