By David Ciccarelli
When a potential investor puts forward a due diligence request, the simple fact that an outsider will be examining your business under a microscope can be intimidating to say the least. However, due diligence requests are a natural and required step in the fundraising process, regardless of if you’re seeking debt or capital by selling equity.
Having recently been through our own investor round, which culminated in $18 million from Morgan Stanley Expansion Capital, this is a topic I realized more entrepreneurs need to be aware of as they go through the process on their own.
Understanding what kind of questions you’re likely to face will mentally prepare you and in turn, you can assemble a lot of the documentation ahead of time. There are four main due diligence request types I've encountered during our own journey. Here's what is being sought after in each, and how to best provide it.
Financial Due Diligence
- Audited financial statements: Most deals are created (and terminated) based on the financial profile of the company. Expect to be asked to deliver audited financial statements for the last two fiscal years.
- Income statements and revenue streams: In addition to your historical annual financial statements, most investors will also ask to see your income statement broken down month by month and by revenue stream. If one of your revenue streams is not pulling its weight, be prepared to explain why it continues to operate. The concentration of revenue in a single month, seasonality, large one-time occurrences (e.g. a big deal that closed), as well as revenue by customers will be analyzed for your company’s ability to repeat the performance, and as such, determine if there are indicators of risk of your company failing in the future.
- Accounts receivable: The statistic that investors are looking for is not only the amount in accounts receivable (AR), but also the average days in AR or days sales are old (SDO). Anywhere under 30 days is incredible because it means your customers are paying you within the month. A DSO number between 30 and 45 is certainly acceptable, while a figure larger than 90 means that you have a poor accounts-receivable process. Now is the time to get this number buttoned up and be prepared for the questions and to share your action plan for improving the situation, so it isn’t seen as a red flag.
- Financial projections: Your financial model will illustrate how you intend to use the funds, as well as allow you to test out different assumptions, conduct a sensitivity analysis and quickly understand which inputs drive financial performance. The most important point here is to create believable projections that you can explain with confidence.
Legal Due Diligence
- Background checks, light investigations and proper documentation: Criminal checks, background checks and other light investigations through the legal system will ensure that you’ve been operating above board. After getting the all clear, expect more organizational legal requests, such a description of the legal structure, the certificate of incorporation, articles of incorporation and other business registrations or intellectual property. Investors are in effect buying a portion of the corporation, which is, after all, a legal entity. Be patient with this aspect of the process. Rushing it or attempting to take shortcuts may be enough for the investor to have pause. Confirm with your lawyer that all your documents are assembled and in good standing, and you’ll be able to quickly turn these requests around.
Customer Due Diligence
- References and reviews: You wouldn’t hire a new employee without checking references. Investors will want to check references from people who have conducted business with you. Customer references are great to have for a variety of reasons, including media opportunities, guest speakers on webinars or conferences, and yes, for when investors want to hear about their experience firsthand. If you haven’t begun a customer reference program, do so in earnest. Start a list of your most loyal customers and create a spreadsheet to track positive customer stories, ensuring you always obtain proper permission to share these stories, so you can use them later on in a case study presentation for investors. Stick to using a reference account no more than once or twice per year. Overusing a key account may leave a bad taste in their mouth, whereas most people are willing to offer up 30 minutes a couple times over the course of a year, especially if they are fans of your company. Remember to send a thank-you card, flowers or treats for their office as a small token of your appreciation. It won’t go unnoticed.
Market Due Diligence
- Assessment of market opportunity: Investors at all stages will want to confirm the size of the opportunity, and as I see it, the bigger the better.
- Total addressable market worksheet: You can’t just pitch that you’ll be a billion-dollar company without demonstrating that you’ve done your research and have validated the market. To do that, create a total addressable market worksheet. This worksheet includes the following:
- Brief overview of core services, target markets, and the pain points you address for your end clients
- Discussion on key industry drivers of growth of target markets current environment trends and market share
- Rationale behind use of proceeds and supporting metrics to link the use of the funds to the projected result
- Discussion on sales forecast and sales model
- Discussion on historical income statement and balance sheet
- Overview of your company’s unique attributes
- Discussion of competition
- Key success factors with supporting metrics (e.g. customer surveys)
- Key management team and brief overview of each of their key priorities
While it may seem overwhelming, the biggest commitment you need to assemble all of the above is time. And while some may complain and say that time is money, each minute spent in compiling all necessary due diligence document is an investment in your future that could pay off exponentially. What better opportunity is there than that?
David Ciccarelli is the co-founder and CEO of Voices.com, the online marketplace that connects business people with professional voice over talent.