Due Diligence Pitfalls
The due diligence process is often overlooked when discussing the venture capital experience. Internet pontificators spend a lot of time talking about deal terms, market sizing, merits & risks of certain deals, founders, etc., but we don’t think about the actual process of performing due diligence all that often. There are probably a ton of good reasons for that, but it’s not something that should be overlooked. Due Diligence can be a lifeblood for venture capital, especially seed stage deals, and if you do it right, you can reap bountiful returns.
Due diligence, when done correctly, can elucidate the various considerations of a contemplated investment. Due diligence helps refine investment theses and provides conviction behind deal terms. It also uncovers various risks that a sophisticated investor can help a company mitigate. The due diligence process can be as beneficial to a founder as it is to an investor.
But first, what is due diligence? Due Diligence is essentially the process in which an investor tries to determine whether or not they should purchase a piece of a company. Every single investor performs diligence in their own unique manner. Some investors are trying to see if a company is going to do what they say they are going to do. Some are looking to see if the market is as big as the company thinks it is going to be. Some are trying to make sure that the business model is feasible. Others want to make sure the product is as good as it needs to be. The point is: there are a million things that an investor can look for in due diligence. Ultimately, they are trying to answer the question of whether or not a company is investable, and that’s different for everybody.
There are a lot of pitfalls that investors can fall into during or surrounding due diligence. Sure it can appear daunting at first, but it’s actually a great tool for entrepreneur as well and venture capitalist.
The first pitfall that I see entrepreneurs fall into during the diligence process is the belief that dealing with the diligence process can get in the way of building a great business. While it is possible that a diligence process be onerous and drag down a company’s productivity, this is uncommon. Instead, a diligence process helps a founder recognize where they have weaknesses within their company. Diligence points out question marks in a business model and helps keep the company as sharp and organized as possible. Founders have a million things to worry about, but sometimes they can get bogged down in day-to-day tasks. The diligence process, alternatively, forces a founder to look at their whole business - to work ON the business instead of working IN their business. Diligence helps a company not get lost in the sauce.
Another landmine that I see both investor and founder trip-up on during the diligence process is the attitude that a deal is already done once a term sheet is signed. First, if that is true for the investor, that might mean they aren’t taking enough risk, which is a completely separate blog in itself. Second, even if it is true, that doesn’t mean due diligence is unnecessary. For the investor, it helps them better understand the business they are purchasing a piece of, which will in turn help make them better members of the capitalization table. They can provide better advice and make better introductions because they really understand a company’s goals and vision. For founders, it’s a great time for them to better understand the investors they are going to spend a lot of time with in the near future. A thorough diligence process will help founders know how to manage an investor and what to expect from them moving forward.
Another pitfall that I see some companies fall into is the idea that “we don’t need to worry about this due diligence item, because it doesn’t affect our business significantly” or “we don’t have a CFO, so we don’t need to really work that hard on projections”. If your investor asks you for a diligence item, they aren’t doing it to annoy you - there is something (either specific or strategic) that they are looking for. They have probably put thought into that diligence item they are requesting and brushing it off can lead to negative miscommunications. But also, if you don’t have it, you should reach out and try and understand why the investor is interested in something like that. This process can help you strengthen your business and improve your understanding of said investor. Plus, this helps prepare you for the next round of financing - due diligence gets more in-depth as you climb up the capital raising ladder.
There is no perfect due diligence process. There is no perfect way to handle due diligence as a founder either. It’s a great get-to-know-you procedure that allows investor and entrepreneur to learn about each other. That relationship doesn’t stop the day money is put into a company. You have probably heard the old, hackneyed phrase that the venture capitalist’s and entrepreneur’s relationship is like a marriage - I don’t know if I would go that far, but it is pretty sacred and can require some couple’s counseling from time to time. The more you know about each other, the easier it is to get through tough times. At the end of the day due diligence can be a beautiful thing.