Due Diligence

I thought I’d post on due diligence since folks seem to be curious as to what it is, how much to do, and where it fits into the whole venture ecosystem. This will be a steady-stream-of-consciousness so please forgive any typos, etc. To oversimplify, due diligence is the process in which a fund decides whether it will make an investment in a particular company and I will include some generic items for consideration later in this post. The earlier the stage of company, the more “art” than “science” there is in analyzing whether to make an investment but most early-stage funds follow the guidelines below to one degree or another. The other aspect of due diligence is often left unsaid, despite the fact it is equally important — the due diligence entrepreneurs SHOULD perform when deciding which fund they would like to work with and whether they want to partner with a particular fund that may have expressed interest in investing in them. It is, after all, a two-way street and both VC and entrepreneur will be essentially “marrying” for the next few years (exceptions/divorces aside).

Deal Due Diligence

Most VCs generally break this down to 1) market; 2) technology; 3) financial; and 4) “operations”. Performing due diligence on a particular market should result in the VC being very familiar (and comfortable) with the size of the market(s) the particular company is targeting with its product(s)/service(s), the direction the market seems to be heading based on historical statistics and the forecast rate of growth (e.g., most funds don’t necessarily like investing in markets that are dying…), the typical sales cycles for the product(s)/serivice(s), and who the players are in a given market (i.e., both the real and potential competition). Technical due diligence depends on what is being offered for sale by the company and whether their success depends on any particular competitive technological advantage (i.e. intellectual property). During technical due diligence, VCs attempt to determine the defensibility of the company’s business, any differentiation, whether the company will have the necessary freedom to operate (i.e., potential patent infringement issues), and any product life-cycle issues. Financial due diligence is essentially two parts: one part is determining how much capital the company will require and whether that fits with the fund’s model and the other part has to do with analyzing the company’s financials (e.g., how much cash they have, their cap table, whether they have any debt, etc.). A part of financial due diligence may also involve determining whether the VC and/or company will be able to pull together a syndicate for larger and/or later rounds of financing. Finally, performing “operational” due diligence involves background checks on the folks involved to determine whether they are the right folks to be able to take the company to the next level based on their past experience and personal characteristics. Operational due diligence also involves making sure the business model is sound, the company doesn’t have any pending or potential legal issues, and the that the general logistics of making the investment make sense. The entire due diligence exercise serves, at a minimum, to identify and mitigate the risks associated with the deal to the extent necessary honor the VC’s fiduciary duties to its LPs. For more information about the types of risks VCs attempt to identify/mitigate, see my Arbiters of Risk post by clicking here.

Fund Due Diligence

A far too often overlooked aspect of the start-up / VC deal consumation is the diligence the start-up should perform on its prospective VCs.    You would be amazed at how much “spaghetti” I get wherein folks are simply looking for funding from anyone and everyone regardless of whether their deal would be a good fit given the stage, size, and investment model of my fund.  So, before I provide more specifics here, do I have all your entrepreneurs’ and would-be-entrepreneurs’ undivided attention???  I thought so…  As sites like The Funded take root, I think you’ll see more transparency in the venture capital industry.  In the interim, here is a short list to get you started.  I started with a list that one of my attorneys, Craig Dauchy, provided for me and added my own items based on my experience as a VC and someone that has raised “OPM”.  So here we go…  Here’s a laundry list of questions you should be asking yourself and/or the VC to determine whether the fund in question is a good fit.:

• What stage fund is it?  Do they invest in your stage of company?
• Where is the fund in its life cycle?
• What is the time horizon for this investment?
• What kind of return does the VC need to make on this investment?
• What happens if there is no exit event providing liquidity by that date?
• What other companies in your sector has the fund invested in?
• Are there any other companies in the fund’s portfolio that would be direct competitors?
•  What deals has this particular VC done?
• On what boards does the VC sit?
• Will the VC be willing and able to participate in the next round of financing?
• Would the VC be willing to work alongside other VCs with whom the entrepreneur is already in discussions?
• Who has the VC syndicated with in the past?
• Are there other funds that the VC thinks should be invited into the deal?
• How has the VC handled management changes in the past?
• Are there any founders in the fund’s portfolio who were pushed aside or pushed out?
• Will the VC introduce you to the founders of other companies the VC has invested in?

For more on fund due diligence and general entrepreneurial advice, I recommend you see my VCs Circle of Life post and spend $45 to pick up a copy of Craig’s book, The Entrepreneur’s Guide to Business Law.  Of the two, his book is better and maybe you can convince him to autograph it for you — just tell him I suggested it ;-)  With that, all you entrepreneurs do your own homework and pick the right partner for the deal at hand and happy venturing.