02/16/2012 11:51 am ET | Updated Apr 17, 2012

Beyond Social Proof: Due Diligence 101

Due diligence for early stage companies is as passé as three-button suits or the Hilton sisters. At least that's the impression that many young technology entrepreneurs have. Instead, they perceive social proof -- the idea that a company is validated by influencers who are involved with it in some capacity -- as the most important factor for securing early-stage funding.

As the CEO of CapLinked, an online platform that gives companies and investors tools for managing private investments, I frequently hear from tech entrepreneurs looking to raise capital. We have $22 billion worth of deal rooms on our site, and Web startups account for around 3 out of every 10 deals. Judging from experience, tech entrepreneurs are often unaware of what due diligence is and completely unprepared for the process.

We receive more inquiries from tech entrepreneurs than all other industries about what kind of information to include in their deal rooms, and some even wonder why due diligence is necessary in the first place. Anecdotally, I've heard a startup founder cite his followers on AngelList and Twitter as proof his company was a good investment candidate. Last fall, my co-founder Chris Grey (who isa professional investor) asked a startup if they could document their intellectual property ownership, and the founders were uncertain why he would even ask such a question.

The perceived decline of the importance of due diligence for software startups is understandable. Unlike companies that are have been in business for a while and are looking to raise a larger sum from institutional investors, early stage tech companies seeking seed money are offering their future promise moreso than their current accomplishments. This makes exchanging data less critical than in other industries.

However, entrepreneurs who plunge into the capital raising process believing that due diligence is not important are simply wrong. Due diligence remains a critical process for many sophisticated angel investors, and for good reason. Noted angel investor Bill Payne, who served on the founding committee of the Angel Capital Association, summarizes research on how due diligence impacts an investor's expected return on investment:

"[A]ngels who collectively did less than 20 hours of due diligence per deal received portfolio returns of 1.1X... But, angels who collectively completed more than 20 hours of due diligence enjoyed portfolio returns of 5.9X, and those who did more than a collective 40 hours of due diligence were rewarded with returns of 7.1X!"

First-time entrepreneurs should be prepared for the due diligence process when they start their raise. Instead of being surprised or pushing back against the perceived intrusiveness of the process, embrace it as a sign that you're dealing with a serious investor who wants to learn more about your business.

There are dozens of due diligence checklists on the Web, so I won't waste time by crafting yet another one. Instead, I'll mention a few high level categories that entrepreneurs should consider in advance of engaging investors:

  • Ownership. A company's ownership structure is critical information for anyone considering a potential investment. Without a clear understanding of this, an investor can't gauge what he's getting in return for his funds. I recommend having an updated cap table that you can share upon request, and also being conversant enough on the subject that you can speak to questions that might come up in conversation.

  • Intellectual property. Smart investors will often ask about a startup's intellectual property (IP). Do you have agreements that cover IP with all your employees, contractors, advisors, and even the founders themselves? That's a key area you should be prepared to discuss. Investors might also be curious about how patents, trademarks, and other legal protections fit into your IP strategy.
  • Financial model. While this may not matter to super angels like Dave McClure who have large portfolios of companies and can make follow-on investments, financial models are important to many sophisticated angels. The point of a model isn't to have a "perfect" projection -- everyone knows it's just a guess. The point is to quantify how your business can make money and demonstrate how key variables impact your company's prospects.
  • Operating metrics. What are the key metrics that measure your product's performance in the marketplace? Ultimately it will be revenue and profit, but for early stage companies, other metrics such as users, page views, or downloads might be more important. Besides putting a graph or two into your slide deck, I advise keeping a spreadsheet on hand that tracks four to five key metrics.
  • Burn rate. An entrepreneur should always be able to recite his approximate cash in the bank, monthly burn rate, and runway. Investors might not ask for bank statements, but they'll certainly want to know this information. A CEO that I advise once said he "wasn't good with numbers" when I asked what his runway was, and suggested his co-founder handle all financial questions. I had to chew him out. Don't go into due diligence without knowing these figures like the back of your hand
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    These broad areas are just a starting point. Due diligence needs vary based on the company and the investment. Being a first-time entrepreneur doesn't mean you can't be savvy, and being prepared for the due diligence process in advance will put you in a good position to close your round.

    Eric M. Jackson is the CEO/co-founder of CapLinked, an online service that gives companies and investors tools to network, manage a capital raise or asset sale, and exchange updates. Eric previously served as PayPal's first marketing director and is author of the award-winning book "The PayPal Wars."