Most entrepreneurs work long and hard to get a handshake agreement from an investor, and then tend to relax and wait for the check to clear. What they don’t realize is that about half the investment deals fail to close at this stage, including mergers and acquisitions, during the due-diligence process. The same is true of Dragon’s Den and Shark Tank investments you see on TV.
Remember that investors at this stage have heard primarily from the founder, and only reviewed written business plans and collateral. Due diligence is going the next step, to meet and interview all key members of the team, visit the business location and follow-up with early customers and advisors. Everyone expects a few flaws, but serious undisclosed issues will likely kill the deal.
For entrepreneurs, due diligence may seem like a mysterious process, with secret formulas and tricky questions, to give investors leverage. In fact, it’s really just an in-depth common-sense analysis of key success parameters of any startup to assess the risk before final commitment. Here are seven key elements of the business that are typically included in the evaluation.
Team synergies, commitment and depth. A dysfunctional team will jeopardize even the best of plans. A smart investor will normally interview all key team members and look for evidence of commitment to the same goals, depth of skills and experience and respect for all constituents. Undisclosed skill gaps or agendas can stall your investment.
Customer and market interaction. Investors will test your relationship with real customers, based on the data you provide. Existing and potential customers echoing your passion can be your best support, while no customer interaction or interest can likewise be a huge negative. It’s smart to contact and prep all customers before investors call.
Solution readiness and quality. This element is usually called technical due diligence and typically consists of a day with your engineering and marketing team led by internal team leaders. This is really an assessment of the team and internal processes as well as the product. Related discussions include intellectual property status and plans.
Competitive positioning and barriers to entry. For this element, investors normally look for an outside expert to validate your analysis of competitors and positioning. Again, you need to head off any surprises by making sure you have mentioned all key competitors and thoroughly prepped the investor team on your strategy and direction.
Business structure and financial risks. Be prepared to present a detailed cap table, identifying by percentage all owners, investors and debtors. Any unusual financial risks, including contingencies, large contracts, recent bankruptcies or credit denials on the part of any owners must be disclosed. The business structure should be clear and simple.
Track record of setting and meeting milestones. Investors have found that results to-date in a startup are very indicative of future results. Entrepreneurs who set milestones for their team, and consistently meet or exceed the commitments are much more likely to do the same with invested funds. No milestones set or most not met is a huge red flag.
Skeletons in the closet. No investor likes to be surprised in their due diligence by non-disclosed individual or startup tax problems, regulatory issues or negative publicity, either currently or in the last five years. Your best defense to any negative is early full disclosure, followed by a credible explanation, no excuses and many positives since.
Based on my own experience as an angel investor, I’m convinced that surprises rarely are any intent by the entrepreneur to defraud or even mislead potential investors. More often, it’s simply an innocent lack of disclosure of current relationship and operational issues which could raise investor qualms about the health of the business, despite a huge opportunity and a great product.
The best entrepreneur strategy for due diligence is to be as open and transparent as possible. Current issues and shortcomings should be disclosed in the most positive way to investors, before issues are exposed as surprises during the diligence process. Even one negative surprise implies others waiting to be found and will kill your integrity as well as sour the deal.
It’s always fair to ask the comparable questions of an investor to avoid surprises in that direction. Taking on an investor for a startup is a long-term partnership or marriage, so both sides need the same level of trust and commitment. It’s nice to start with a little mystery in a relationship, but neither side likes surprises during the honeymoon or later.
*** First published on Entrepreneur.com on 01/08/2016 ***