Lifting the lid on VC due diligence for start-ups and small businesses
If you want to secure a credible VC investor you need to be prepared to undergo detailed due diligence before a deal is sealed. SEP explains
When buying a house your temptation to snap up a property at first viewing may be tempered by the major financial commitment and legally-binding contract.
You will engage experts to check for hidden problems, assess the cost of repairs or upgrades, determine an appropriate offer price, and gauge potential resale value.
The same disciplines of informed investment apples to venture capital. Due diligence is an essential part of the investment process.
When an investor commences due diligence it is a sign of intent to ‘buy’. The due diligence process enables an investor to identify, quantify and mitigate risk and to determine both the current value and potential future value of a business.
It is a discipline that results in highly specific recommendations which benefit both the company and the investor. The findings feed into a detailed 100-day action plan that a company’s management team can execute after the investment completes. Due diligence can form the solid foundations of a longer-term strategic road-map to build value for all shareholders.
What is involved in the VC due diligence process?
An investor should explain the areas to be covered, parties involved, likely duration and how management can prepare.
Timing for due diligence varies with each company but is unlikely to take much less than four weeks and in extreme cases may take three to four months. Typically, between three and eight weeks.
Generally, diligence is a two-stage process. Internal due diligence will follow initial meetings with management and may be sufficient to allow an outline term sheet to be issued. Detailed due diligence will follow. This is a more rigorous process involving external specialists focusing on different aspects of the business spanning financial, commercial, legal, technical as well as human resources and governance. Ideally, the cost of conducting external due diligence is factored into funding calculations but this is not always the case.
Due diligence is vital to ensure that both the downside risk and upside potential of a prospective investment are properly assessed and to make certain the venture capital firm meets its obligations to its own investors in terms of backing businesses that meet their criteria – not only in terms of business stage and focus but also ethics, social, environmental and governance issues. The latter are increasingly important and can have a major impact on a company’s reputation and prospects.
How can your business prepare for due diligence?
It can be time-consuming to gather all the information required so allocate specific responsibilities to senior management and support staff as appropriate. Investors appreciate well-organised teams that respond promptly and efficiently to information requests.
Management can be a company’s greatest asset or liability. Investors will want to know all they can about the management team and key individuals such as existing shareholders. This may involve reference calls and background checks. It sounds intrusive but it can uncover issues of which even the management team might be unaware.
And, while an investor is assessing you, you also get the opportunity to size them up before committing to a deal. Personal dynamics are fundamental to investment success so take every chance to deepen relationships.
Feedback on due diligence should be shared with management. It is important to be open and transparent. Management teams generally embrace an opportunity for constructive feedback and to address weaknesses, mitigate business risk and build value.
Who carries out the due diligence?
Investors will have advisers that they like to work with.
Scottish Equity Partners invests in technology or tech enabled companies to accelerate growth and expansion and our diligence advisers have a technology focus and understand the issues that matter to us. The interplay of different strands of diligence provides a detailed and accurate picture of every business we invest in.
For financial diligence, larger accountancy firms are often used as they have deep expertise and can mobilise a team quickly. They will scrutinise financial models to ascertain the degree of integrity and highlight any anomalies. If a company has audited accounts, this can speed up financial diligence.
Diligence reports enable investors to determine how each element of a business plan stands up under scrutiny. For example, a company may state their financial model reflects their best view of costs but technical diligence may identify a requirement to upgrade their cloud infrastructure to support sales growth. Technical and financial diligence findings would be overlaid to ensure adequate provision is made for IT investment.
Commercial diligence may test assumptions on market share and sales – scrutinising the underlying expectations to determine where growth is coming from. Is it expansion into new markets, new product launches or an impending deal with a new customer. The risk attached to each assumption will be assessed. Commercial diligence can also include reference calls to customers to verify quality of product and service.
Legal diligence often uncovers the most contentious issues. For example, leases that are about to run out, questionable legal structures or employment contracts, regulatory issues and even criminal convictions.
Responsible investors will also look at employee share option schemes, supplier relationships, governance and environmental and social impact. Each diligence exercise is tailored.
While providing a snapshot at the time of entry into a business, diligence can also influence exit planning. It may identify a strong relationship with a customer which could in time become a strategic acquirer of the business.
If you are seeking a long-term financial commitment and want an informed investment partner to support your growth, due diligence is an essential and beneficial part of the process.
Paul Neeson is associate of Scottish Equity Partners (SEP). Want more advice like this? Read more from SEP’s blog series: