The Due Diligence Dipsey Doodle

Ahh, Due Diligence.  A happy process where people sit around in comfy chairs, casually talking about business metrics, laughingly reviewing a few spreadsheets done in VisiCalc, and enjoying a friendly barb or two about the felony convictions for misappropriation of Government funds. 

There is nothing more relaxing for entrepreneurs to do then spend weeks of time making Venture Capitalists risks go down.

Or something like that.

Truth be told, Due Diligence is like a root canal from a really bad dentist who uses diluted Romulan Ale for Novocain and Silly Putty for filling material.  It's a very painful process.

Here some things you might consider when embarking on your start up routine.

Day one:

• Document everything.  Document the ideas, the process, the dates, the times, etc. 
• Keep receipts for everything.  If you want the money back, get a receipt. Ten cents? Want it back? Get a receipt.
• Get a good lawyer and good (part time) book keeper.  Even before you ever set foot in an Angel's office, have these two people riding shotgun on your team.

Now these three simple things sound almost silly but they are the foundation of everything moving forward. The cleaner your books are, the more documentation you have, the tighter the corporate paperwork is, the better/faster you will get financing under the assumption, of course,  the idea has merit.  Angels, like VCs, put a high value on organized material because it shows smart, organized people.  One less problem to have in our collective judgement.

In more detail, here are some hot buttons to think about:

Financial Forecasts

Pre-revenue this is a pile of forecasts, I understand that.  When you are doing those forecasts, the number one thing that actually matters arethe assumptions behind them.  How many per hour, how much per byte, how many hours in a cycle, how big, how fast, how far, how many.  That first sheet is the list of every metric and assumption that anyone could reasonably want to track/measure the business on.  From these metrics, you build up your forecast.  Behind the assumptions, you will try to get any market data you can that backs up what you assume.  So if you assume 20 customers a day and the potential market is 12 billion people as shown by this and that report, okay.  If you claim a 1,000 customer sign ups per hour based on your gut and the fact that the guys in the office just love it, not okay. 

Don't laugh, this happens all the time:

Them: "We are sure we will see at least 1 million sign ups in the first week, people love this news magazine.

Me: "Really. How many readers to you have?"

Them: "On average 200 per day."

Me: "So, if I understand your math, day one the 200 people are going to convince 500 friends that day to sign up and tomorrow a new set of 200 people are going to get another set of 500 people to sign up with this process going on for 7 days, right?

Them: <cough, gag, ahem> "Well, somewhat like that."

As I said, happens all the time.

Cash Flow

Simply put, how long is the money going to last. Really. It is not that difficult and there is no hidden agenda with the cash flow question.  Using a set of assumptions (see above) and projecting expenses against those assumptions, deducting the revenue you anticipate, gets you how much cash is needed.  If you are not raising at or more than you need, the cash flow statement will tell you how long this raise is going to last. We want to know that and you should be tracking this.

Budget to Actual

From the day you start, do forecasts and track your progress against these forecasts.  If you expected to have a beta done in one month with two programmers at 10 grand a month and then come in at 40 days, excellent, you are ahead of schedule and under budget.  If you are over by a week, okay, you are over.  The more important point will be that you are tracking all of this with trends being seen and surprises kept to a minimum. 

With a start up, much of the angel's investment and the VC (who does start ups) thesis is based on assumptions, gut feelings, marketing conditions, and a host of other irrational things I can't think of right now.  The more grounded your presentation is; the more real data you have, the better you will be in getting this off the 'gut feel' list and onto the 'real business' list.  Being on the gut feel list means that a bad hair day, spooky news story, wonky stock market, all can impact the person's gut.  Real businesses usually get evaluated as just that; real businesses.

Business Thesis and Assumptions

To believe in SIRIT (one of my portfolio companies), you have to believe in RFID technology, growth of near field communications, more and more tolling and metered HOV lanes, etc.  I do and hence we are in the company.  You have to believe in blogs as a window into the next form of one to many communications with an amazing feedback/community aspect to them. You have to believe in a revenue stream that will rival today's media revenues and you have to believe in the continuing growth of quality over crap.  I do; hence my b5 investment.

For you, what do I have to believe?  What do you believe?  And, of course, what are the assumptions behind those beliefs.  For example, in the case of b5, the rise in blog creation doesn't tell the real blog story, per se.  What's important is the rise of readership, ad dollars, and the mainstream guys switching to 'blogs' (or daily dosage content) in order to grow a core readership base.  Guys like CNN's Anderson Cooper has a blog.  Is he/CNN doing it for fun?  I suspect not. Business Week's team, The New York Times, etc, all have blogs as a part of the offering.  All have increasing readership and when you combine this with the numbers b5 puts out, you can make a reasonable assumption on some metrics and place the bets accordingly.

You have to have the same story, metrics, thesis, etc, from day one.  My partner, Stuart Lombard, felt the call to do another start up.  When he raised apital in addition to our (JLA) money, his opening pitch started with a slide that said if you don't believe in these 6 things, stop now, we're done.  If you make that pitch with that slide, you might get better feedback even in the no meetings because you can have a very pointed discussion on specific business points.

Just disclose it.

