When a founder reaches a major milestone with his company (like an investment round or even an exit), he faces one of his fearsome challenges yet, Due Diligence, these two words describe a process that is comprehensive as it is precise. This article will explain what is usually asked in due diligence, what's important to remember, and what digital aids can be used to assist along the way.
What is a Due Diligence (DD)?
When a small company or a startup caught the interest the eye of an investor or a big company, they will often want to know that this promising seed has strong roots. It means that they will ask “what are you made of?” and then push you to prove it through every aspect possible. Although it sounds a little frightening, the DD is usually predictable as it is built mostly the same, with extras or variations regarding different industries.
A Due Diligence (DD) requires:
These reports are commonly required by most DD requests you will meet along your way:
Why do investors and companies ask for a DD?
The time of the DD is the opportunity for an investor to interact with his investment closely, the reason is simple, to get an early identification of opportunities and risk factors, and to deny any concept of foul play that will affect himself or his potential future portfolio company in any matter. The largest example of a wrongly done DD that eventually caused significant damage, is the case of Elizabeth Anne Holmes.
Holmes founded Theranos, a health-tech company that soared in valuation after the company claimed to have revolutionized blood testing by developing a method that only needs a small finger prick. By 2015, Forbes named Holmes the youngest and wealthiest self-made female billionaire in America. Merely a year later her net value dropped to zero after firm accusations of her being a fraud, started to surface. The question is, how could Holmes recruit so many funds without anyone realizing she has nothing? Well, when investors are dazzled by a saleswoman's personality, looks, and well-constructed speech, they neglect the most important protector of every great deal, the DD.
This case made waves across the financial community and made people reevaluate the importance of the DD, it protects the investor and helps prepare for anything that might come. The funded company also benefits from an opened, well-constructed DD as she will be covered if any claim will be made to foul play.
Keep cash not information
Honesty is key to any successful DD. When submitting information to a DD make sure to keep it as clear as possible, information that might seem unimportant at the moment might lead to a lawsuit ahead. To prevent cases that require money that sometimes is hard to come by, most of the time an Escrow service is required by the hands of a trustee. As we often play the role of the trustee we’ve witnessed first-hand many companies drag through court years after a merge or an exit, just because they didn’t reveal some so-called irrelevant information in the DD process.
Make realistic promises
There is a fine line between a good sales pitch to exaggeration, never say something you can't back up. Many investors and large companies will move to the next level after an incredible meeting, but the next level includes the DD, and therefore you will have to prove everything that was just promised. What if you can’t stand behind your pitch? Then you might want to go back to the drawing board because this door might have just been closed forever.
Organize your (data) room
Consider working via a digital data room. A data room is a great way to seamlessly apply every document needed. It is basically a virtual binder, containing everything you want or required with a permission limitation, to show only what you want however you want. If you drop and organize every document in your data room, when the time for the DD comes, all you need to do is just open excess to the relevant investor.
What’s on the table?
When creating the Due Diligence, notice that all the capital structure DD is basically a well-made Cap Table, if you didn't neglect it so far it shouldn't be a problem for you. If you run an automated Cap-Table just extract it as a hole and voila! Your capital structure report is done. If your Caps are via a spreadsheet, just make sure everything is updated, add every stock owner's unique privilege, and you are good to go. Keep in mind that If you have a spreadsheet version you most probably be required to show a few cap tables from different time periods in order to give the same perspective.
Run the table to a waterfall
Although the capital structure DD is completely based on the cap table, there are a few more reports and important information it can provide. If you have an automated cap table, multiple investment and waterfall scenarios can be made in order to inspect all possible outcomes of this deal and provide important information to adjust. Although a spreadsheet cap table might not be as effective here, you can still ask whoever runs it for you to create a single scenario that is crucial to you (take into consideration that it might take a few weeks).
In order to finalize any major deal, you might be required to go through due diligence. This thorough inspection will make sure your company is what you claim it to be and find any red flags along the way. We advise giving any information you find, no matter how insignificant or harmful it might seem. A data room and a cap table are important tools to help build the way for the capital structure report and help set the ground for a trusted interaction between you - the founder, and your soon-to-be investor.
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