Decoding Diligence: how to get a deal over the line
Previously in our Navigating VC series, Johnny Hewett shared insight into how to think about the luxurious position of having multiple term sheets and the criteria for picking your new partner. In this article, I take a look at the key components of the diligence process and share some top tips for getting a deal over the line.
No entrepreneurs like the thought of (and often not the reality of…) Due Diligence. VC’s asking lots of questions that probably seem irrelevant and worse still entrepreneurs get the sense that they are looking for reasons to chip the valuation you’ve agreed. A bad way to start a long-term relationship, and hugely time consuming just at a time when the VC are telling you that you have to hit your numbers.
Our view on DD is that it is confirmatory DD — it is not an opportunity to learn more about a business / market. It is an opportunity to confirm what we think we already know. You should be able to write a very detailed plan with a VC prior to signing a term sheet of what DD they are going to do and why. Be honest. If you think they won’t be able to prove what they want to, tell them early and work out a way around it. Very, very rarely do our processes fall over in DD and only then when there were huge inconsistencies in what we had been told, compared to what we found.
I’m going to try to lay out the different types of diligence, why they exist and how to make it less painful, more certain and, better still, value add to your business.
The Big Five:
- Commercial — to check all the five fundamentals (excluding Team), but of course including Unit Economics are as described, and make sure the managements plan going forward makes sense
- Technical — to check that the platform is stable, scalable and documented…
- People — to check that everything under Team in the Five Fundamentals, plus, how best to fill any gaps, all stacks up
- Financial — Do the historic numbers look right and are historic taxes in order?
- Legal — Is the “house” in order and well managed? This includes everything from contracts (employee (especially ref IP) and commercial) to filings etc. A sample of DD questions can be found here.
Diligence will be a lot of work, especially if it’s your first time — as start-ups don’t always focus on the admin! But think of this as house tidying ready for the next phase of growth without old issues to trip over…
A few tips
1: Before signing a term sheet work out what the diligence plan is in detail. Agree what the VC is looking for around each item and how they will prove it out.
2: Prepare — get your side in order. Use your lawyers, CFO / accountant and CTO to make sure you’re as ready as possible whilst you are doing your rounds of pitching, don’t wait until diligence starts.
3: Take the opportunity to answer some questions that you have in the business as well — get the VC to do the data work on it, or leverage their customer interviews to ask some questions you really should have asked but haven’t.
4: If there are elements that can be brought forwards to pre-term sheet, either because they will make you look great or because you think they are a major risk, then pull them forwards (E.g. some key customer interviews).
5: Be open, honest and collaborative — all businesses have weaker spots, just approach the VC’s thinking with an open mind. If you’ve chosen the right partner this is a good opportunity to start your working relationship together.
6: Time elapses during diligence > don’t miss your financial plan in that period (just as it’s really important not to miss it in the pitching process too).
7: Finally, take a deep breath. There will be some elements of diligence that you don’t see the purpose of — remember you know your business inside out and the VC is just learning. Don’t be afraid to explain why you think they are looking in the wrong place, but equally be prepared to help them tick off their concerns logically.
After diligence (or in parallel) comes the legal process of putting the term sheet into long form. Your lawyers will guide you through this and a good summary of the documents can be found here. Again, it is worth preparing by getting your lawyer to give you examples of where the contentious parts are so that you can get your head around what will be involved before it’s live in your process. This process will involve negotiation — be prepared to be on the opposite side to your new long-term partner again, but you’re almost at the finish line!
Next up, and saving probably the most important topic until last, The first 100 days: how do you get the most out of your VC?