For chief executives of growing companies, fundraising is never far from mind. Whether you’re out seeking venture capital for the first or fifth time, your future investor will need to perform due diligence at some point.
Diligence allows both parties to exchange ideas and questions, identify challenges, develop solutions and, hopefully, establish a mutually beneficial business relationship.
In my experience, the best managed diligence practices begin with full disclosure of expectations. Clear communication early is key. If you and your potential investor don’t have the lines of communication open now, what will your relationship be like in the future?
As simple as it sounds, knowing what to expect throughout the due diligence period can help you map out a strategy that allows you to pursue financing more efficiently and with fewer headaches along the way.
Here are four basic ideas to enhance your diligence experience.
1. Get familiar with timing and objectives.
If you’re new to the world of venture capital, be aware there is no single, one-size-fits-all diligence methodology. Each VC firm may have different objectives, standards and time frames to their diligence approach.
What should you expect during the diligence process? Be prepared for an examination of personnel, products, financials and customers. You’ll receive requests for information in the areas of accounting, technology and compliance. At OpenView, we may have an outside firm or one of our CTOs take a look at your technology architecture to identify technical strengths and potential weaknesses. On the accounting side, we’ll likely ask a third-party vendor to perform high-level tests on the financials to ensure no fraudulent activity exists -- it’s a minimally invasive approach to validating the numbers we’ve been provided.
Concurrent with the confirmatory diligence work, we’ll work with legal counsel to get the final documentation in order and to help us answer any legal diligence questions.
Most investors will also want to speak with customers, both before and after signing a term sheet. Understandably, entrepreneurs are protective of their clients and may feel uneasy when asked for customer references. But inviting prospective investors to speak to real people who use your product or service on a daily basis helps tell your company’s story and illustrate its value in the market. On the investor side, this may be one of the most critical pieces of diligence as it gives direct insight into how customers view your business and product.
Some CEOs put off introductions as late as possible, but in my experience, customer intros earlier in the process can help move the process along more quickly as well as help answer questions to many diligence questions that may arise.
Tip: Think about introducing current customers early on.
2. Get the right people involved.
As CEO, part of your job is to make sure your company is adequately capitalized. Of course, you also have much more on your plate (running the business, for example). While investors expect you to offer insights into key metrics that drive your business, nobody expects you to have all the answers to every question they might ask. That’s why it’s important to leverage the expertise of your executive staff, especially your CFO.
As CEO, partner with your CFO/VP of Finance to tag-team the fundraising process. Having someone on your team who you can push key questions and requests to will be critical to your diligence success.
That said, involving the broader management team in a fundraise is a tricky activity. On one hand, you want your team to be focused on their "day job" --running sales, marketing and product, among other responsibilities. On the other hand, investors will want to get some exposure to your team, and you will likely want to show them off. Asking them to spend a bunch of time with investors may not be in the best interest of your company, so I would limit that activity to once you’ve narrowed your search down to the firm you want to work with.
Tip: Don’t take on all the responsibility: delegate to your team.
3. Have your data ready.
Gathering data may be the most time-consuming part of the diligence process. Before you actively engage in new funding conversations with potential investors, revisit your last round of financing. Keep in mind that your business may have changed dramatically since then. Ask existing investors and board members for their thoughts on the kind of information VC firms might want to know about as well as the status of your current business operation and market positioning.
One common data request made by OpenView’s investment team is “revenue by customer by month since inception.” It sounds like a mouthful, but we use this data to run various cohort-type analyses to track customer growth trends over time.
Since many prospective investors may ask for similar metrics I would suggest starting to look at your data in this way in advance. Doing so can also be very informative on your business, as it will help you better identify customer patterns that translate into lifetime value.
Tip: One key stat to have
4. Establish good lines of communication.
If you’re seeking a long-term VC partner interested in helping your business grow, communication must be a two-way street from the beginning. Prep to make initial conversations as productive as possible by talking to entrepreneurs who have received venture capital in the past and determining what questions you should be asking investors.
Tip: Speak up
If a VC firm makes a request you don’t think you can deliver on, don’t ignore it. Bring that up. By being fully transparent early on, you and the investor can figure out the best way to get an answer and move forward.
Red flags to watch out for
This may sound like a lot to do, but keep in mind we’re talking about bringing on board a partner who is going to be vested in and engaged with growing your business for the long haul. That’s why it’s important to enter the diligence process with eyes wide open. I’ll leave you with a few potential warning signs to watch out for.
Pressure to sign a term sheet quickly. If an investment firm tries to sign you to a term sheet early - say, before preliminary diligence is completed - think twice. First, the term sheet will likely include binding exclusivity language that precludes your company from talking to other VC firms. If for some reason that deal doesn’t close, you will have to restart your process.
Second, signing a term sheet with big unanswered questions creates uncertainty. It doesn’t mean the deal won’t close, but I prefer completing the heavy legwork upfront. Once I sign a term sheet, I want the remaining diligence to confirm previous findings so we can close the deal as quickly as possible.
It’s all about dollars and cents. If I ask an entrepreneur during our first meeting what they’re looking for in a VC partner and their only response is “money,” that’s a sign it may not be a great match (at least for me). Obviously, money is essential to invest in the growth of these companies, but when establishing a long-term relationship I think it’s important to look at the bigger picture first.
Where do you hope to take your business and what do you hope to accomplish over the next five years? How do you think a VC partner can help you achieve your goals? What are you targeting from a board member? What are the key challenges you are facing and how can an investor be helpful?
If these aren’t questions that come up in your first conversations, you may want to step back and reconsider them.
You haven’t looked at many options It’s important to talk to multiple VC firms early on to find those that match up best with your business mission and stage of operations. Ask about their expertise within your industry, and how they can be helpful in scaling your business. As you move closer to action, narrow your focus to two or three prospective investors and then really dive in to determine which is the very best fit for your business at this stage.