Bargaining with investors, getting advisers on board and poring over term sheets (the provisional contacts offered following a successful pitch) will probably wear you out.
Naturally, you’ll want to ease off the gas and take it easy, while advisers cross the T’s and dot the I’s. No chance. Due diligence is the most taxing part of the process – it is sometimes referred to as the business equivalent of being strip-searched – and Venture Capitalists (VCs) will demand a bewildering range of details about the company’s past, present and future status. So be ready.
A COMPLEX OPERATION
The VC community is split on how many different types of due diligence there are. You may come across references to technical, insurance and even human resource due diligence, but the most common are commercial and legal. Essentially, it boils down to the same thing – with an amazing level of openness required from the management.
You will hand over accounts details, management CVs, legal documents and information concerning clients, suppliers and, even competitors, on top of any other morsels of data your investors feel they should know.
VCs want to be sure you can achieve your expansion plans with the money they’re offering, so they’ll look into your IT systems, office space and production facilities. They’ll talk to your clients, customers and suppliers to find out whether you have a good relationship with them, and whether they plan to work with you or buy more of your product in the future.
VCs also insist on checking the work history of the company’s senior executives. These checks can be exhaustive, and while you probably won’t have to account for school merit badges, you will almost certaintly have to explain career gaps.
And as Mark Spinner, head of private equity at commercial law group Eversheds explains, investors will always want you to account for past business failures too. “There’s an old saying from the US that you can’t count yourself a true business person until you’ve failed, at least, once. Unfortunately, private equity companies don’t see it that way,” he says.
Formal angel networks carry out some checks, although are usually less rigorous and less expensive overall, with the likes of Hotbed and PiCapital honourable exceptions. Due diligence is more the responsibility of angels themselves.
THREE’S A CROWD? TRY 20
To get the clearest possible impression of your business, VCs hire specialist commercial due diligence companies to assess your operation against your competitors.
Add the various lawyers, bankers and advisers on both sides of the transaction and you are left with a gaggle of interested parties, all of whom want access to your business. Rob Donaldson, corporate finance partner at Baker Tilly, admits this sometimes leads to disagreements as to exactly who is running the show. “There are a lot of bodies at this stage and the process can be overwhelming,” he says. “Your financial adviser should manage them and ensure there is the right level of access to your business. “
In many ways, this stage is more frenetic than when the management team is negotiating terms with different VCs. However, it’s less up in the air than the term sheet stage and, at least you can see the light at the end of the tunnel.”
It’s a good idea to nominate a project manager – usually the MD – to be the first port of call and to relay information back to the company. Unfortunately, all of these advisers must be paid. And while VCs will want to establish a good rapport with management teams, they will not pick up the bill.
You should expect to pay up to 10% of the value of the investment in costs. This money comes from what the investors give you, so if you’re looking for, say, £1m you should ask for around £1.1m to help settle up afterwards. But be aware you might end up footing the fees if something is discovered which leads to the investor pulling out. Check your term sheet carefully, and make sure you’re comfortable with it; the VC will want you to write back confirming you are satisfied before due diligence begins.
HONESTY IS THE BEST POLICY
The extent of the checks may come as a surprise to uninitiated management teams. Even those who have sought funding in the past will be shocked at how the industry has come on. High-profile accounting scandals and fraud cases have taken their toll, making investors ultra-cautious about where they put their money. “You have to see it from their point of view,” says Mark Wignall, chief executive at Matrix Private Equity Partners. “They are handing over millions of pounds to a company that, initially, they know very little about.”
Wignall says he can list scores of examples where deals have fallen through due to holes in the management’s story. He remembers one example where the director general of a company seeking investment turned out to be an alcoholic, and another where it was discovered the company chief was a compulsive gambler. An angel network that preferred not to be named also had an investment fall through when due diligence checks revealed that the “entrepreneur” was actually a convicted fraudster.
More importantly, from a business point of view, Wignall cites instances where the managers were divided into warring parties, and where customers were about to cancel major contracts. However, he says deals rarely break down at this stage – perhaps one in every 20 cases – largely because managers are encouraged to be as honest as possible about their shortcomings. Being honest is one of two ways companies can speed up due diligence. You’ll get on better with your VC if you allow them complete access to the company and give a fair appraisal of it.
