Several readers have expressed concern about not knowing what is
meant by "due diligence" as it relates to potential
funding sources for their emerging ventures. Here's how to
think of it: It's actually a very simple concept with many
interpretations and multiple levels of implementation.
First, the definition should mean nothing more than an investor
being "diligent" when checking out the substance of the
claims made by an entrepreneur with respect to the market, the
product or service concept, the competition, the management team
and so on. The term "due" means that it's expected
and someone has to perform this task. So the concept is really all
about the diligence that is due the investigation into an emerging
company's plan for doing business. There are some in the
financing environment who expect this to be done by the
entrepreneur on behalf of the investors, and that's a
completely wrong understanding. The company founder makes some form
of disclosure within the business plan, but the responsibility to
follow-up on and check out the statements made in that document
falls squarely on the shoulders of the investor. For the scope of
your financing experiences, always assume that the potential
funding source is the one that will check and recheck everything
presented by the entrepreneur.
The next issue to consider is how the due diligence gets
accomplished. As I said before, this varies considerably from deal
to deal. At the first level, a potential investor may pass the
business plan along to a colleague who has specific experience in
the same (or a similar) area of the new venture. Technical
drawings, terminology, articles cited, machinery or processes
described, pricing and shipping practices, and marketing channels
are all examples of categories within the plan that need to be
checked carefully by investors to see if the entrepreneur really
knows what he or she is talking about. Certain industries may have
very unique issues in these and other company functions. A skilled
eye with experience in that same market space will be able to
comment on the accuracy of the statements made. If your general
contracting business idea doesn't convey a clear understanding
of the specific issues related to building supplies, pricing,
payment terms or financial commitments on real estate, then due
diligence should readily pick up on these as red flags that bring
into question the overall quality of the deal.
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Due diligence can also go several steps further. Investors will
often pick up the phone and contact people or companies named in
your business plan. If Jill Smith is listed on your advisory board
with an impressive electrical engineering background, investors
will want to speak directly with her and follow-up on where she
went to school, how long has she been in the industry and hear her
version of what she's doing on the board. If Jones and Jones
Inc. is listed in the plan as the primary supplier of parts
inventory to the new venture, not only will investors want to talk
with shipping and manufacturing people at Jones and Jones, but they
may also want to visit the factory to meet the owners and
production crew and see the operation firsthand. When an accounting
practice, law firm or design company is named in the plan, a
thorough due diligence speaks directly with each of these and
discusses the extent of the business relationship with the
entrepreneur and the new company.
This also applies to statements about patents, trademarks,
exclusive contracts and deals currently in process with a large
buyer. Investors would like to mitigate as many risks as possible
related to the funding opportunity. Due diligence simply allows
them to check and double-check the pertinent pieces of the deal
before deciding whether to provide capital. So don't get upset
when an exhaustive due diligence is performed on your business
proposal. If everything's accurate in your presentation, then
the due diligence will further validate that fact and investors
will be more likely to put money into your deal.
David Newton is a professor of entrepreneurial finance and head
of the entrepreneurship program, which he founded in 1990, at
Westmont College in Santa Barbara, California. The author of four
books on both entrepreneurship and finance investments, David was
formerly a contributing editor on growth capital for Industry
Week Growing Companies magazine and has contributed to such
publications as Entrepreneur, Your Money,
Success, Red Herring, Business Week, Inc.
and Solutions. He's also consulted to nearly 100
emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.