Due Diligence – a Must Do
By Aron Solomon
Probably worth starting this piece with the admission that the most fun part of due diligence is when it ends. This is true for both parties and it doesn’t become any more fun as you do it more.
Part of the diligence process is to confirm that what you’ve said in the relationship-building process with your investor is true. The point of diligence is NOT, for either party (far more often than not, the investor) to weasel out of the deal. Worth noting here: If you want to weasel out of the deal, just tell the startup “hey – we’ve changed our minds.” Done. Much better than using the diligence process as a sword.
Our experience is that 70% of issues that arise during the due diligence process are through poor communication, equally weak comprehension, and a deeply baffling inability to ask questions.
Let me give you an example from my own professional life: I’m often in meetings where people start throwing around acronyms. “The WVX in 2015 could have been better relative to the VL the previous year.”
Years ago, I used to nod but now interrupt and say “Sorry – I don’t know what WVX and VL mean.”
Almost always, not only is the issue well-addressed, the rest of the conversation is much clearer to follow. In the very, very rare situation where I’m mocked for asking the question, I’m literally out of the room, often sharing some prime verbiage during my exit.
So when due diligence begins, our first piece of advice is to ask for a clarification of all of the things you don’t understand. Investors aren’t dumb – unless you’ve deceived them into believing that they’ve invested in an entrepreneur with significantly more experience, they know what they’re getting into. Ask away.
Next is material changes. We see this come up a lot in the period between deck creation and diligence. Sometimes, forecasts change for the better. Often, they do not.
Our counsel here is to be forthcoming and transparent. “So, remember that we had 4 big deals in the funnel? Well, I Tommy Boy-ed (the classic diner scene with the rolls) 2 of them, 1 ghosted, and we landed the other. So, we won’t hit our Q3 revenue goal until halfway through Q1 next year.”
Okay. Not as great news as “I’m giving you a Golden Retriever puppy!” but it is what it is. You all deal with it.
Neither side, absent the presence of sociopathy (hey – we’ve seen it all) cowardice, or a dramatic change in the investors’ position and cash reserves, gains from an absence of transparency and it does actually save time. So why isn’t it always the rule?
One plausible answer is that we live in the Periscope Age. Anything we do can be shared or even livestreamed through social media, industry sites that help set reputations, or common-man-bizarrely-gets-huge-audience venues, such as Medium. Understandably, in this environment, missteps and admissions can be amplified. Some reason erroneously so, that silent and inactive is the way to go.
Investment synergies are critically important. One of the things that drive me the most nuts when startups and investors decide to make a deal is when startups are coy as to whom their investors are and when investors don’t press enough on the issue before diligence.
Simply put, I wouldn’t want to invest in the same company as certain people because I consider them to be less than stellar people (and the feeling is almost certainly mutual). So please be as detailed as you need to be in leading up to an agreement so that the cause of your deal falling through isn’t existing investors or the cap table.
On the latter issue, we always ask entrepreneurs up front of their cap table is “clean.” We phrase it this way as we’re trying to draw information out the startup and, probably more importantly, see what they don’t tell us now but will almost surely come out later.
For example, if there are two founders in the room pitching, it’s naturally and generally accurate to assume that in an early-stage startup, they are the two primary shareholders. Some shares might be owned by employees as part of the option pool, by a very early investor or two, or by friends and family.
But if they didn’t tell us and we later find out that the two shareholders own only 40% of the business, and some inactive and hostile founder owns 40%, we think this is deceptive. If your cap table isn’t perfect, if you have outstanding employee issues or legal claims, just shoot straight with us (which would include your best sense of how much money it’s going to take at this point to get things where they need to be).
Another housekeeping note – and we’re always stunned when this happens – is when companies get to diligence without the most simple paperwork or with some dramatic omission.
A good example of the former would be a startup that has always existed without a shareholders’ agreement or even a scrawled napkin sketch.
The dramatic omission can take multiple forms, from withholding relevant information about your startup’s competitive landscape, to not sharing information (yep, seen this one too) that founders in the deck are planning to leave the company for a job elsewhere once the funding round is closed. Really.
Our overriding theme here is that the diligence process isn’t the greatest thing in the world to do with your life. But as it’s absolutely critical, all parties should deeply embrace the goal of getting it done as efficiently and humanely as possible. We hope that by following some of our advice here, this will happen for you.