Most founders have heard the term “due diligence” but how do you prepare for what amounts to a forensic audit of you, your team, and your company?
The first thing to understand about due diligence is to start preparing for it the moment you found your company. Why? Because investors are going to dig back to that founding, for example, wanting to review your founder’s agreement. More importantly, you need to realize everything you, your team, and your company does is potentially subject to due diligence inspection and review.
Investors generally are most interested in three things when they consider an investment: the team, the technology, and the market opportunity. That’s going to be the focus of due diligence, but it will go beyond those three elements.
- The team – you and your team need to be “100% referenceable”. What does that mean? It’s a term used by Bill Kaiser of Greylock when I asked him if I could talk to the CEOs of other companies Greylock had invested in before we accepted his term sheet. He said, “Sure, we are 100% referenceable. Feel free to contact anyone at any of the companies we’ve invested in.” Investors may well contact the former employers of everyone of your team members. So make sure that if they do, they’ll hear nothing but good things. And if there are any skeletons in your teammates closets you are prepared to explain them. The same may go for your former college professors, colleagues, and former employees. As soon as you enter due diligence you and your team should alert everyone in your business network that they may be contacted by your potential investor and how important their reference will be to your closing the investment.
- The company – investors will want to review all financial records of your venture. So from day one set up a proper accounting system that can generate accurate financial reports. If necessary hire a consultant to set up your accounting system for you and teach you how to use it. It’s not rocket science, but it does require everyone to properly account for all expenditures made by the company, and to properly categorize them. Equally important are any and all contracts executed by the company, from the lease on your office space to contracts with freelancers. Keep both paper and electronic copies and have two sets of backups of all company data, one in the cloud and one on a hard drive not connected to the Internet and not located in your company’s offices (the CEO’s home is the typical place to store this drive). And if you have any loans, from a bank, relative or any other entity make sure you have all the requisite documentation and the loan shows up in your financial statements. You’ll need those: income statement, cash flow, and balance sheet, it should go without saying. If you have had a Board of Directors, investors may want to review the minutes of all Board meetings.
- Your technology – Your CTO and VP of Engineering should be prepared for a real 3rd degree, either from one of the partners or often from a hired gun with expertise in your tech, who will come in and grill you. You need to be careful here, as if you disclose trade secrets during this process they could potentially end up in a competitor’s hands. That’s one important reason to do your own due diligence on any potential investors, well before you get to the due diligence phase.
- Your customers – You investor will want to talk to several of your customers. So contact your best customers and prep them for a possible investor call. Here again you want to be 100& referenceable. If you’ve had any issue with a customer be prepared to explain it and why it’s not an issue any longer.
- IP – even if you don’t have any patents and haven’t filed for any, you have to pay attention to IP both offensively and defensively. Have you had trademark searches done on your company name and your product name? You want to make sure you are not infringing on another company’s registered trademark. And if you aren’t, then file your own trademarks to protect your company’s name and/or product name. If you produce any documents related to either your company or your products make sure they are copyrighted, which is easily done by including a copyright notice. You do have an attorney who specializing in IP, right? Investors like to know who your law firm is and which partners are representing you. (The same goes for accounting firms.)
- Employee agreements – Investors will insist that all employees sign NDA agreements (confidential non-disclosure agreements) with the company. They may also expect those employee agreements to include non-solicitation and
non-compete clauses as well. NDAs protect the company’s IP; non-solicitation protects against employees leaving and then poaching other staff; non-competes protect against employees starting a company in direct competition with yours. - The cap table – a clean cap table is imperative if you are going to get through the due diligence process. Your capitalization table lists all of the stockholders in the company and their shares. Investors don’t like to see lots of non-employees holding stock, it can be hard to corral these stockholders when necessary. There should be no doubt in anyone’s mind who owns how many shares in the company. Keep your cap table clean and clear from day one. It can be expensive and time-consuming to clean it up later. So resist the temptation to pay contractors, your landlord or others with company stock. Pay them with cash; if necessary, stretch out the payments, but keep your equity inside the company. And whether you set aside shares for future employees from day one or not investors will insist on an employee pool of roughly 15% to 20%, and keep in mind you will take the dilution, not them.
- Stock agreements – just as important as the cap table is the company’s stock agreement, which governs such issues as the vesting schedule for stock, what happens when an employee with stock leaves the company, and many other issues. Simply having a founder’s agreement that divvies up equity is necessary, but not sufficient. The terms and conditions governing the equity are just as important.
- C-Corp – while it isn’t necessary to be Delaware corporation from day one, if you know you’ll be raising capital you’ll need to go to the time and expense of either setting up a C-Corp from immediately or converting your LLC. You should have copies of all your incorporation papers ready for review.
These are the highlights from my experience. Due diligence gets more complicated once you get to second and third rounds, as such things as audited financials are expected and you will have many more contracts, employees, stockholders, etc. And finally, it should go without saying that investors are loathe to put money into a company that is involved in a law suit. So make sure you treat everyone fairly, document any and all agreements, and keep your reputation sparkling clean and shiny from day one.
While top lawyers and accountants are expensive they are investments in your company’s future. If you build your foundation correctly you can build a great company on top of it. But just like someone buying a house, investors are going to insist on a very careful inspection of your company – from the foundation on up. Your attorney and accountant can provide much more detail about the due diligence process. Be sure to consult with them when you start raising capital and alert them immediately if you are about to undergo due diligence.
If you’ve been diligent about how you have built and managed your company so far you should have no problem with the due diligence process.
Mentorphile 