Introduction to Due Diligence
Getting your house in order
When you mention DD to most founders, they take a sharp intake of breath, their eyes roll, their heads slowly bow and they shuffle towards the nearest exit. The two little letters make founders go weak at the knees because it means admin, not just any admin, but really boring admin and a thousand questions just to add a cherry on top.
Due diligence for fundraising has a negative connotation as no one likes admin, but it’s a necessary task if you want to raise and raise well. If you are raising investment, then grab the chance with both hands to get DD ready and learn the ropes of good v bad DD. In this piece we’ll answer;
- What exactly is DD
- Why DD is important
- When to perform DD
- Who is DD for
- What areas do you need to prepare DD for
- How to make DD easy
- How not to alienate investors
The fact that we all know admin sucks & you may have other stuff to do, doesn’t mean you can get away without doing it.
If you don’t prep properly you’re taking a big risk on closing your round, is that a risk you are willing to take? !
What exactly is due diligence (DD)
It’s the governance process whereby information on a company is given to a potential investor to help them perform a range of formal checks to verify a range of items from;
- Legal documents to ensure ownership, company rules & full statutory compliance
- Detailed financial information on past, present of future projections
- Records of policies and procedures to ensure compliances and formal practices
- Ownership of intellectual property
Plus a whole host of other relevant information to ensure a company is meeting legal, regulatory and other compliance purposes and can provide evidence of any information provided as part of an investment process.
DD isn’t just for fundraising equity or debt, it could be part of a merger, an exit, an acquisition or even a supplier or strategic partner completing checks on you. Even investors have DD performed on themselves by companies who want to ensure their investment is from a legitimate source or an investment platform completing their regulatory know your client (KYC) checks.
DD isn’t just for investor on your company, it’s also used for companies on potential investors
Why is dd so important
It’s a critical process to get the 3rd party over the line before a deal can be executed, especially the bigger you scale and the higher the amounts involved.
It’s there as a protection mechanism for a few scenarios. It helps people find out the skeletons in your closet whether innocent or through lack of attention. For example if you don’t have properly executed legal documents such as share certificates or signed shareholder agreements then you need to get those all up to date and tidy.
Even worse than innocent mistakes it may help investors unearth where “your bodies are buried” if you are trying to intentionally mis-lead investors with false information such as prior revenue and profit figures being mis-stated to deceive. This can be common and a major cause of fraud in early stage companies when things get desperate for funding, so an investor should expect a basic level of DD to be made available as a minimum, before they even ask for anything more specific and always prior to releasing any cash or signing any documents.
Likewise it’s important to know that DD should be a two way process when fundraising, not just the investor performing DD on you! It’s important to have a full background on any investors in your cap table as you don’t know the ramifications it could have down the line, what their motives are or even the sources of their funds. They may have investments in competitors, looking to obtain insider information, or their funding is being taken from an illegal or irreparable source, which may cause harm if you try to raise funding again and future investors discover this as a major cause for concern.
When you have a well organised ship, with your DD items all neatly filed and to hand for a process, then it creates huge efficiency as it’s simply a case of dropping files into your data room, giving investors access and letting them self-serve their own specific information needs. This is the dream scenario for any investor and the brownie points will come rolling in for your obvious professionalism and only serve to enhance your reputation as an entrepreneur. .
DD is highly valuable as it helps identify issues you may not have even been aware of, so you are able to spot them before investors do.
When do you need to perform DD
You’ve got to be DD ready from day 1. It’s fundraising 101 and it’s the basics to keep your house in order as standard company secretarial admin. It shouldn’t be seen as a process you prepare for as a one off and react to when people ask for it, but for something you do as a matter of course, having a whole host of documents, organised, indexed and ready to go when someone asks.
Being DD ready will provide the immediate confidence when they can step through and tick the boxes efficiently as it shows them you are on it and not just grabbing stuff out from the bottom of a messy teenagers wardrobe, but neatly folded and ready to see the light of day when the investors finally come calling!
When you have things ready and at hand it actually eases peoples concern from digging and asking questions. An inability to provide things raises questions, but if you have a whole host of information ready and waiting, people are less likely to look as they take reassurance in your wonderfully organised sock drawer, all neatly matched in pairs and ordered by colour.
The way to motivate yourself and see the value in DD and how to approach it is to consider you are getting ready to sell your business in an exit for hundreds of millions. The day has finally arrived, the lawyers have been contacted to draw up the offer and your buyer needs to see all your dusty docs, policies, procedures, employment contracts and even the fixed asset list that now knows where any of it actually is. But wait, your major deal has fallen over right at the key point when the skeletons are uncovered in DD and you have just lost your deposit on that sports car you put down too swiftly and the beach house you’ve picked out is now going to the next bidder who did have their docs in order!
