Ask an investor: How do I prepare for due diligence on my startup?

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We’ve talked a lot over the last few weeks about what it takes to get a deal on the table, either to raise funding or to get your company acquired. Today, I’m going to draw off my book Funded as we dive into what it takes to close a deal — in other words, how you prepare to ace the due diligence process.

If there are red flags during the due diligence process, an investor can bring them up with the company. Many concerns can easily be addressed and not materially affect the deal.

“Due diligence” is a term given to the investigation or audit of a potential investment. Throughout the due diligence process, investors look to confirm all material facts in regards to a sale. Almost all investors conduct at least minimal — and sometimes extensive — due diligence on the deals they invest in. Investing in early-stage companies is risky, and conducting due diligence can reveal problems with a company’s business early on, allowing investors to identify the key risks. This will allow them to either develop a risk mitigation plan with the company or to back out of the investment altogether.

Some investors conduct due diligence prior to issuing a term sheet, a non-binding agreement used to propose the terms of an investment. However, most investors, especially when participating in more competitive deals, will issue a term sheet and then complete due diligence. For those deals, successful due diligence results in the legal paperwork being drafted and the investment round closing.

For investors, due diligence is a necessary evil. A 2007 study found that angel investors that put in at least 20 hours of due diligence were five times more likely to have a positive return than investments made with less due diligence time.

The actual process of conducting due diligence generally takes the form of an extensive checklist. You can check out a sample due diligence checklist here, prepared by the Tacoma Angel Network. The due diligence checklist is sent to a startup by a prospective investor.

As part of due diligence, investors also often request conversations with a company’s customers, past investors, employees, and other key stakeholders. During due diligence, investors are both looking to confirm information presented in the company’s initial pitch and to identify red flags. Is any information noticeably missing? Are there any inconsistencies? Does the company have legal rights to its product and trademarks? Is there anything disclosed during due diligence that might cause concern?

If there are red flags during the due diligence process, an investor can bring them up with the company. Many concerns can easily be addressed and not materially affect the deal. Other red flags may result in a renegotiation of aspects of the deal — or in extreme cases, the deal not happening at all.

Responding to a due diligence request

Your due diligence folder, also known as your “virtual data room,” is a digital folder containing documents related to your company and the requests made in the due diligence process. Sharing this folder is how you respond to a due diligence request. You will share your data room with investors when the due diligence period arises. Your data room will take the form of an online repository of information in the form of documents, often organized into folders.

Dropbox is a great tool to use for your data room. To start your data room, simply create a Data Room folder on Dropbox and continue updating it with information as you prepare to hit the fundraising trail. Because Dropbox is always synced in real time, when you share your folder with investors, the shared version will always remain synced with your version. Be sure to keep your data room organized. Clearly label folders and files. For extra credit with each of your prospective investors, customize your due diligence folder to match the checklist requested by the investor, naming each folder to match each point in the investor’s list.

How to prepare for due diligence

The due diligence process may sound a bit overwhelming, especially if you don’t come from a legal or accounting background, but it is actually quite a straightforward process.

When a startup is prepared with their due diligence folder ready, due diligence is much faster and smoother than if a company is gathering all of the information for the first time. As due diligence is fairly standardized, a startup can actually preemptively complete 95 percent of the questions they will get during due diligence. Apart from just saving you a lot of time, doing this can have a number of other important advantages.

Being prepared saves you time and gives you a better shot at success. Prepare your data room as part of your toolkit.

Pre-empting due diligence allows you to define the narrative rather than prepare each piece of information in piecemeal. It will also make you come off as professional to your prospective investors, solidifying their initial investment interest. Going through the due diligence process ahead of a fundraise will force you to take a long hard look at the inner workings of your business, exposing any weaknesses before you start pitching and allowing you to recalibrate.

How much information you are able to provide during the due diligence process can depend on what stage your business is at. Earlier stage businesses will naturally have fewer historical numbers and documents. The two primary types of due diligence that you will go through are business due diligence and legal due diligence. Both happen at the same time and are generally combined into one list in the requests from your prospective investors.

During business due diligence, investors are looking to confirm details about the financial health of a company, its sales data, market, and team. Some of the things asked for in a business due diligence checklist are:

  • Organizational charts
  • Past financials and projections
  • Management reports
  • Stockholder communications
  • Customer and supplier agreements
  • Credit agreements and loan obligations
  • Partnership or joint venture agreements

During legal due diligence, investors are looking into the structure of the company, its legal obligations, and its right over intellectual property. Some of the things asked for in a legal due diligence are:

  • A capitalization table
  • Articles of incorporation
  • Shareholder arrangements
  • IP related agreements
  • Government authorizations

These standard documents should be easy for you to gather and place in your data room. However, there are other documents that you may be asked to provide that are more customized, and that may need to be prepared specifically for due diligence purposes. These three documents are:

1. An overview of your customer acquisition channels

This would include an overview of your lead funnel and your customers by source, along with any information you have on your customer acquisition costs. If you have case studies of some of your key customers, this is a great place to include them. If you are a business reliant on larger deals, you may also want to be able to show a list of customers in your current sales pipeline.

2. A spreadsheet with your key metrics

There are a number of key metrics that investors may request during the fundraising process. Prepare a spreadsheet with your company’s core metrics for your data room. These key metrics may include: your revenue, users, growth rates, customer acquisition cost, lifetime value, burn rate, runway, and any other core metrics you are actively tracking.

3. A financial plan for the next three years

Projections are one of the key documents a startup founder prepares before hitting the fundraising trail. While your financial statements are a current snapshot of your business, your projections will tell investors about the expected future of your startup. These projections are one of the primary documents investors review during the due diligence process. Reviewing financials can help investors understand if a business has the potential to scale, while highlighting any gaps in the business.

Being prepared saves you time and gives you a better shot at success. Prepare your data room as part of your toolkit before you set out on the fundraising trail. If you’re already out on the trail, be sure you pull it together as soon as possible! You won’t regret it.

Editor’s Note: Part of this entry is an excerpt from Katherine Hague’s new book – Funded: The Entrepreneur’s Guide to Raising Your First Round. The book is now available through O’Reilly Media.

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Katherine Homuth

Katherine Homuth

Katherine Homuth is a serial entrepreneur, angel investor, and the founder of Female Funders, an online destination dedicated to inspiring and educating the next generation of female angels. She is the author of O’Reilly’s upcoming book, “Funded: The Entrepreneur’s Guide toRaising Your First Round”. Prior to leading Female Funders, Katherine founded ShopLocket —acquired in 2014 by PCH. Katherine has been named one of the Women to Watch in Wearables, one of Canada’s Top 100 Most Powerful Women and one of Flare’s Sixty Under 30. She has been quoted in the New York Times on fashion tech and was recently interviewed for the Oprah Winfrey Network. Find Katherine online at katherinehague.com.