We're going to find out.  We do background checks and real/paid reference reviews.  We will know about jail time, know about bankruptcy, know you got fired despite the "pursue other options" nonsense so fess up.  Speaking for myself, I have no problem with somebody that is passionate, head strong with a great idea that got tossed from a company because she didn't get along with the founder.  It happens. It has happened to me. I got fired before and everybody made nice nice but I got fired. I lived and so can you.  If you are going to miss your numbers, tell me now.  If the CTO is going to be leaving, tell me now.  Disclose it all because this investment gig is based on mutual trust.

A fairly weird VC guy I know sits in meetings a listens to an entrepreneur's pitch without saying much or asking many questions.  At the end, he almost always says, okay, thanks, now tell me everything I'm going to find out when I do due diligence.  While his style is questionable, the point is valid.  Fess up early and often.

Document Everything.

Did I mention that documenting everything is huge? Good, I'm mentioning it again.

Save a Tree, Buy a Scanner

Scan the documents, give them friendly names, store them on a server and you have 90% of your Due Diligence problems solved.  If you review the DD checklists from me or any other VC, you can get a head start today with keeping materials ready to go and available for review.  Simple and cheap.  And here is a free tip for you on this scanner topic.  If your VC says he can only accept a 3 ring binder with all the materials organized by tabs, numbered, etc, and with two sets of binders?  You've got trouble brewing before the game starts.  To have you waste time like that as well as money should tell you something.  Yes, I'd like the stuff in handy binders as well (and ask) but if I get in in electronic format, I'm good and I appreciate the efficiency of it all.

Expect Hard Questions

I've got three signed terms sheets right now.  I'd like to close all of them.  So far, the due diligence on one is a disaster, two hasn't shown up yet and one is not meeting the minimal expectations like being able to open the spreadsheet.  Part of the process is conversations to dig into the business and match the dig results to the basic business thesis.  I know somebody is going to be pissed off at me if we don't close because all three have term sheets.  Doesn't matter if it is $500k or $5mm, for us the DD is all the same.  The hard questions tend to be go something like these:

• In your presentation, you have X shipping now and it isn't, what happened?
• In your materials, you show 10 million users by day 10, it is day 20 and you have 5 users, what happened?
• What's the name of the Microsoft person you've talked with? Define this partnership.
• Did Oracle was excited? Cool, who did you talk to and what's their email/phone number?

When you get defensive, exasperated, bugged, pissed off, etc, because I'm digging into everything you've presented to me, that's a red flag.  The simple message, folks, is to lay out 'facts' with material to back em up.  Really. It isn't more complex.  If you say, Bill Gates loved it, I will call em.  If you say Eric Schmidt wanted to buy you on the spot, I will call em.  If you say you are getting 40 million page views a day, I will look and verify it.  Most of the questions come as a direct reaction to the materials and data you present.

Line Up the Calls.

Customer calls. Client calls. Partner calls. Reference calls.  Expect most of these people to get calls from your investor.  Line em up, folks.  I can't tell you how many times the process breaks down because we are waiting on call backs, call information, etc.  We are not the bottleneck, the process is.  This part is brutal so do what you can to line up the calls.

Release the Hounds!

Tell your team that everything is an open book. Let everybody know to hide nothing and use good judgement in answering questions.  In a company of less than 20 people, I talk to everybody.  That's my personal thing, may not be everybody's.  I can tell via the body language if there has been a massive brief on how to deal with the VC and, trust me, they aren't as loyal as you think. People will tell the truth so you might as well set the tone up front.

Just that one more thing.....

Hopefully, I've given you some food for thought on this whole due diligence cha cha.  It can be a royal pain but if you do some up front homework, you can lessen the pain significantly.  Now, there's just these forms you need to fill out in triplicate with the backs signed in blue pen on top a number 2 pencil signature from your sister's nephew's uncle on your Mother's side. 

It's always one more thing.

Comments

[Sdw]

I just want to note that virtually every key metric for you in due diligence has next to nothing to do with legal due diligence. (Which is, by the way, how it should be for a VC investment.) And yet still, in this day and age, my start-up clients are getting hit with demands for $10-20k depsoits so certain VC's lawyers can perform "Due diligence." You can have clean paper, good documents, great records, and it's not going to take $10-20 k for a lawyer who isn't dyslexic to confirm it for a VC. You wouldn't do this, right?

[Rick Segal]

Hi Suzi,

In the case of pre-revenue start-up, what's to do with respec to legals. In thinking back to the last couple, Tungle comes to immediate mind, it was a review of the incorporation paperwork and prior stockholders agreement. I've never encountered deposits before, all legal fees are capped and come out at closing else both sides eat em.

You are correct, this should not be happening... Bad VC lawyer, bad!

[David]

Excellent points on the DD. It's not rocket science but it is surprising how important documentation becomes when you have 48 hours before it's needed. It's just not fun building architecture documents, outlining patents, assembling resumes and dreaming up cash flows in 48 hours. To many start-ups consider the docs to be a sign of weakness, or feel they slow down the company. Frankly, without proper docs you're causing huge harm, especially when you're attempting to grow a company. Nothing sets an initial tone that you have your collective $$it together then being able to produce quality content for common due diligence requirements. Rick, you might want to share a common list of the "asks" in the blog.