Paying Your Dues If you're looking for investor money, brace yourself for a rigorous due-diligence process.

On the road to building his telecom technology company, AscendentTelecommunications, founder and president Stephen Forte thoughtthat finding funding was going to be the easy part. It was February2000, and Ascendent was riding high on the double wave of Internetmania and boundless telecom spending.

Ascendent's product, which marries wireless phones totraditional phone systems, had just been installed at the famousBeverly Hills Four Seasons Hotel. The company had managed to getthrough its first year in business with some seed capital still inthe bank. Moreover, within hours of announcing a second round offundraising, Forte received a lucrative term sheet from a largeEast Coast VC.

The future looked bright, but Forte's prospective investorsweren't expecting the telecom market meltdown of 2001. AndForte wasn't expecting the extended-and expensive-period of duediligence that followed.

Due diligence is simply the investor's process offact-finding. By stripping away the gloss and glitz of businessplans and marketing materials, investors try to assure themselvesthat there won't be any nasty surprises after they write acheck.

In practice, due diligence is never simple. Forte recalls wherethe trouble began for Ascendent. "We spent weeks in duediligence with [the VC] team," he says. "We spentprobably $50,000 with attorneys going through the agreements andeven installed one of our systems at their office. We had thedocuments finished." But the abrupt market downturn caused theVC fund to rethink its investment. The deal was cancelled at thelast second.

Fortunately, Forte found a West Coast investor who was morewilling to take a chance on Encino, California-based Ascendent. Thegood news: The East Coast firm would ship all the due-diligencedocuments to the new team. The bad news: The West Coast team wantedmore time to see how Ascendent would fare in the new, less friendlytelecom market.

Forte, now 37, was in a due-diligence Catch-22. "You haveto show sales and growth, which take time and capital. So you findyourself pushing on the accelerator, even as the wall is gettingcloser. We got within six weeks of our cash [running out]," herecalls. Finally, almost a year after the process started, a nearlybroke Ascendent received its second round.

Getting to Know You

Forte's experiences are typical of entrepreneurs raisingmoney from angels, VCs or private equity groups. And sinceinvestors want to know the whole story, companies will find thatdue diligence gets more and more difficult as they grow. The morecomplex your company is, the more Draconian the due diligencebecomes.

Andrew Lindner, partner at venture fund FrontierCapital in Charlotte, North Carolina, says that after anentrepreneur makes it through Frontier's first screeningprocess, they still face four different levels of duediligence-financial, market, personal and legal-which getprogressively more detailed.

"The first wave is financial diligence to validate threethings: Is there demand, is the model good, and is there a reasonthat this team can provide it more efficiently than anyoneelse?" says Lindner.

If the deal passes that financial review, the Frontier partnersexamine the company's customers and partners, includingdistributors, vendors or integrators. Not all customers will bethrilled about discussing internal operations and purchasedecisions with your investors. Let them know what's going onand how the additional capital from outside investors will help youserve them better.

Skeletons in the Closet

After an initial screening, a financial reality check and athorough customer interrogation, an investor knows whether yourbusiness model is sound. He doesn't know what liabilities mightbe hiding in your personal past or in the legal nooks and cranniesof the business itself.

When it comes to personal issues, Lindner says his team checksout both founders and employees. A thorough background check willlikely include a review of your personal credit history, yourdriving record, and, of course, a search for any criminal orsecurities violations.

During this period, investors will undoubtedly ask for personalreferences. You can also count on an investor talking with yourleast favorite people, like that disgruntled employee or the vendoryou stiffed. If you've got those kinds of ghosts, offer them upat the beginning so there are no surprises. "In almost allcases, we can figure out a back-channel reference, on top of statedreferences," says Lindner.

Of course, an undisclosed criminal past or a pending lawsuitwill spook an investor. But they're also interested in thesmaller personality issues. Says Lindner, "The more importantthing is talking to previous investors, employers and employees tosee what kind of performer and manager [the entrepreneur has]been."

Liabilities and Litigation

Finally, legal due diligence will include a complete review ofyour company's contracts and commitments. In most cases,investors will want to see historical records going back at leastthree years. That means finding three years' worth of balancesheets; major purchase receipts; correspondence with attorneys,consultants and auditors; and the like. The level of detailrequired can be excruciating.

It gets worse. Since financial liabilities and securities issuesare foremost in an investor's mind, they'll often ask fortax and corporate records going back seven years or more. Collectall your tax returns, shareholder meeting minutes, bankingagreements and investor documents. Any litigation in thecompany's history is likely to be important.

Lessons Learned

From his experiences in 2000, Forte learned firsthand howdetailed the due-diligence process can be. Today, as Ascendentsales approach $10 million, Forte has just closed on a third roundof funding-$7 million from several VC firms.

Ascendent's future is once again rosy, but Forte'sstruggle with due diligence will not be fondly remembered. In aword? He laughs: "It was onerous."

is an investment banker and author of the e-book Finding Funding.