Deep due diligence: how to minimize disruption and maximize chance of success
When it comes to fundraising, most founders are so laser-focused on convincing investors to invest that they don’t fully consider the due diligence process that comes after. But as the funding landscape becomes tougher, it pays to know what kind of investor you’re dealing with, and how to handle due diligence right from the outset, so that it doesn’t jeopardise your chances a signing a deal.
When it comes to due diligence, investors can vary enormously in their approach. While many VCs are flexible, particularly at early stage, there are situations where you will face a deeper process, involving specialist external consultants. I’ve found that this is most common amongst venture capital trusts, corporate VCs and government backed VCs – where the concern of potential litigation is higher – and at late series A or Series B stage.
Having been through several of these processes with portfolio companies, I’ve seen first-hand the risks involved, due to the time they can suck from the founding team and the business. If you’re not careful, you can come up against delays, or worse, investors pulling out at the last minute. That means your focus shouldn’t only be on passing successfully, but also minimising the disruption to your team and your business growth.
Here I’ll outline a few tactics that can help to ensure you emerge from deep due diligence unscathed and, crucially, don’t end up back at square one.
Don’t waste time until you have clear commitment
Due diligence is a business cost, that can suck up a lot of time. On top of that, by entering this stage you’re giving an investor a certain amount of exclusivity, which means opportunity cost elsewhere. So, before you put any significant resource towards it, you need to have clear commitment from investors.
It isn’t uncommon for big corporates to say they’re interested, sign a term sheet with you along with several other businesses, bring in a team to get educated on your sector and business, and then pull out. Because ultimately, they’re the competition.
So, in early discussions you need to get an idea of the certainty of closing, a term sheet on the table, and specifically ask what the conditions are. This will give you an idea of how serious they are, the due diligence you will face, and where you might face issues. You need to be assertive, to understand what their offer is and the reasons behind their decision to invest. If you’re satisfied, move ahead. Otherwise, it’s probably not a good use of your time.
Some companies prepare a detailed data room before they even start fundraising, and while it might be helpful to have some of the basics ready to go, everything should ultimately flow from what the investor wants. I’ve seen founders who have prepared an amazing data room and haven’t ended up raising money. Similarly, I’ve seen the opposite situation where a founder hasn’t prepared anything, and they have raised. So based on that, my advice would be to wait until you know exactly what they want. You also have confidentiality to consider, so don’t share anything sensitive before you know that an investor is serious.
Manage the scope and timeline
I would also recommend asking for the scope of work at the outset, not only to know what you’re in for, but also to help streamline the requirements as much as possible. For example, if you have audited accounts available, this should cover off a lot of the financial questions. If they’re doing technical diligence, you may want to limit the amount of code you give access to for security purposes. Or if they want to do an HR review, try to control the involvement of the team, as that will be a big diversion of time.
Another way to manage the risk is to break the process into stages, focusing on the most important elements first. With deep due diligence, advisors are creating a report that will go to the investment committee (IC) for a decision. But there is usually one aspect which has the power to sway the decision, be that financial, the commercial outlook, or the details of the technology. So, find out what that is and ask for it to be completed first, reported individually to the IC for feedback, before continuing with the lengthy process. We have recently done this with a portfolio company, having been burnt in a previous process, and it gives you comfort that you’re not wasting time and money.
Control the narrative from day one
If it’s likely you will face a deep due diligence process, you need to ensure that the picture you are presenting in your pitch deck is consistent with what is happening under the hood. That means full awareness of any potential red flags, and addressing any negativity, whether that’s issues with the figures, customer complaints, a system hack, or negative press attention.
If you know that there are potential red flags, make sure you surface these with investors early in the due diligence process. Be fully open and explain what you have done or are doing to address the issue. If you don’t control it early, then it will come out in the final report and by then it’s too late – and you’ve wasted a lot of time for nothing.
Keep the feedback loop going
A good due diligence advisor can do a good report in two to three weeks if they’re pushed. If they’re not pushed, it’s more likely to take a month. So, stay on top of your deal person, by checking in every few days to make sure things are progressing, asking for feedback, and timelines of next steps. Don’t let things go off the boil. Keep building a relationship with them by meeting regularly and talking through how things are going.
There should be a regular feedback loop from investors that goes beyond the superficial. You don’t want to hear everything is great and you don’t want easy questions. Hard questions mean that they’re interested, passionate about what you do, and genuinely want to understand the sector. Plus, it encourages a positive discussion about challenges and opportunities, and gives you a chance to explain more about your business.
If they don’t challenge you then either they don’t understand what you do, they don’t care, or they’re afraid to raise an issue for some reason. Either way it’s a red flag. If you find that the process is dragging and there seems to be a lack of engagement or commitment, then you should seriously consider stopping the process early. Don’t be afraid to call it off if the chemistry isn’t right.
Don’t put all your eggs in one basket
Even where you have signed up to exclusivity with an investor, you have a fiduciary duty to your current investors and the board to maintain options around funding. For that reason, don’t stop hustling to keep other investors in the background. Deals can and do fall through during deep diligence, and as you’re likely to be running out of money soon, it can be a very disruptive and damaging experience if you don’t have a plan B. You’ve wasted three months, you’ve got even less cash, your team is exhausted, morale is low, and it’s going to take you another six months to raise again.
A healthy dose of caution goes a long way
It’s a lot easier to write this with the benefit of hindsight, but fundraising can be an unpredictable and fast-moving process. If you’ve never faced a particular situation before, it can be easy to get carried away and miss red flags. But if you enter each deal with a healthy dose of caution and do your utmost to protect your team’s time and business priorities, then you’ll be sure to spend time with investors who are serious about your business.