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Decoding Diligence

August 6, 2014

One of the most mystifying parts of venture fundraising is the murky process of due diligence.  There is a ton of advice out there on how to get in and pitch a venture investor, but little on how to manage the ‘boring-sounding’ but critical due diligence process.  Yet this is where make or break happens for many venture deals.  Due diligence is the homework that investors do – tech reviews, reference calls, market checks – to understand the opportunities and risks of an investment.  For some investors, diligence is a structured process.  For others, it’s an informal dating ritual.  Either way, it’s important for entrepreneurs to understand the process and manage it.

1.   Know the difference: exploratory v. confirmatory

It’s important to know where you stand with a potential investor – how serious are they about the opportunity? One way to know is to ask if you are in “exploratory” or “confirmatory” diligence.  There is a huge difference between the two. Exploratory diligence is when an investor is gathering data to figure out if they are interested in the opportunity. This can be time consuming and a long exercise in free education. Confirmatory diligence is when an investor is inclined to do the deal and is checking the facts. Really good investors will approach your market and company with a thesis and have done a lot of their homework before they even meet you. Exploratory diligence typically precedes a term sheet and confirmatory diligence (including legal reviews and reference checks) happens after. If you’re more than two meetings in with an investor, it is entirely fair to ask which phase of diligence you’re in – that will help you know where you stand.

2.   Make it easy…

The best entrepreneurial fundraisers make it easy for investors to get through diligence quickly. All startups have their issues, and it can be helpful for entrepreneurs to frame key issues and risks themselves before they become potential objections. This kind of framing is a great way to build trust; it also helps to see if you and your potential investor see things in the same way. As a practical matter, have materials ready in an online folder for both the investor and legal diligence: financials and key metrics, team and customer references, product documentation, and all legal documentation. That will make it easy and speed up your fundraising process.

3.   …but don’t give it away

Good salespeople know how to ask their prospects for things as they move along the sales process. While I’ve made the point above that you should be ready with all the data an investor needs, you should also be careful about what you share and when. You have a right to ask for increased interest/commitment as you share more diligence materials. One of the classic examples here is customer references. It’s not uncommon for investors to want to do a few or even dozens of customer calls. Share these precious references sparingly, and only when investors are serious – it’s a good way to validate their interest.

4.  Do your own diligence

It’s a cliché that taking capital from an early-stage investor is like a marriage.  Yet it’s amazing to me how many entrepreneurs don’t bother to check out their potential partner.  Public sources like Crunchbase or TheFunded make it increasingly easy to find out more about investors – including the failed investments they don’t list on their websites (those are the ones you probably want to call). At Altos, we always encourage entrepreneurs to call our CEOs – including the ones that we’ve had to transition out of companies – and check us out. How do we contribute, how do we think, how do we perform in tough situations?

Due diligence is more than a check-the-box exercise. Managed wisely, it can be a way to move along the fundraising process – a process that the most successful entrepreneurs know how to manage and expedite.

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