What is due diligence and why do investors make so much noise about it?

An entrepreneur pitching for investment is in a sales process. Due diligence, diligence or DD involves the investor making sure that they are actually getting what they were sold in the pitch. The level of detail required by an investor will vary from fund to fund but is most clearly linked to the size of the investment round. For a Seed round the main points being scrutinised will be the team and legal history of the company. For a Series A business the exercise will also include looking at financials, scrutinising the technology and maybe speaking to existing clients. Beyond Series A, investors will increasingly look to understand the unit economics and assumptions around profitability.

What does diligence involve?

• Legal DD. Legal DD requirements do not vary massively between a Seed, Series A and Series B round. The purpose of this process is to discover any previous legal challenges, to ensure the business has been established properly and that none of the senior employees have been involved in any illegality. This process is typically led by the investor’s lawyers and normally takes 2–3 weeks. This can also include Intellectual Property investigations for more established businesses.
• Team DD and references. In the case of a Seed round, often the team will be the only asset. As a result, most investors will look to reference the senior management with previous employers, trusted individuals close to the business and perhaps existing investors.
• Financial DD. This is more typical for Series A investments and beyond. This normally involves the investors scrutinising the assumptions behind the Income Statement and forecasts, ensuring there is nothing untoward in the balance sheet, making sure there are no taxation issues, checking the validity of a company’s historic financial performance and allowing investors to make a judgement on any future financial challenges. This exercise can also provide a strong indication of how professionalised a company is and the strength of the finance function. This area is normally where the entrepreneurs should expect the most questions and interaction with the investors. This is normally conducted by the investor but sometimes involves using third-parties.
• Commercial & customer calls. In order to validate the value of the product to the client and the competitive landscape it is typical for an investor to ask to speak to multiple clients. Normal process will be for the company to provide a range of clients and then for the investor to make a selection. The company will then make the introduction to the investor and a confidential conversation will take place. For a company with a substantial base of clients, this could involve 3–6 client/partner calls. It is worth giving consideration to who these clients may be. In the event an investor gets exclusively positive commentary, they may be inclined to seek client references from people you have not introduced. If there are multiple investors who will be speaking with your customers it is worth aligning the investors and their questions to save duplication, repetition and your references’ patience!
• Technical DD. This is often completed by a third-party provider and can include scrutinising the architecture, a sample of code and the processes employed by the dev team. A report is then normally produced which outlines any potential weaknesses.

Who is involved in the DD process?

Legal DD is typically conducted by the lead investor’s lawyers with any questions that emerge being surfaced to the investors. Team DD and customer calls will also be managed directly by the lead investor. Financial DD and Technical DD are often outsourced to specialists, normally with a fee attached.

The CEO should be the main interface with the new investors and should ensure the process is running smoothly. Ideally a CFO or similar would manage the specific information requests. This makes sure the diligence does not impact the commercial running of the business. The CEO is also best placed to challenge any diligence which may seem excessive. The value of having a CFO in the business during an investment round is immediately obvious and virtually all our portfolio companies will attest to this.

Smart tips from experience

• Front-load the process and populate the data room before investors ask for access. The majority of the documents that will be requested will already exist before you start fund raising so get them together early on.
• Populating the data room can be simplified by pre-emptively adopting an internal file directory, including things like employment contracts and NDAs.
• Security and watermarking. Whilst the data room is useful for investors it is also a repository of all your most sensitive and confidential materials. It is often sensible to watermark materials with the name of the investor to make any data leaks obvious and also password protect materials.
• Calling time on wayward questions. There is sometimes a tendency for due diligence to stray from commercially important points to details which have no bearing on the overall conclusions. The scope and timeframe should be agreed up front and if diligence is focussing on non-material issues, it is worthwhile sensitively indicating this. This is especially true for legal DD where the focus is on mitigating risk and sometimes a commercial view might not be the first instinct. In a similar way, the lead investor should have a short discussion with the CEO to set expectations and agree what the scope of the work should be are prior to diligence starting.
• Request the results of the diligence yourself. Any risks or issues that are highlighted when accompanied with advice can be very valuable. This is especially true with technical DD, deficiencies in employment contracts and weaknesses in IP strategy. At the end of the day, you are paying for this so make sure you get some value out of it.
• Every interaction is diligence of a sort. Whilst diligence can be reduced to a specific set of information requests and judgements, the manner in which a company manages the DD process is also a very valuable data point for an investor in terms of how well-run a company is and how robust internal processes are. For example, if it takes a week to obtain a revenue forecast this is a red flag that the company is not strong at planning.
• The typical deal costs for the lead investor are in the range of £15–20k for legal drafting, negotiations and diligence for a Seed deal, £20–30k Series A, £30–60k for Series B and beyond when it may require specialist diligence. These are always paid by the start-up and it’s worth noting that these may increase if the company is disorganised or gives confusing answers. Best practice involves getting regular fee updates from all parties as well as an agreement that you are alerted when the fee cap is approached.

The good news is that every time the company goes through diligence, it should become better at it. This is brilliant practice for any exit you may ultimately wish to achieve, which could, after all, be with multiple buyers, multiple pages of questions and multiple advisers.

In case this leaves you with any questions, feel free to get in touch.

Will