How to Avoid Red Flags When Preparing Your Startup for Investor Due Diligence

 


You worked to hard to mess things up


Fundraising is hard. It's not like the movies or shark tank where a fancy pitch and 20 minutes will have investors showering you with cash. There is a myth that raising funds can be easy - it's not.

So many factors outside your control combine to make the process frustrating. As a startup founder you want to focus on your product and team. You want to sell to customers. Talking to investors can feel like a distraction from your core vision. It's not. It's your job. You wanted to be a startup founder, raising money is a key part of the job description.

Once you finally get an investor interested you need to prepare yourself for the questions they will ask during their due diligence. Putting yourself in their shoes and understanding why they will ask for certain information will help.

Don’t get frustrated. It may seem like you are being asked for unimportant information. I can’t tell you how many startup CEOs have complained about the process. I share that frustration. When working on an M&A transaction it’s aggravating to get a long generic checklist of items prepared by somebody that clearly doesn’t understand the business.

As a startup CEO you need to understand that there is a reason why an informed investor will ask for certain information. Your response to their requests might raise a red flag and kill the deal.

Red Flags

The sale of shares in your company is regulated. Most startups raise funds using rules that exempt them from the most onerous registration requirements. But even exempt securities are regulated.
Those of us that are registered with FINRA to broker the sales of private securities are obligated to follow certain procedures put in place to protect investors. Basic due diligence is one of our obligations. There are four specific red flags we look for. When they come up during our diligence we have a responsibility to address them with the investor.
  1. Inconsistent Information. You will be talking with a lot of investors and it's easy to share information on product delivery times and sales pipelines that change. Stay ahead of this by updating your numbers at the start of the diligence process. Call attention to the updates with an explanation of major changes.
  2. Unreasonable Assumptions. If your Go-To-Market roadmap calls for a rapid product release and quick customer adoption, prepare a defense of  these assumptions
  3. Lack of relevant management experience. While early stage tech companies are given a great deal of leeway, the investor should be fully aware if you or your team are untested or inexperienced in the market.
  4. Refusal to Provide or Respond. I recall one founder that was so frustrated with the process that he literally threw up his hands in front of me and said, “they keep asking for more and more information. They should know by now if they want to invest. I’m done wasting my time with them.” Do you think he got a check? 
You might have a great term sheet, but If you fail any of these tests during diligence, the resulting red-flag could derail the transaction. Be aware that they exist and be proactive to address them early.

Due Diligence Checklist

You must also understand that the person conducting due diligence has an obligation to verify the information. If a broker is conducting diligence, they have a fiduciary responsibility to not depend exclusively on the information provided by the issuer (you). 

Your deal room should be populated early in the process. Use this checklist as a way to get yourself prepared in advance:
  • Governing Documents
  • Financial Statements
  • Trends in Financials
  • Cash and business needs and expectations of affiliates
  • Audit Controls
  • Contacting Customers and Suppliers. Reviewing Contracts, employment agreements
  • Past Offerings / Cap Table
  • Legal Issues
  • Regulatory Issues and Credit Checks
  • Management Stability
  • Management Compensation
  • Change of business focus
  • Viability of Patents and IP
  • Regulatory Environment / Market Position
  • Business and Financial Model Assumptions
Larger transactions will require a more detailed understanding of the product. For software, code audits, architectural reviews, product roadmaps and a clear understanding of technical debt are important areas for the diligence team.  I would also want to be sure the buyer has a solid understanding of your marketing fundamentals and sales pipeline.

Expect The Unexpected

So now you might be still wondering, what’s the deal with the image of the vending machine cats with shrimp on their heads? I can tell you it's there as a reminder that everybody doing diligence on your company will have a slightly different perspective and motivation. Be patient and be understanding. They may ask you questions you don’t expect, but those questions might reveal something important to both you and the investor. 


The truth of the mater is that I was looking for a good picture to highlight the blog with and that was the best I found from a recent trip to Osaka.

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