Venture funding: the due diligence process
“Why is Venture funding always intervened by a lengthy diligence process?” yelled Kapil. “I need money in the next two months and these investors claim that the due diligence process itself will take 4 months. These investors are playing around with me. They probably don’t have enough money to fund me.” Jaideep who shares the same wall across their cabins was able to hear Kapil’s frustration through the walls. Jaideep works late in the night to catch on some learning which he cannot during a work day.
Having worked in the same incubation space for more than two years, Jaideep and Kapil know each other as neighboring startup founders. Jaideep received his seed funding a month ago and was wrapping up operations to move into a new office space. He hears Kapil’s resentment and steps into Kapil’s cabin to enquire about the matter and show concern towards his state.
Kapil sees Jaideep walk into his cabin. He looks red and helpless at that moment. Jaideep enquires into the matter. Kapil explains that he needs money to launch his product and the investors who are reviewing his deal are asking for more and more time. Jaideep understands the situation and draws a cup of hot coffee for Kapil to compose himself.
Kapil sits on the table while comforting Jaideep into his seat. Jaideep then shares his funding saga about his investors with Kapil. He explains that bringing seed capital or any kind of external funding into a company is always a challenge. He goes on to counsel Kapil that, as novice entrepreneurs, we tend to take things for granted, and allot very little time to raise capital. Just like when a company plans to go for an IPO the management usually starts preparing for it at least 2 years in advance. We, as startup entrepreneurs, before we start the fund raising activity, we need to spare reasonable amount of time to raise capital and factor in time for the due diligence process. Let me explain why it takes so long. As investors, venture investors or VCs need to evaluate their investments and hence they follow this process which involves the following steps.Due diligence process
Investors diligently review your business plan on various metrics like accounting, customer, markets, team, and company structure and so on. Each investor has his/her order to follow with these metrics, while evaluating a deal.
Accounting and finance: A firm’s accounting books are diligently scrutinized right from the day of incorporation. All the annual financial reports, accounting processes, accounting policies and procedures and accounting books come under the scope of due diligence process. Accounting books are reviewed and the information and conclusions which can be explicitly drawn from it are thoroughly validated by experts.
Customer references: Some of the key customers mentioned in the business plan are used as reference checks. The customers are interviewed on the product/ service satisfaction levels, after sale services, payment norms and further references. An investor examines the product offerings, revenues, agreements or liabilities due on the business roles, billing cycle, credit policies and customer-seller relationship.
Company structure: Since an investor would be directly affected by the company structure, every detail from the past about the structure dynamics are an important part of the review. He would investigate and gather information in matters like current ownership structures, shareholders, directors, past directors, shareholder policies, division of equity and preference shares and more.
Competition and markets: A business plan is also evaluated on some real time metrics like what are the key differentiators, other competitors in the market, market share and potential market growth, market size, probable exit options and exit and entry barriers.
Team: The team is one of the key reasons for an investor to invest in the idea. Execution of an idea is majorly dependent on the team and group dynamics. If the founding team has many people, then each of their past track records is examined using the reference checks provided. Education, work experience, other engagements and commitment with the current team is evaluated by all dimensions.
Jaideep adds to this information, that an investor upon his discretion may choose to add more parameters into the due diligence process. Depending on the levels of transparency and simplicity maintained in the investee firm, the process sprawls over from 3 to 6 months. Jaideep assures that any day an investor takes substantial time to understand the business thoroughly and only if they are satisfied invest in it.
Jaideep comforts Kapil on the note that the time consumed by due diligence process is within the norm of the industry and not otherwise. Kapil realizes that he was inadvertently getting anxious about the whole act and in future has to plan better and hence realign his goals by a different timeline.
This article contains fictitious characters and circumstances. Any resemblances to real characters, individuals or organizations are a coincidence and unintended. We do not hold any responsibility for such resemblances. The article is presented to share the challenges an entrepreneur faces while starting a business. However, the factors affecting one’s entrepreneurial journey are not exhaustive and subject to the nature and type of business and the team involved.
Utthishta is a Hyderabad based seed fund for start-ups in software, web, mobile and the cloud computing space. Along with seed funding it also provides focused mentoring to early stage startups in a business accelerator environment.