Getting Funded, Step 4: Due Diligence
You made it through the partner meeting, your email dings, your phone rings — good news: the VCs liked your company enough to proceed to the next step: due diligence. Usually, the word will come from your “inside coach”, as explained in a prior post.
“Due Diligence” is a broadly defined term with explanations here: WikiPedia, Webster's, and elsewhere. But, basically, it means researching you and your company to ensure that investors are taking care to validate the assumptions they are making about the worthiness of the deal. There are funds that prefer to do significant due diligence before issuing a term sheet, and some save the bulk of the detailed work for the time between the term sheet’s signing and the actual closing of financing. However the process is split, it is pretty much inevitable and tells you a lot about how the fund likes to operate. And entrepreneurs should be wary of guys offering to “invest on the spot” — they are either clueless or hiding something about themselves. You want a diligence period because this is also a time for you to do your checkup of the fund and the people offering to finance his company. Due diligence is a two-way street. They take their time, and you should take yours.
Remember, we selected your company because of the market it is trying to address, the product it built for that market, and the team that built the product. In our due diligence checks, we want to validate that all the conclusions we made about these important areas are, more or less, accurate. We trusted you and your presentation, but, as the Russian saying made famous by Ronald Reagan goes: “trust but verify.” Due diligence is all about verification.
Typically, a VC team will be using the gathered diligence materials to write some sort of “qualification memo” for internal consumption by the other members of the fund as well as their limited partners. This memo will be a part of the investment documents that the fund will keep to remind itself and their own investors about their assumptions at the time of making an investment in your company. This memo is an important document for your VCs, so you should try to make its writing as easy and as accurate as you possibly can.
Prepare the paperwork….
You should have these documents ready before the presentation. You will need them if all goes well:
- a list of 3–4 customer/user references (even if it’s a B2C business, have a few “fans” ready to talk). Don’t worry, you’ll have a chance to warn them that a call is coming, but have them ready and, obviously, make sure they have good things to say before putting their names down.
- a list of 2–3 professional references on each of the founders
- incorporation documents
- capitalization table (who owns what). Even if there was an informal split agreement between partners, at least put it into a spreadsheet
- patents and filings for patents you have claimed. I, for one, place relatively little value on patents because I invest in software. There are investment areas where validation of patent claims are critical.
- financial statements since the company’s founding. MBA types, take it easy, but you should be able to produce basic financials.
- prior financing documents (including angel or friends and family rounds). Obviously, these are important.
As I said, the goal of due diligence is to verify the assumptions being made. Once the call comes,
- provide a complete package of documents (described above) at the start of the diligence process, all at once, rather than tricking emails over the course of the week. The fund will, most likely, have a team of people doing due diligence on your deal, so it’s easier to split up the work if all the materials are available at the outset. Send them to the one person in the fund that is coordinating the process.
- expect us to call your customers to validate market conclusions. Warn your customer references that they will get ONE call from each VC doing due diligence on you and that you appreciate them taking 30–45 minutes to talk.
We will be asking them the following questions of your business users:
- are you really experiencing the problems that the company described?
- does the company’s product help solve these problems? how?
- what were you doing before you met the company and how much were you spending (time and money) on doing this?
- how has the company’s product changed the way you do things?
can you quantify what the overall impact of the company’s solution is on your organization in terms of time and money? are you saving money? are you increasing revenues?
- how much will your company use the product and how much will it eventually spend with the company if all needed features are delivered?
what has been your experience working with the team? do they seem knowledgeable? are they responsive?
We will be asking the following questions of your consumer users:
- How did you find out about the product? Word of mouth is fine, but we also want to know what marketing programs (if any) you used and how they worked.
- How often do you use the product? If you are building a business dependent on traffic, this is important.
- Has your usage of the product increased or decreased with time? See above.
- Are all your friends using the product? We want to determine the “viral” qualities of the product.
- Would you recommend this product to your friends? See above.
- How would your life be worse without the product? Important. Is this something “nice” or something addictive and needed.
- Would you ever pay for a product like this? Will be asked gently, but it helps us understand how much you value the product.
Expect us to schedule a technical session with your product team to validate the product conclusions
- there should be an on-site visit from one or more members of the technical due diligence team (or your team will be asked to visit the VC again)
- no slides — whiteboard. We want the presentation to be a freeform discussion using graphics and drawings to make points. You will be explaining this to your customers and your developers — we want to see how well you can do it.
We will want to talk understand the product architecture
- a block diagram of the product’s components and how data and function interact
- inputs/outputs to processes in the diagram
- internal and external interfaces to the product (REST, ATOM, etc.) and formats for all
- languages, frameworks, libraries used
We will want to understand any immediate robustness issues
- extensibility: how does the software incorporate new technical features and extensions
- portability: how easy is it to move between platforms
- openness: how easy is it for others to integrate with the software
- standards compliance: are you paying attention
- scalability: when and why will we see “the twitter whale” on your home page. What if you had 1000x the traffic you have now — what would be the first thing to break?
