Due Diligence Humanized (cont’d)
Hi there, you are witnessing a premier, my first blog post… Not something lawyers normally do, but I will try hard to keep it readable and useful, even though it’s on the somewhat “dry” topic of due diligence. :-)
Recently my colleague Christoph published a blog post on Making European Venture Capital a Little More Human. One of the reasons for the cumbersomeness of many VC investments, which Christoph addresses in his post, are the due diligence (“DD”) requirements of investors. With this we mean the review of certain company information prior to the investment — an exercise that has a notoriously bad reputation. Founders often complain that much of it is a waste of time, keeping them away from what is more important: running and growing their business. We, at Point Nine, (mostly) agree. And since we make around 10–12 new investments each year, we too have a strong incentive to waste as little time on DD as possible.
With this blog post I’d like to provide more detail on the “Point Nine take on DD”, starting off with a bit of background on why the due diligence process is almost as bad as its reputation (hint: as often in finance, history and special interests play a role), and then explain how we approach the exercise, and why founders don’t need to worry about DD, especially not when talking to Point Nine. :-)
Two things to note upfront:
We only require a due diligence “effort” worthy of the name if we invest for the first time. In follow-on rounds we generally do not need any additional information on top of what we know already based on the regular interactions with the founders.
And when talking about due diligence we mean the legal and, to a certain degree, financial review of a business. In a broader sense the thorough vetting of product, market, product/market fit and founding team can also be considered “due diligence”, but we use the term only for the work that is done after we’ve signed a term sheet, i.e. when we’ve decided that we want to invest.
Some “History”
“Traditional” DD requirements have been developed mostly by large corporations and private equity investors purchasing mature businesses, often with the assistance of advisers paid by the hour and therefore incentivized to maximize the effort. While the basic idea is to identify material risks and problems in the business already prior to signing binding agreements, the exercise has somewhat developed a life of its own with many DD items serving “tick the box” purposes without material impact on the “if” and “how” of the transaction. Still, in many areas a quite extensive DD makes sense for most “traditional” acquisitions, where the purchase price is to a large degree a reflection of existing revenues, earnings and assets rather than the potential of the relevant product and growth expectations. This is the key difference to (most) early-stage venture investments, where the main value drivers are the business idea and its potential as well as the founding team.
Purpose and Limitations
Broadly speaking, traditional legal DD serves two purposes: identify problems and risks in the existing business and help prepare restructuring measures or post-merger integration (which is especially important if the acquirer is a corporate rather than a financial investor). Both objectives have only limited (or no) relevance for early-stage venture capital investments. For example, at the seed stage there will generally be no or only few customer contracts. While these may serve as an early indication of the business model’s viability, they will hardly help with the more important questions of growth potential and scalability. We therefore try to focus due diligence on the greatest hazards: “skeletons in the closet” and “structural” risks that might jeopardize the business as such (e.g. absence of necessary IP).
To illustrate the differences between “traditional” and venture-related DD, the following table sets out — based on our experience and in simplified form — the respective areas of DD (in a broader sense) in order of importance.
Point Nine’s Approach
As you can see, the most important (broader) DD areas in the VC world (top 2) are of the commercial type — the kind of DD that we do before we sign a Term Sheet. Traditional legal DD is a clear third (if not fourth). Hence our goal to limit it to the most critical risk factors which we have sought to reflect in this super-short due diligence list already introduced by Christoph in his aforementioned blog post. Keep in mind that usually the list becomes even shorter when applied in practice as not all items will fit the particular model and development stage of the business under review. Note also that not all of the list’s topics (if relevant) must necessarily have to be resolved with pre-investment intelligence, but can (also) be addressed in the transaction documentation (e.g. by an indemnity or warranty).
In case you are interested in diving deeper into the legalistics (which unfortunately we could not avoid entirely), we have added a few annotations to those items in the list which we think may not be self-explanatory for someone not dealing with this sort of thing on a regular basis.
What does this mean in practice?
One side aspect of due diligence is, we must admit, to confirm that the business has its “house in order”, meaning that relevant documents like permits and contracts are properly filed and findable. If this is the case, due diligence with Point Nine will definitely be easy and nothing to worry about! Our review is generally quick and we will only require more of your time in the rare case that something really critical pops up (“red flag”).
If, for whatever reasons (we struggle to think of one :-) ), you do due diligence with somebody other than Point Nine, things may of course be a bit bumpier. But keep in mind: generally all good seed investors will be highly efficient and focused on key value drivers, so if DD demands appear excessive think twice about whether you have the right investor!
Regardless with whom you do DD, the following best practice measures should help facilitate the process (and also the management of your company!):
- As a matter of principle: file important documents systematically and right away, including emails/web communications that constitute a binding agreement, preferably after conversion to PDF.
- Ask early about DD requirements — a good investor will know what he or she needs.
- If info requirements appear excessive, ask about priorities.
- Make documents available in a well-sorted Cloud-based data room (e.g. Dropbox); do not send emails/attachments.
- When adding documents after review has started, put them in a separate folder labelled “new” for better transparency.
- Keep and file proper records of any written Q&A conducted.
We hope that the above thoughts help to lift some of the fog around the unloved due diligence aspect of venture capital. As always we are keen to hear your views and experiences — please do not hesitate to get in touch (tilman@pointninecap.com). Depending on the feedback we receive we will publish updated versions of our DD list, especially if it becomes even shorter. :-)
