Due diligence is a critical part of the private equity investment process. Each firm has a different process, but generally all include review of financials (historical and projections), team background and employment agreements, organizational documents, customer agreements, product roadmap, cap table, and more.
At Silicon Road Ventures, our diligence process is quite thorough, since we hope to back companies from an initial check of $250k-$500k all the way up to a $5M to $7M commitment from our Opportunity Fund. If there is something that could disqualify our investment at the larger round, we plan to identify it before our first check.
For any founder about to embark on fundraising from VC and go through a due diligence process, I would suggest the following 3 best practices.
1. Be transparent and tell the truth, always.
We love founders who can cast a big vision, those whose businesses are going to the moon, but it's important to also be factual with your current business. We look for operators that are focused on capturing a big part of a growing market, but that vision must be balanced with the reality of the day-to-day operations.
Vision can be speculative, but the best founders we work with are exceptional operators and they know their numbers cold. All VCs capture key metrics that founders say in meetings. If in an initial meeting the past year's revenue is one number but then on review of the financials, it wasn't, this can be a problem.
"I don't know, but I will get the answer and come back to you" is a much stronger statement than reaching for something or intentionally fabricating it.
2. If there is something in the history of the company that could be a black mark, it's best to proactively address it early.
Human nature is to avoid the bad news. The best founders own bad news - a missed month, a lost customer, departure of a key employee - and use it as a way to self-reflect on the business and improve whatever broke. Similarly in due diligence, a founder who is open and draws attention to something that may not be flattering to the business shows us a communicative person who owns setbacks.
Whether it is a poor quarter, a contract signed after the quarter closed being counted in the prior quarter, or even something that may come up on a background check, it is better for the founder to address these before it gets flagged in a diligence process.
Openness and collaboration are must-have values for us. As former operators turned VCs, we want to help founders manage challenges, but cannot if they aren't shared proactively.
3. Understand the VC's process for making an investment.
Each firm has a slightly different process, but ask the VC what their process is for making an investment. Some firms prefer to do a lot of diligence prior to issuing a term sheet. Others do the bulk of their diligence after the term sheet is signed, while some VCs admit to only following a lead investor and do extremely minimal diligence. Understanding how this works will help you manage your time and expectations.
Our due diligence process is designed so that if there are any show stoppers for a future investment out of our Opportunity Fund, we will identify those before making the first investment. As a result, we're very hands-on in this process. As an added benefit, our founders often go into their next fundraise very well prepared. Portfolio founders have told us that our diligence process at the pre-seed stage helped them have a more streamlined diligence at the following round.
In summary, due diligence is a vital step in any institutional investor’s process. Founders that are communicative and transparent can help make the process more efficient which will allow them to get back to building the business.