We will want to understand the product construction mechanics
- development infrastructure (servers, storage, machines) why?
- IDEs used (TextMate, Eclipse, IntelliJ, Visual Studio, etc.) why?
- Version control systems in place (SVN, Git,….)
- Build tools (Bamboo, Jenkins, n/a …)
- Defect tracking systems (Jira, YouTrack, …) how are they used?
- Development methodology: Scrum, Extreme, Kanban, etc
We will want to understand the product management, engineering, QA, acceptance workflow
- how are features introduced (customer ->PM -> Engineering -> QA ->PM -> customer)
- how is QA integrated into the development process
- who has final signoff, who decides when the product “ships” or “goes live”
- how are bugs handled
- how are customer requests handled
- how is the beta program managed
Expect us to call your professional references to validate the team conclusions. These can be your former partners, your reports, your former company’s partners. We will ask them….
- What is it like to work with this person? We would rather not deal with assholes.
- Is the person honest and trustworthy? This is very important. Sometimes being classified as a “consummate salesman” raises eyebrows. We value honesty.
- Is the person smart? Needless to say, we prefer genuinely smart people leading our companies.
- Does the person learn new things? Flexibility is important when growing a new business.
- What is the person’s management style? Depending on the company and maturity of the team, management style matters. A person who is used to commanding an army of followers may have a difficult time running a company of five where everyone expects to be heard. On the flip side, consensus is good within reason. Sometimes the CEO has to be firm and make decisions.
- What things is the person strong/weak at? Please, don’t let us hear “he needs to stop working so hard.” Everyone has areas for improvement and it’s totally normal.
- Is this someone you would work with/for again? This is important. Even if companies fail, there should be a willingness to trust the person in new ventures.
Your diligence on the VC
But, remember that this is also a time for you to do your due diligence on us:
Research the fund’s financials. The VCs should answer these questions. Information is also available online on various sites (crunchbase, thefunded, etc.) though it may be out of date.
- How much money is in the current fund? Understand the difference between the fund that’s investing in your company and “assets under management” that is usually a much larger figure. Often, funds list “under management” as the sum of all the assets they have ever managed. So, if they are on fund SIX, it means that they have been successful enough in funds 1–5 to warrant a six but, also, that the money for your company is coming from fund six which can be a much lower figure than the total.
- When was the fund raised? This is important for understanding whether the fund is in “management mode” or “investment mode.” Usually, VCs are actively investing new money during the first 3–6 years of a fund’s life (typically 10 years). During the first few years, they are actively looking for new investments and then focus on managing companies, follow-on investments and raising the next fund. You prefer to get an investment from the “new money.”
- When will the VC be raising another fund? Remember, usually VCs don’t invest cross-fund so you’ll be stuck for follow-on investments from the fund that originally gave you money even if they raise more in a couple of years. If the fund that backed you is in its late stages, has not had a lot of exits, and doesn’t raise the next round, you’re screwed, most likely.
- How much money is left in the current fund and how much is reserved for follow-ons already in the portfolio? If you plan on raising significant additional capital, you should make sure the fund has enough money reserved to at least have an option of following on to this investment. If they don’t, you’re basically left raising money from scratch again the next time around.
Research the fund’s track record to figure out where your company fits:
- Has the fund made investments in your company’s area of specialization? If they have, and they are still hungry for more, means they have had a good experience and have built both expertise and a contact network to help your business grow. There may be new partners in the fund that came from another fund that really know your space so don’t overlook that fact either.
- Have they had many “home runs”? On the one hand, this is great and means the fund will probably be around for at least another iteration. On the other hand, they are now looking for big hits to equal the prior ones and if your company is not one of those hits it will get less attention.
- Are they spread too thin? A fund should have a reasonable number of current portfolio investment per partner. These numbers vary, but they are usually somewhere around 5–7. If there are more, you will get less attention. Fewer, and there’s a chance you will get micro managed.
Understand the fund’s operating style
- How often do they require board meetings? Monthly is the norm, but, remember, these are emotional circuses and resource drains. See if monthly reporting and bi-monthly meetings have been done (a much better scheme).
- Are you getting a “super star” investor? Though having a big name VC on your board is prestigious, they are often too busy doing other things to pay attention to your company. The big shot VCs are often shadowed by more junior members of the firm at board meetings and that, usually is a good thing.
- How responsive is the investor? If they are hard to get a hold of during the “wooing” period prior to deal closing, they will be even harder to reach once the deal is done. Then, it’s just money, and you don’t want that. You want your lead partner’s phone number on your speed dial.
Do personal reference checks on the partner that will be leading the investment and ask…
- Does he understand my market? Usually, this means having operating experience at companies like yours. There are few other ways to really get an understanding of the players in your space. They should have street smarts as well as book smarts about your market.
- Does he appreciate the technology? The partner should know which things are technically difficult and which are easy. The partner should be able to sit through a design session with your team (though it will rarely happen) and not act smug or chuckle about everything being over his head.
- Has he been in your shoes? Empathy for the things you will experience is built over time, in personal crucibles. Best VCs are often ex-entrepreneurs who have started companies themselves — started, not walked in and managed. They know what it’s like to hear an echo in an empty new office and run downstairs to buy coffee for the new coffee machine, to drink it sitting on the floor. They know what it’s like to lose a deal or get screwed over by a partner. They know how hiring mistakes feel. (Blows my mind, but there are actually VCs out there who have NEVER MANAGED PEOPLE — stay the hell away).
- Is he an asshole? This is the biggest concern. There are positive assholes and negative assholes. Having someone who is tough and demanding (good asshole) is a plus on your team especially when he isn’t really there bothering you every day. Someone who is just full of himself and commanding without rhyme or reason is a bad thing. Whenever you hear the word “asshole” in any personal reference checks, beware and do a double take.
- Can he actually help? Usually, VCs help with two things: ideas and recruiting. You should ask your reference what new ideas did the VC bring up that were not useless drivel (e.g. “It is very important to have paying customers. — I was actually told that by a VC on my board). What people did the VC actually help recruit vs. just spew about the importance of having good people on board (e.g. “You should really hire only the best. — ditto, heard it from a board member)?
Talk to failed companies in which the fund invested.
Funds will happily give you names of CEOs from companies that are doing well of have already succeeded. But it’s the failures that are interesting. CEOs of failed companies don’t usually badmouth past investors strictly for emotional reasons — they have other companies to do and are worried about their reputation as much as the VC. However, you should talk to the companies that didn’t work out to understand how the VC responds in times of crisis. Take these calls with a grain of salt and filter them through your own lens of understanding. Just because a VC shut down a company does not necessarily mean he did the wrong thing. It’s how he acted that matters.
- What was the reaction of the VC when the company started heading downhill? Was it a knee-jerk “cut staff” call or was it more thoughtful? Was he strong and supportive, or a baby?
- Did the VC try to pull any clever financing tricks when the company was up against the wall? (“I will give you more money at 5x preference” — actually happened, “I will give you a loan that you can not repay secured by your IP that I will move over to another company if you don’t” — actually happened). Were they courteous or assholes?
- Would you have this person on your board again? Why or why not?
The VCs should…
- clearly explain what is needed for the due diligence process from our side. In a succinct email, we should let the CEO know what documents will be required, what he should expect from us, and the deadline by which these materials are expected. We should ask for all the materials once and not have requests trickle in as we think of them.
- ask what the entrepreneur needs from us to complete their own diligence. We too should be “reference selling” ourselves. We should offer them a list of people they can talk to about our work, offer an opportunity to meet the rest of the team, and, in general give them a sense of comfort for the group. We should understand that they have as much hand in this relationship as we do.
- propose a schedule for completing due diligence. In most Series A financing, due diligence should take two weeks max prior to term sheets. Additional diligence takes place during the financing paperwork phase which should not take more than six weeks. There should be an outline and a plan.
- not take too long. Due diligence should be a process engaged in by two parties whose ultimate goal is to get the deal done, not to find flaws in the deal. Both parties should feel the time pressure set by the schedule. I have seen some organizations take months (!!!) to complete due diligence. Entrepreneur, walk away from these people and never come back. Due diligence is work, but it should be done with maximal effort and support from both sides with the goal of making it accurate, complete (within reason), and quick.
- limit the number of reference calls. We should not need to speak to 10 references or 10 customers. This is overkill. If the first three all give us a mixed message, there is a problem and we should re-consider the deal. Same is true of references. There is no need to go fishing for either good stuff or bad stuff. The facts should speak for themselves, simply and clearly.
- do our own market research. We should know and understand the competition in the field and not just take the entrepreneur’s word for it. We should make sure that the experts giving us opinions about the market are real experts and not just people “more technical than us.” We should make sure our market information is timely — a software CEO from 10 years ago who has been “investing” for the last 7 years is rarely an expert on the modern software market. We should have a battery of trusted authorities who provide points of view for our analysis. We should not base our conclusions on the praise or the condemnation of any one external specialist.
- do our own personal reference checks. The company will, obviously, provide references that are good. We should look through our own Rolodex and find people who know the team. The goal should not be “digging for dirt.” The goal should be seeing a balanced picture. There are few angels or devils walking the earth. Each person has character flaws and wonderful qualities that your standard professional references, coached by the individual being references, rarely provide.
- not pull the rug from under the entrepreneur’s feet. If we discover something in the due diligence that significantly changes our perception of the deal, it’s probably best to stop the negotiation, explain why, and walk away. We should not try to change the deal terms such as valuation, board composition, preferences, etc. post facto.
The term sheet should appear sometime during this process (by the end, definitely). Often, a term sheet will be issued subject to completion of due diligence. You are almost there…