How to Demystify Investor Due Diligence

Before any investor worth their salt will consider funding your startup, they’re going to do their due diligence. Get an early start on putting together the information they’ll require to make a decision about your future.

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Investor due diligence is the magic that happens between piquing a private (angel) investor’s curiosity during your pitch and having them sign off on that much-coveted investment into your company.

In most cases, this due diligence takes a great deal of time (up to 10 weeks in some cases) because investors want to minimize the already risky proposition of investing in startups. For an already-busy entrepreneur, this requires patience and mental effort, especially if it’s your first experience with the process.

To increase your chances of being funded, and to get the most out of your fundraising experience, it’s vital that you are prepared. Many founders say that if they’d realized how much work fundraising actually is, they would have delegated a greater proportion of their day-to-day tasks to others in order to focus on fundraising until the money was in the bank.

Be Smarter
If you’re thinking about raising private equity for the first time, I strongly recommend you take a step back and educate yourself about the process before you jump in. A good place to start is by reading Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist (Wiley, 2012) by Brad Feld and Jason Mendelson. This book will give you a great overview of the fundraising process as well as some general dos and don’ts.

While you’re reading Venture Deals, you should also reach out through angel investment groups and startup incubators to find out how to connect with other startup founders in your community. By talking with these founders, you’ll get the most up-to-date local knowledge and figure out what approach works. The connection may even help connect you with potential investors. Shaun Jamieson is a great example of a CEO who turned around a fledgling startup through exceptional investor relations. Shaun was able to demonstrate an investment strategy to move startup SilkStart forward with exceptional documentation to back up his implementation plan to grow SilkStart in Victoria. Shaun has also done an exceptional job communicating milestones and wins with investors quarterly using a simple email template. Sending this update out is a habit all CEOs should implement post investment to create more meaningful investor relationships for future rounds.

Professional service providers working in the startup space, including lawyers, accountants, intellectual property strategists and business consultants, are another great source of referrals to potential investors. Lastly, when looking online, search terms like fundraising on websites such as Reddit and Hacker News.

The Paper Chase
Once you feel confident or at least “buzz-word” compatible, as I like to say, you need to prepare your documents to share with potential investors when asked.

Your documentation should include:

 Your Business Plan
My preference when it comes to a documented business plan, especially if you’re pre-revenue, is the Business Model Canvas and the Value Proposition Design (businessmodelgeneration.com), two valuable tools by Alexander Osterwalder of Strategyzer.

Regardless of which tools or business-plan model you use, your business plan needs to address the following:
• Your business model — how do you plan to deliver value?
• A detailed product overview and status report —what are you building and where are you at in the process?
• Your value proposition — why should anyone care?
• Sources of projected revenue — how will you make money?
• Technical studies — is this interesting enough to be a big idea worth investing in?
• Market studies — how big is the opportunity?

 Corporate Documents
Pay close attention, especially in the early days, to make sure you keep your founder(s) agreements simple and the number of shareholders low. This is essential when you seek outside funding for the first time — anything complicated is a red flag for investors.
• List of current shareholders — who owns what?
• All shareholder agreements — what have they been promised?

 Customers and Supplier Documents
These documents are your road map and proof that you have a repeatable and scalable business worth investing in. These documents should include:
• Your sales strategy – what does your playbook for closing sales look like?
• Your marketing strategy — how do you plan to attract leads for your sales people?
• Distribution strategy — once the sale is made, how will you deliver on your promises?

Material Contracts
Include every contract, good and bad, in the documents you give to potential investors. No investor likes to find out after the fact that you made a bad deal with a supplier. This is also a good chance for you to ask the potential investor if they have any continuous-improvement advice for supplier dealings to help your company reduce overhead.

Your material contracts package should include:
• Customer contracts, present and intended.
• Sales — include sales partnerships as well.
• Distribution — who is involved in your supply chain?
• Marketing — what have you outsourced?
• Employment agreements – this is typically for senior paid roles.
• All loan agreements — who have you borrowed money from, including credit card companies?

 Intellectual Property
Investors love intellectual property. If you feel you have nothing patentable at this time, consider contracting with an intellectual property strategist to examine your business and to ensure the investor that you’ve looked for opportunities and explain why you can’t create intellectual property at this time.

Your intellectual property submission should include:
• Copies of patents pending, assuming you have any.
• Copies of applications pending, assuming you have any.

 Financial Information
As an investor, I believe revenue modeling is just as important as the Business Model Canvas and the Value Proposition. Any founder who can produce a well-thought-out revenue model is a superstar. So pay for it if you have to, but get it done.

Your financial package should include:
• Pro forma — I recommend these be done professionally when raising funds.
• Financial statements — make sure you include all, not just the latest.

– Corporate Financing
You’ve heard the expression “numbers don’t lie.” When you are seeking investment, it’s worth preparing and submitting your financials, as this is where you’ll show your attention to detail and prove you can manage the investment of other people’s hard-earned money.

Include the following:
• Projected use of current funds —  how do you plan on accelerating the business?
• Agreements for outstanding obligations — whom do you owe, and how did you use their investment?
• Copies of agreements — what are your legal obligations?

 Employee Agreements
Almost all startups these days have to offer incentives to attract talent. Your employee agreement submissions should include:
• General cap table and stock options – what have you promised and to whom?

 Legal Information
Again, good or bad, don’t hide anything, including lawsuits, no matter how trivial or embarrassing this information may be. Include information about any lawsuits — past, current and pending.

Increase Your Chance of Success
Once you have accepted outside investment, start sending out regular updates to your investors and meet with them periodically (formally or informally) to make sure they remain confident that you are doing the right thing for the company.

In the end, never get discouraged when a deal falls through. Often, it really just means there was a better offer on the table from another company at the time. You just need to dust yourself off and get back out there.