I haven't posted in my VC Primer series for a while. So far, we have covered: Fundraising, The Carry, Funds of Funds, The J Curve, and Management Fees. There is a topic that has become increasingly important to me and this is the topic of Due Diligence. I cannot emphasize the importance of understanding this topic from both the perspective of the entrepreneur and the investor. I apologize in advance for the length of this post but I want to make sure my readers get the point.
The reason this topic is important to me is that more and more I am seeing entrepreneurs and start up companies who really don't have the first clue as to how to go about obtaining funding. They have piqued the interest of some investors, but they do not know what the next step is. They may have heard the term "Due Diligence" but they really don't know exactly what it means or how it is conducted. Every venture firm or angel investor will have (should have) his or her own protocol of conducting due diligence. I have seen as formal a process as a due diligence worksheet where the company is scored on various metrics. Or as informal as a group of partners giving a company the thumbs up or thumbs down. With angels, I have seen it as simple as a discussion over a cup of coffee.
If you had $5 to $10 mm to invest in the life of a startup company, how extensive would you want to check up on the company and its managers? There are only a few real life examples that I can think of that stress the importance of what due diligence really means. For example: when you go to hire your babysitter or live-in nanny, what kind of information would you want to find out to make sure they are a fit for your family? Surely this would include references, a biography, a resume, and some research about what this person is all about.
If you were a famous politician, what kind of due diligence would you do on your closest security personnel? I would imagine that it would be pretty stringent. If you are lucky enough to survive the treacherous Goldman Sachs interviews and get an offer for a job, they will basically do an FBI background check on you to make sure that you have not had any run ins with the law and that everything you say with regards to your criminal history is true (Don't ask me how I know this!)
An old school financially-minded venture institution will conduct due diligence on a company that will at the minimum include seeing audited and unaudited financials since inception, all correspondence to investors, all versions of a business plan and its updates, background checks on key personnel, lease agreements, purchase or sale agreements, and employment contracts. There is a good chance that the firm has a due diligence team or will hire outside professional lawyers and accountants to make sure everything is OK. You have to remember that these firms have LPs and have a fiduciary duty to do what they can to make sure their investments are crisp and clean. They want to make sure there are no hidden liabilites or debts that they are going to become responsible for once they become attached to the company.
In short, if you are going to obtain serious venture financing, be ready to go to the Proctologist. They are going to make sure your financials are srubbed squeaky clean. If they sense there is any misrepresentation, then get ready to start explaining.
What does this mean for you the entrepreneur? Well if you know you are going to the Proctologist, then you better start cleaning out your system and flushing yourself thoroughly. You don't want him to find out that you are full of SHIT!!! In ordinary terms this means keeping your accounting and financials clean, having a good reporting system in place, and most importantly, creating a DUE DILIGENCE BINDER!
You don't understand how happy I am when I am interested in a company and THEY send me a due diligence binder that pretty much has everything I want. This means I don't have to ask. I don't have to wait. I don't have to hear some lame excuses about why they don't have the information I want already accumulated. When I work with an entrepeneur who has already prepared one, I know I am dealing with someone highly sophisticated who has been through the drill before. Perhaps he or she has obtained financing before, has M & A experience, or investment banking experience. Anybody who has this prepared obviously knows that the venture financing drill can take a while and they want to make it as expedient as possible.
So if you are an entrepreneur, here is my advice. A good due diligence binder is a royal pain to make. The easiest thing to do is to find out what you want to include in your due diligence binder and make a template of the sections. Update these templates on a quarterly, semiannual, and annual basis - make it a standard part of your accounting and reporting procedures that you report to your shareholders. Some things to include are an update of your business metrics, financial performance, and budget. When it comes time for you to put out a due diligence binder you will already have in place what you need!
I believe a good entrepreneur will create a due diligence binder on a yearly basis even if he or she is not in the market for financing. Creating a due diligence binder forces an entrepreneur to analyze his company as a whole and see what holes are in it. If he took a step back and looked at the company as an outsider, what weaknesses would he identify? If he is particularly sophisticated, he may realize that the process of updating and creating this binder and report is really a simulation of the rigorous reporting standards required to be on the public markets. If he is very sophisticated, he may take advantage of key advisors and consultants and send this binder out for free feedback that would serve his company well. By having one of these binders in hand, he will be prepared if there is an unexpected event and his company needs financing. If he is having a great day, a potential suitor for his company may come knocking on the door with interest in buying his company....voila! he has a package for them that they can look over and he won't be disrputed from day to day activities scrambling for all this information and potentially turning away an acquirer.
If you haven't figured it out yet, a due diligence binder is far more than just a binder - it is the hard copy that represents a faithful process of reporting, updating, and analyzing your whole business.
I already have my list of what I like to see included in a due diligence binder. If any of my readers have suggestions, please feel free to comment.