It’s an extreme case, BUT it’s paperwork and paperwork matters when big cheques are getting cut. You may have 2-4+ chances normally in your company’s lifecycle to practice this depending on how many times you raise or go through a major event. Don’t leave things to chance and find yourself scrambling around for key documents like articles of association, shareholders agreements, ex-co founder agreements with hidden clauses, that may bite you on the bum!
Crucially, you also don’t know when an investment opportunity may come along, so if you’re not DD ready you may completely miss the boat.
Who is DD for
From a funding perspective, you need to consider a whole range of parties and how far they want and need to go as all parties have their own requirements.
For example some of the funding providers must conduct a specific min level of diligence due to their formal duties such as debt providers and formal fund investors. They can’t avoid it and must complete a formal process to ensure they have complied with their investment/funding obligations. They will abandon deals if you cannot meet their DD requirements.
High Net Worths (HNWs) may operate at very different ends of the DD spectrum, some may write a cheque from a conversation on the golf course with no pitch deck, financial model or paperwork in sight, whilst others maybe far more detailed with their own or a formal deal person or team to perform their own level of DD to their satisfaction.
Angel Groups have a level of responsibility to complete satisfactory DD if they invest through an individual or syndicated round. Processes may be a single coordinated amount of DD from the group, or it may occur through their own personal DD needs for each investor if they’d like to “kick the tyre’s personally”.
Individual Angels will vary entirely on their own background, knowledge of the sector and investment size. Their DD may be minimal, but each Angel is different so you need to prepare the same way and be ready and prepared for it to ensure you don’t lose an investors confidence if you are sending bits of information piecemeal, with big gaps and creating it on the fly.
What areas do you need to prepare DD for
The full range of DD covers a range from, banking, corporate documents, financials, IP, legal compliance, personnel, policies, trading and any asset registers. It is a wide range given any company’s breadth and depth of operations.
Every company will have different emphasis on each area depending on the nature of its operations, sector and stage, so a DD exercise may target very different things.
How to make DD easy
Things are easy when there is a process and structure in place from the start. The best way to make life easy for yourself is to have a DD list on your network, or in a shareable folder like Google drive, dropbox or something equally as easy to share externally.
Then with a simple folder structure similar to the above list, have your files all in there ready to roll. Then periodically, just keep a calendar entry each Qtr to ensure everything is up to date, from shareholder certificates, major new contracts, employees agreements, etc. It doesn’t need to be anything different to your normal file management system, so it’s no huge extra burden and saves a ton of time when you need to eventually place your hands on the documents.
By being DD ready from day 1, it just becomes part of your normal process and routine
How not to alienate investors
You’ve sold the vision, convinced someone to jump aboard your investment round, then you commit the cardinal sin of alienating them by creating barriers to any DD requests they request. Investors shouldn’t be made to feel like they are inconveniencing founders by asking to perform some DD:
- Any DD process & requests should be volunteered by the founder,
- Investors should be asked what they need; and
- You should ask them if they need any of it explaining or walking through.
This is a key part of finally getting the term sheet signed and the money banked. Up until this point there’s no deal done, so it’s still all to play for.
This is the part of the process where you can really show you are investable and on top of things and prepared for your raise and if founders don’t respond positively to requests then investors may simply move onto the next deal, there is absolutely no shortage of dealflow for them.
DD caution
A note of caution on DD is for individuals with ulterior motives. Some individuals may be seeking to gain a competitive advantage or insider knowledge, so before you open up your cupboard to expose all, be mindful of who & what you are sharing information with. You can always refuse to provide information, but if you do it needs a valid reason to avoid raising alarm bells with the investor.
Now you have some good context on DD, FundingHero’s Pillar 6 will help you truly get DD ready.
Pillar 6 Process
To make it simple, within our platform on our paid plans we’re broken this area down into specific DD areas with basic accompanying checklists, and some key terms you need to know so you can be one step ahead with your understanding.
You will know what you need to do and when they have in place to be a true FundingHero DD legend. Then watch investors eyes light up with sheer joy when you show off your beautifully prepared data room, DD list and organised documents.
Fundraising shouldn’t have a 99% failure rate…
FundingHero is your all in one platform for tech founders looking to raise their early stage funding. We teach you the rules of fundraising to help you to Learn, Prepare & Raise.
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- Online canvases & templates
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- Simple investment tools
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If you need help then contact at [email protected] or sign up to our freemium platform now to sample how easy our canvases are to use and take your first steps to smashing your fundraising goals and becoming a FundingHero today!
