How Due Diligence Works

Due Diligence is the name given to the process of finding out every little thing about your company before an investment is made. The goal is to ferret out any problem or risk that might make an investment less-than-wise. The Due Diligence process starts with a list of 100 to 200 questions designed to disclose everything about the business. If you go to Google and type in “Due Dilligence Questions” or a similar search term, you will see the kind of list I am talking about.

For many younger companies, the answer to a lot of the questions is going to be “no” or “not applicable”. Many of the remaining questions are going to require research or the creation of documents. For example, you will be asked to send in an employee manual for your company. If your company is a year old with 3 or 4 employees, it is quite possible that you do not have an employee manual yet. So either you will reply, “Not applicable” or you will create the company’s first employee manual.

There will be myriad questions about the company’s stock (have you issued options? have you sold shares to anyone?), the company’s contracts (any joint ventures? existing sales contracts?), the company’s employees (how many? who are they? what are their salaries? any employment contracts? are IP agreements in place? turnover statistics?), the company’s competitors, the company’s insurance policies, the company’s property (real estate, equipment, furniture), the company’s intellectual property, all of the company’s financial documents (income statements, balance statements, revenue by customer, capital expenditures, revenue projections, etc.), the company’s existing and past customers, sales and marketing efforts, and so on.

What you will find if this is the first due diligence process you have been through is that investors expect you to take your company seriously, as though it is a company aspiring to be a publicly traded company. That may feel uncomfortable, intimidating or ridiculous depending on your frame of reference, but it is exactly where your company needs to be. If an investor is going to invest in your company, the investor’s expectation is an exit. The only way to successfully exit is to have all of your ducks in a row. The due diligence process here simply prepares you for the due diligence process of an exit.

Therefore, you will fill out the Due Diligence questionnaire for the investor and turn it in. It will prompt a round of questions and then the second phase of Due Diligence will begin.

In the second phase, the investor will check up on your company. The investor may call your customers (both current and past), your suppliers and your references. The investor will want to look at your technology, or bring in experts to look at it. An investor may have an accountant go through your books. All of this is an effort to make sure that no stone is left unturned. If there is a problem with your business, the investor wants to find it ahead of time and either address it, fix it or reject your application because of it.

After Due Diligence is complete, it will be time to vote. In an angel group, all of the investors will review the results of due diligence and vote yay or nay. In an venture capital group, the partners will meet and vote. If the vote is no, you may be told what to do fix the problems found in DD and then be offered the chance to apply again. If the DD vote is successful, you will move to the term sheet.