What investor due diligence really means for fundraising firms
The gruelling and legalistic world of due diligence
Bargaining with investors, getting advisers on board and poring over term sheets (the provisional contacts offered following a successful pitch) will probably wear you out.
Naturally, you’ll want to ease off the gas and take it easy, while advisers cross the T’s and dot the I’s. No chance. Due diligence is the most taxing part of the process – it is sometimes referred to as the business equivalent of being strip-searched – and Venture Capitalists (VCs) will demand a bewildering range of details about the company’s past, present and future status. So be ready.
A complex operation
The VC community is split on how many different types of due diligence there are. You may come across references to technical, insurance and even human resource due diligence, but the most common are commercial and legal. Essentially, it boils down to the same thing – with an amazing level of openness required from the management.
You will hand over accounts details, management CVs, legal documents and information concerning clients, suppliers and, even competitors, on top of any other morsels of data your investors feel they should know.
VCs want to be sure you can achieve your expansion plans with the money they’re offering, so they’ll look into your IT systems, office space and production facilities. They’ll talk to your clients, customers and suppliers to find out whether you have a good relationship with them, and whether they plan to work with you or buy more of your product in the future.
VCs also insist on checking the work history of the company’s senior executives. These checks can be exhaustive, and while you probably won’t have to account for school merit badges, you will almost certaintly have to explain career gaps.
And as Mark Spinner, head of private equity at commercial law group Eversheds explains, investors will always want you to account for past business failures too. “There’s an old saying from the US that you can’t count yourself a true business person until you’ve failed, at least, once. Unfortunately, private equity companies don’t see it that way,” he says.
Formal angel networks carry out some checks, although are usually less rigorous and less expensive overall, with the likes of Hotbed and PiCapital honourable exceptions. Due diligence is more the responsibility of angels themselves.
Three’s a crowd? Try 20
To get the clearest possible impression of your business, VCs hire specialist commercial due diligence companies to assess your operation against your competitors.
Add the various lawyers, bankers and advisers on both sides of the transaction and you are left with a gaggle of interested parties, all of whom want access to your business. Rob Donaldson, corporate finance partner at Baker Tilly, admits this sometimes leads to disagreements as to exactly who is running the show. “There are a lot of bodies at this stage and the process can be overwhelming,” he says. “Your financial adviser should manage them and ensure there is the right level of access to your business. “
In many ways, this stage is more frenetic than when the management team is negotiating terms with different VCs. However, it’s less up in the air than the term sheet stage and, at least you can see the light at the end of the tunnel.”
It’s a good idea to nominate a project manager – usually the MD – to be the first port of call and to relay information back to the company. Unfortunately, all of these advisers must be paid. And while VCs will want to establish a good rapport with management teams, they will not pick up the bill.
You should expect to pay up to 10% of the value of the investment in costs. This money comes from what the investors give you, so if you’re looking for, say, £1m you should ask for around £1.1m to help settle up afterwards. But be aware you might end up footing the fees if something is discovered which leads to the investor pulling out. Check your term sheet carefully, and make sure you’re comfortable with it; the VC will want you to write back confirming you are satisfied before due diligence begins.
Honest is the best policy
The extent of the checks may come as a surprise to uninitiated management teams. Even those who have sought funding in the past will be shocked at how the industry has come on. High-profile accounting scandals and fraud cases have taken their toll, making investors ultra-cautious about where they put their money. “You have to see it from their point of view,” says Mark Wignall, chief executive at Matrix Private Equity Partners. “They are handing over millions of pounds to a company that, initially, they know very little about.”
Wignall says he can list scores of examples where deals have fallen through due to holes in the management’s story. He remembers one example where the director general of a company seeking investment turned out to be an alcoholic, and another where it was discovered the company chief was a compulsive gambler. An angel network that preferred not to be named also had an investment fall through when due diligence checks revealed that the “entrepreneur” was actually a convicted fraudster.
More importantly, from a business point of view, Wignall cites instances where the managers were divided into warring parties, and where customers were about to cancel major contracts. However, he says deals rarely break down at this stage – perhaps one in every 20 cases – largely because managers are encouraged to be as honest as possible about their shortcomings. Being honest is one of two ways companies can speed up due diligence. You’ll get on better with your VC if you allow them complete access to the company and give a fair appraisal of it.
VCs will hire professionals skilled in weeding out cheats to put your business under the microscope – and you might well incur personal liability if you have misrepresented your business. A far better option is to give a ‘warts and all’ appraisal of your company. Investors know that there’s no such thing as the perfect deal, and even the most inviting prospect can take a turn for the worse when you lift the corporate kimono.
For the best results, plan
The second way to speed up due diligence is to take more time agreeing conditions in the term sheet. You should aim to get as much as possible sorted out before due diligence even begins in earnest.
That means laying down the parameters of the deal – even regarding sensitive issues such as pay and benefits. Having a deal break down is a catastrophic waste of time, effort and money for all concerned, and the last thing you want is for it to happen over a technicality.
Liaise with your advisers and ask what kind of information will be required, thereby having it ready when called upon, instead of scrabbling around in dusty cupboards for long-lost documents. Remember also there are several different groups involved in the process who may ask for the same information at once. It pays to sort out copies of documents and arrange with your lawyers to have them distributed as soon as they are needed.
It cuts both ways
When you sign an agreement with a private equity company exclusivity becomes a binding principle and you inevitably waive some of your bargaining power. Conversely, due diligence gives VCs plenty of scope to alter the terms of the deal.
“VCs will try to outbid each other at the term-sheet stage, but will then look to uncover surprises during their investigations to help them renegotiate a better deal,” says Spinner. Wignall admits that both sides can try to change the terms, but he argues that it’s in VCs interests to keep post-term sheet negotiation to a minimum. Reputation plays a crucial part in investors’ business, and a VC risks becoming an outcast if it fails to play by the rules.
Donaldson adds that investors get a sizeable chunk of their deals through recommendations from financial advisers – deals which could easily dry up if investors show themselves to be untrustworthy. Remember, due diligence cuts both ways, and it’s not uncommon for bosses to return the favour and demand details from the investor.
A good private equity company will have client contact details on hand, and will be happy to supply prospective partners with information about bygone deals. Your advisers will tell you whether the investor is good at striking a fair deal, but clients will be better placed to tell you if they can see the deal through.
Rarely will you be given access to the same level of information as is demanded from you, but it’s good to find out who you are dealing with nonetheless. While renegotiation on this footing is rare, managers can ask for a better deal, if during the process something happens to make their offer more valuable – like if you win a big contract.
Due diligence is wearing, but also mercifully brief. On average, it takes between three and six weeks to complete. To minimise risk, investors look at likely problems first and then move on to the finer details once they’re happy the business has nothing obviously wrong with it.
At the end, the lawyers will draw up a shareholder’s agreement – which should mirror the term sheet, although it will be legally binding, with more detail. Then you’re ready for the money.
Securing equity finance is a withering experience, but the potential gains are huge. Managers should be aware of what they’re getting into and prepared for a rollercoaster ride.
And when you think the process is just too much, think of Mark Goldberg. He made a fortune from a recruitment business, then ploughed most of it into Crystal Palace FC, only to see the club go into administration shortly afterwards. He was subsequently made bankrupt. Why? It is said he commissioned a ‘big four’ firm of accountants to prepare a due diligence report on the club, for £250,000, which was smart. Less smart was that, it is said, he never read the report, which pointed out many of the dangers in the purchase.
Due diligence can save investors everything – and while it’s a pain, done well, it might even highlight some areas for you to make genuine improvements to your company.