There is no consensus about what constitutes good due diligence when in the convoluted sphere of early-stage startup evaluation. When a co-investor asks “Have you done due diligence already?” or when a tag-along angel investor claims “Well if they’ve [Respectable VC Firm] done their due diligence then that’s good enough for me”, they often have only a limited understanding of what effort was actually undertaken. In addition, there are often unspoken and competing ideas around the due diligence process’s actual purpose. Therefore, in the spirit of better communication to entrepreneurs who pitch us at M25, LPs that invest in us and co-investors who trust us when joining a round alongside us, I’m going to outline our view on the due diligence process, what our due diligence process looks like and what each piece of the due diligence process actually entails.
I’d first like to dig into what exactly due diligence is — and isn’t. Thoughts and definitions around the term “due diligence” are vague and subjective, but I like the definition outlined in Investopedia which starts: “Due diligence is an investigation or audit of a potential investment to confirm all material facts in regards to a sale…”
Two sections here are important to understand, and I think get lost in many early-stage investors’ application of due diligence:
- “A potential investment” — this should mean it’s a company with real potential for an investment at that current point in time. This is not a company the investor is stringing along waiting for an increase in traction or waiting for something to happen to help them make a decision. Due diligence is not to be done for every company that pitches, but a select few that the investor actually seeks to invest in.
- “Confirm all material facts” — Due diligence is distinct from the investor’s analysis — due diligence is for after the investor has already decided that, if everything is as is presented, an investment will be made. Information found in the due diligence process should be either confirming or denying parts of the investor’s analysis, and only if some information significantly contradict earlier assumptions should an investor reevaluate their investment decision.
Another understanding that we have at M25 is that the amount and intensity of due diligence should be relative to the size, scale and history of the company. It should not take 6 months of due diligence to close a $1M deal with a company that is less than 2 years old and has a minimal P&L history; it should probably take 6 months to close a $1B deal with a company that’s 15 years old and has robust audited financial statements.
Our due diligence process is generally completed in a month or less, though it can vary depending on the speed of the startup we are working with. In general, after we’ve met the startup and completed our internal analysis, we decide whether to pass, wait or proceed. If we choose to proceed we follow-up with our due diligence checklist and work with the founders to complete it at a timeline that makes sense.
Our due diligence checklist is broken out into three sections — internal, external and legal. Some of the items may have been done at a higher level in our earlier analysis, but the due diligence process is about digging deeper. Other investors’ processes may have some differences but in general you tend to find many of these elements amongst most of our peers:
Internal (using primarily our team including our advisors, with assistance from the startup’s founders):
- Financial Review — We review at least six months of monthly P&L history and at least 24 months of forward-looking projections. There are usually followup conversations with the founders to discuss questions/concerns that come up.
- Market Review — We dig into the overall market opportunity, the trends and expected growth and do a full competitive analysis.
- Product Demo — We have one of our team members, often utilizing one of our more specialized strategic advisors, experience the product first-hand to see where it is at and how it is truly helpful and unique.
External (primarily our team interacting with third parties connected to the startup/founders):
- Client Interviews — We connect with at least one client from every touchpoint (i.e. both a large partnership contact and two SMBs with direct revenue relationships, or both a seller and a buyer on each side of the marketplace)
- Team Meeting at Startup’s Office — We visit the startup’s HQ and meet the employees. Often other parts of our due diligence take place during that meeting.
- Founder Reference Check — We talk with professional relationships of the founder(s) that have known him/her longer than the length of the company.
- Advisor and/or Investor Interviews — We interview some or all of the advisors/mentors and always get to know the other large investors in the round [M25 is not always the largest check in the round and may not be the lead investor, so meeting the other investors is important to us]
Legal (our team and the founders and our respective legal counsels):
- The legal review is the last piece of our process, as we don’t want either side to spend time or money on legal until the deal is highly likely to be consummated. Also, our firm avoids leading deals, so there are usually some terms and documents in place or established from an existing lead. We then look at everything from the articles of organization, investment documents, cap tables and any special documents like IP agreements, employee agreements, etc. that are significant enough to be reviewed.
Remember, this entire process outlined is specific to M25, and though each investor is unique, we do believe there are “right” and “wrong” ways to go about due diligence. We hope entrepreneurs can find this helpful when interacting with us or other investors. We hope our LPs better understand what we do and do not do when confirming our investment decisions. And we hope this can help reform the investors dragging 6-month-old startups through a 6-month-long “due diligence process” with no end in sight…
About the Author
Victor Gutwein, founder and managing partner of M25. A Kauffman Fellow (Class 22) and former leader in Hyde Park Angels, Victor founded M25 in 2015 and quickly grew it to become one of the most active venture firms in the region. Victor lives with his wife and daughter on the South Side of Chicago and loves staying active with running, biking, swimming, backpacking and any team sport you’ll let him join. If he can’t convince you to break a sweat with him though, he’ll usually succeed in getting you to try out a Euro-style board game (like Settlers of Catan) with his friends.
Twitter: @lalayak
About M25
M25 is a Chicago-based Midwest-focused venture capital firm run by Victor Gutwein and Mike Asem. Since the firm’s inception in 2015, M25 has invested in over seventy early-stage tech startups in over 20 cities across 11 states in the Midwest. M25’s objective, analytical model and collaborative, forward-thinking approach creates a large portfolio spanning several industries across the entire region, allowing them to establish M25 as a key node in Midwest startup ecosystem.
