Since I've been engaged in heavy due diligence on a company over the last several weeks, it struck me that it might be useful to let people know what sort of things VCs typical dig in on when they get interested in a company. For what its worth, "due diligence" is a term of art which basically means get a bunch more information. The term comes from US securities laws -- underwriters of a public offering are required to engage in "due diligence" to assure that all material facts with respect to the security being sold have been disclosed. The concept has expanded beyond the securities laws and has become a bit of a business catch-all that simply means to acquire the necessary data to make a sound business decision.
If a VC is engaged in due diligence on a company, it means that the VC finds something sufficiently compelling about the business proposition that he or she views it as worthy of further investigation. While the specific business being investigated will dictate where a VC puts emphasis in the diligence process, the information reviewed is generally the same stuff across businesses and among investors. Here are the typical categories investigated:
- Personal References -- Many VCs view the team as the single most powerful determinant of success or failure in a startup. As a result, VCs will always want a list of business references for the senior management. We always want to talk to the folks with whom the management team has worked before. Be sure when you provide a reference list that you not only provide the name and most recent contact information (including phone number and email address) for your referrers, but also provide what they are doing today and the context in which you got to know that particular individual. It also makes sense to contact everyone you put on the list and let them know that they may be hearing from a VC. There's nothing stranger than calling someone for a reference and have them say "Who's that again? Yeah, I worked with him a long time ago."
- Business References -- Ideally when you get to the process of diligence with a VC your company has a customer or two. VCs will unquestionably want to speak with your existing customers and will possibly push you for introductions to potential customers as well. I had the good fortune of taking a trip out the the Lucky Charms factory one day while doing diligence on a company -- I got to see a piece of software in action and find out first hand why General Mills had bought it. It was very helpful in understanding why the product worked and why the customer cared. Mind you, this can be a tricky one. You don't want to fatigue your references too greatly, particularly not your customer references. So it will often make sense to gauge the seriousness of a particular venture investor before hooking them up with one of your most valuable resources, your happy customers.
- Technical Due Diligence -- Whatever your business proposition, the VCs will want to dig in on how it works, how its different, and how it stays competitive. For some deals, that will involve bringing in experts in a particular field to opine on the originality and defensibility of a particular technology (those experts are often friends of the firm, including senior executives from other companies in that VCs portfolio). In other instances, the VC him or herself will feel sufficiently versed in a particular technology that it will be enough to simply spend a bunch of time with the senior technical team and measure the technology against its competition.
- Financials -- As we've said in the past, we look at financials as a reflection of a company's business and how they look at the tradeoffs of growing that business. While the bottom line numbers are important -- VCs ultimately want to invest in companies that get profitable on a reasonable amount of money yet still get interestingly large in a reasonable period of time -- the assumptions behind those numbers are far more important. Given that, VCs will want to understand the details and assumptions behind your financial projections during the diligence process. That doesn't mean that they will likely dig in too hard on your assumptions about near term office space needs, but it does mean that you should be prepared to defend your assumptions around marketing spend, channel costs, margins, penetration, etc. Each of these things can have a huge impact upon cash needs and can greatly alter how appealing a particular company's business model looks.
- Hiring Forecast -- One of the key drivers of cash and equity expense in any early stage business is head count. Thus, VCs will typically want to understand your hiring plans. Lots of interesting data comes from understanding hiring plans. It helps VCs see where you think there are gaps in the management team. It helps VCs see what areas of development you prioritize. And it helps VCs understand what are the likely equity needs for your company for hiring in the future. Despite that, I often find that early stage companies have not gone through the process of building a hiring forecast for the coming months and years. It is a good discipline, will help you better understand your business, and VCs will likely want to see it in their diligence process.
- Competition -- VCs will undoubtedly want to know about your competition. The more data you are able to provide on your competition, the better informed you will appear. Entrepreneurs can gain as much credibility understanding the business of their competitors as they do understanding their own.
There is no question that each VC is different and will focus on different aspects of your business. But I suspect that as a baseline, most will want to discuss the things above. You will appear more prepared and better informed if you have pulled together all the information you need to meet these requests in advance of having someone ask for them. The diligence process can be a long, frustrating and time consuming one. But from the VCs perspective, it is the time when you truly get to know a team and their business. And hopefully it is as good a chance for the entrepreneur to get to know an investor and his or her style, focus, expectations, etc. The diligence process is about gaining knowledge -- hopefully on both sides of the table.