Startup Financing 2: Due Diligence and the investors of your dreams
In your newly founded company, you’re working like maniacs, but tasks are still piling up. Some more developers need to be employed, new devices must be bought, servers rented, and so on. To really get your product going, expenses will need to skyrocket. It was most likely a worthwhile decision to make use of all your idea’s potential by giving away some shares of your company to have the money for realizing your goals. Consequently, the search begins...but whom for? How to choose the investor of your dreams? This decision can already determine your success or failure.
As mentioned in the first article, not every idea is capable of being realized without financial help of others. Most of the business ideas out there cannot be thrown into the market and start returning revenue right away. In most cases, it will take you months and years of hard work to conceptualize your product and have it withstand the harsh reality out there. There won’t be a great market fit right from the start – the real people out there testing your MVP will most probably not fall in love with the initial features of your product the way you did. So you start adjusting, repairing, spending fortunes on research and marketing and finally launch another version. If your idea holds potential, it’s worth the hassle and it will dramatically increase the chances for your official release to be a success. But, heck, who’s gonna pay for that? More often than not, the best answer is a Business Angel (BA) or a VC.
As you know by now, Business Angels are not just some rich people looking to invest their money profitably. They also commonly have a strong background in the industry they pick startups from, have been through founding a business themselves and therefore know of the common mistakes to be avoided and the general DOs and DON’Ts. VCs are companies with an attached funds which have the same goal and should also have the same kind of background in the industry, only you won’t be their only investment and they will arguably be around for longer. Go for experienced and skilled partners if you have the choice.
More and more people tend to view fundraising as a mere begging for money, which is partly fueled by popular TV shows that depict startups like junkies who would go with anyone who's got some cash:
What they neglect is the mutual interest investor and startup need to have in each other, which you can barely identify in a five-minute pitch. You profit from each other, you work together. Period.
In the initial phase of your company, we’re – most of the time – talking about a good idea and rather inexperienced people trying to make it a thing. The risk for your investors will be high, the conditions under which you receive the money will be poor. As your team and product matures and the investor can better assess how the chances are for you to succeed, you will receive more money for fewer shares of your company. In these later phases of funding, only very few BAs will be involved, as the capital raised will be significantly higher.
Talking about assessing your chances to succeed: this is where things get really interesting for you. Because your investor will examine every single element of every single aspect and person in your company. Afraid yet? You shouldn’t, and I’ll tell you why in a minute. But first, let’s see what we’re talking about here.
The Due Diligence process
There are persistent rumors claiming the Due Diligence investigation is the worst entrepreneurial nightmare. But what is it exactly?
Basically, the Due Diligence process (DD) is a way for investors to make sure their money will be in a safe place with your company. During the DD, which precedes the actual issuing of the funds, they try to understand if there are potential risks or obvious shortcomings and which are the areas in your company that could lead to serious problems in the future – problems of that nature that will lead to bankruptcy or worse. They will scan the team, the product, your finances including bookkeeping, and even your private and professional contacts. You’d better not have any skeleton in your closet.
That’s rule #1 – establish mutual trust. Don’t hide mistakes, don’t lie, don’t think you’re smart enough to cover anything that is a potential threat. When your investors finds out – and they will – they will drop you immediately. If you lied once, you will lie twice and three times. Doesn’t matter, nobody will want to work with you now. Well done, you screwed everything up. Both parties need to be abolsutely genuine in order to allow each other to address problems and achieve the most from all available resources.
The DD can be conducted by your investor in any funding round and tends to be a little less intensive in the seed or pre-seed phases. Pretty obviously, when your company is very young, you won’t have a product ready and not too many documents and licences – there are less error sources. Most of the time, in these phases the team and the business case will be examined.
When you've never had a Due Diligence, it sounds awful, like your career is about to end if you've lost only one receipt at some point. In reality it's not that impossible to overcome. You've made it until here, this won't be any harder than what you've been through already.
The more advanced the funding phase, the higher the investments and, accordingly, the more intense the DD. Typically, a thorough Due Diligence will consist of at least the following areas:
- Financial DD
- Technical DD
- Legal DD
- Product DD
- Team DD, …
Accordingly, what will be examined (amongst other things in the respective areas) will be your bookkeeping, financial plan, bank accounts and potential creditors (Financial DD), the technologies you use, the code base of your product, including quality check by professionals and checking licences (Technical DD), all existing contracts including employment contracts, founding documents, patents, insurances (Legal DD), the business case, scalability and potential market fit of your product (Product DD), as well as your team constellation, work atmosphere and cooperation and current and former business partners (Team DD).
For the latter part, it could already be a game stopper if you have one member in your team who is always blocking things and holding you back while managing to poison the atmosphere for everyone else. To find out about all this, your investor will likely make some reference calls with stakeholders and relevant contacts of yours, asking about your team, how it was working with you and, generally, if all of you possibly are a bunch of idiots. For all of the above mentioned areas of a DD, a large VC will have own teams or external experts.
But you don’t have to be afraid if you stick to rule #2 – work diligently. Still sounds hard to overcome? Relax. While you won’t need to be perfect in everything you are doing for the first time, be as accurate as possible, pay your taxes, avoid anything that might appear even a little shady at some later point. With supportive and experienced partners, it will be okay to ask for some tips and a little help. Just don’t take shortcuts, your investor depends on your reputation and knows you are not an expert at leading a company, yet.
At Railslove, we have already lead quite a few startups through the process, with special focus on Tech Due Diligence. If you need some tips or guidance, let us know!
The Due Diligence process is not all that hard. For a $10m round it will probably be very thorough and a lot of effort needs to be put into it, but then again we are talking about quite a lot of money. But before you sign any contract, you should also put your investors to the test to make sure THEY are a fit for you as well. It’s not a one-way street. It shouldn’t be.
The investor of your dreams…
...should fulfill a couple of prerequisites. That is because by acquiring shares of your venture, they acquire the right to decide. Who would you want to have this kind of power in your company that you’ve put so much love, passion and effort into?
Here comes rule #3 – learn from and teach each other This is of course easier said than done and not all of you will be lucky enough to engage in a utopic loving relationship with your investor where the grass is always green, the sun always shining and everyone is happy all the time. Still, let’s draw a picture of the perfect investors to see what it should be like in a perfect world:
They are super experienced in the industry and know the market you are planning to tap into. They are backed by a strong fund and have in their portfolio only a fine selection of startups which enables them to intensively support every single one of them – but without smothering them with too much involvement. Through this approach, they have successfully invested in various ventures, learned about different business cases and their shortcomings as well as strengths. They are super experienced and have a confident team of people with all the competencies needed for your business activities. But most importantly, they love what they do and are enthusiastic about your business case.
Your perfect investor will also support you in terms of networking, making use of their vast contacts in the industry. They will open doors for you, because your success is their success likewise. They need to be able to understand your visions and ideas perfectly, anticipate problems and let you know about them. Moreover, they need to be confident in accepting setbacks and handle mistakes professionally. Of course you don’t need another mummy looking after you, so your perfect investor needs to be able to let you breathe and learn how to act on your own while doing all of the above. The base for all this is rule #1 – trust. To establish mutual trust, you need to be able to connect on a personal level, you need to have some good chemistry.
Yeah, sure, this is ridiculous, right? You won’t need your investor to score 100% on all of this, but keep these points in mind when looking for your perfect VC. Some people think they will be well off receiving some capital from anyone and some of them might be able to get along with this.
Most of the time, though, it’s far more enjoyable to build up something you love with someone who also does.