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Take the Mystery Out of Investor Due Diligence

Take the Mystery Out of Investor Due Diligence

You’ve made dozens of presentations, and an angel or venture investor finally hands you a term sheet, offering to kick in the capital you need to grow your business. As you skim through the term sheet, towards the bottom, you come across the following clause: “The investment described in this term sheet is conditional on the successful completion of due diligence by the investor.”

Due diligence is the final hurdle you need to clear before your investor cuts a check. The thought of due diligence strikes fear in the hearts of many entrepreneurs, primarily because they don’t understand what the process involves.

Due diligence is simply a detailed review to ensure that your business and team are really who you said you are. During the process, the investor(s) will take a close look at your management team, business plan, customers, financial records, and legal records. If you understand the process and can make the necessary information easy to access, then there’s no need to dread investor due diligence.

Until now, the investor has probably had limited contact with your company: they’ve reviewed your business plan and they’ve had some conversations with you and other key executives in the company. Due diligence is where they, or their representative, will talk to other members of your team, call on customers to see if they like your product as much as you’ve alluded, and carefully evaluate your product out for themselves. If they discover details that are not congruent with what you’ve told them, they can back out of the deal.

Each investor has their own process for conducting due diligence, but here are the major items they will all dig into:

  • Management team. The investors want to ensure that the entire team is on the same page, is rowing the boat in the same direction, and has the skills and backgrounds you’ve represented. If your team is small, they will want to interview everybody. Any sign of team dysfunction could be an excuse to head for the exit. Some investors will run background checks – looking at educational and employment history, criminal records, and credit scores – on key members of the management team.
  • Product integrity. If you have a technology product, the investors will likely hire a technical consultant who can test the product and evaluate the underlying technology. They will also want to interview your engineers and product managers to understand the development road map and underlying intellectual property. The product doesn’t have to be perfect – you just need to be able to demonstrate that the product will be market-ready on time and on budget with the quality and features you promised.
  • Market validation. The true test of a product is whether or not customers are ready to fork over money for it. Therefore, investors spend a lot of time during due diligence talking to your existing and target customers to understand how they view your product. They may also reach out to thought leaders in the industry to obtain their views on what sets your product apart, and to get their independent assessments of market size and market potential. If the investors get a tepid response from customers or industry leaders, the funding deal is in jeopardy.
  • Competitive advantages. Every business has competition, either from direct competitors offering similar products or from indirect competitors with substitute products that satisfy the same underlying need. Investors want to know how you intend to differentiate  yourself from these competitors, and how you can erect barriers to prevent them from replicating your unique value proposition. Simply being “first to market” isn’t enough. Every successful business in existence has one or more competitive advantage, whether it lies in intellectual property, location, distribution agreements, or something else. Investors will want to confirm, usually through discussions with industry analysts, that your competitive advantages are real and sustainable.
  • Business and financial health. The investor’s attorney will dig through all of your corporate records – your incorporation documents, employment agreements, stock purchase agreements, stock option plan agreements, customer contracts, supplier contracts, partnership agreements, board resolutions, shareholder voting records, etc. – to ensure that everything is properly documented. Their accountants may dig through bank and financial records to ensure that you maintain proper financial controls and that you have a track record of wise financial decisions. They will also want to ensure that all promises of ownership that you’ve made – say, the 2% of the company you promised to your cousin for his help designing your first website – is properly documented and accounted for.

The keys to surviving due diligence is to develop and enforce good record keeping habits from day one, and to be truthful and forthcoming in all of your written documentation including your business plan and financial forecast. Keep a due diligence three-ring binder with copies of all of the documentation your investor is likely to ask for. Your investor will be impressed, and you’ll cut days or weeks out of the due diligence timeline.


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Original Publication DateFebruary 22, 2012
Related categoriesRaising Capital

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