Venture capital due diligence processes can be frustrating for both VCs and entrepreneurs alike, particularly with later-stage companies as there is more information to sift through.
I’ve found that — largely — this frustration results from poorly managed expectations. Investors often fail to manage entrepreneurs’ expectations with regard to timeline and scope of diligence. Investors find frustration in a management team’s failure to provide materials quickly, and a lack of preparedness for what we investors may think are obvious requests.
In an effort to provide greater clarity into an expansion stage venture capital investor’s due diligence, I’ve laid out a typical post-term sheet diligence process below.
Week 1 – Venture Capital Due Diligence Process
Immediately after both parties sign the term sheet, the investment team will sit down and craft a diligence plan with a framework/goals for the following 30-45 day period.
Day 1: We’ll send an information request list to the management team likely asking for the following:
1. Customer data
- An introduction to at least 10 customers so that we can conduct “customer calls” to better understand the product/services differentiation, value proposition, and customer satisfaction
- Revenue by customer
- Customer churn/cohort data, so that we can perform cohort analyses
- Introduction to references for the management team
3. Business/financial data
- Historical and projected financial statements (though we will have likely already received this prior to signing a term sheet)
- Discussion about assumptions behind the projected financial model so we can test and construct our own “sensitized” operating model
- Detailed break-out of COGs and operating expenses so that we can deeply understand unit economics and cost structures
- A company organization chart detailing key employees and responsibilities, and a detailed employee headcount
- Updated capitalization table (though we will likely have this already)
- Any board/investor presentations
4. Sales and marketing information
- Sales and marketing team organization chart
- A list of sales representatives with date of hire/termination and revenue by sales person
- Detailed breakout of sales and marketing expenses (if not included in financial information)
- Details of qualified pipeline and bookings
- Details around current marketing initiatives and metrics if available
5. Market data
- Any U.S./global market and industry data available
- Any relevant research reports/articles (the investors will likely spend much of their own time understanding the market landscape and market size, but any additional information that the company can provide is always appreciated)
This might look like an overwhelming list, but remember that it will be sorted over the entire diligence period. In addition, during the first week the investor will likely retain an accounting firm to help with financial diligence and potentially a technology consultant to help assess the scalability and architecture of a company’s software solution. Additionally, attorneys for both the investor and company will be working during this same period to make sure everything is in order on the legal side of the equation. At the beginning of Week 2, the investor will present the findings to-date to an investment committee and ask for permission to proceed.
Week 2 – Venture Capital Due Diligence Process
The investor should be deep into diligence at this point, having hopefully received a meaningful portion of the information requested. The investors will likely be in the process of managing the legal/accounting diligence, conducting and/or scheduling customer calls, and composing their own operating model for the company.
The second week might involve several phone calls with the company’s management team to discuss anything from a particular expense line item to the productivity of the sales team. An investment committee update will probably take place at the beginning of Week 3.
Week 3 – Venture Capital Due Diligence Process
Ideally, both investors and company management alike will feel that significant progress has been made at this point, and the end is near. If no red flags have popped up on the the accounting, tech, or legal diligence, the investor will be working to finish customer calls, management reference calls, market sizing analyses, sales and marketing economics analyses, cohort analyses, and the operating model.
The goal is to have the vast majority of this completed in Week 3 so that the investment committee can evaluate the findings at the beginning of the fourth week and vote to fund the business at the end of Week 4.
Week 4 – Venture Capital Due Diligence Process
If all diligence activities have been completed and both parties are satisfied, the investor will present the final update to his/her investment committee and ask for permission to fund. If permission is granted and all the legal documents are in order, funding can take place immediately. Then the real work begins…
Please note that this is a bit of a simplified explanation of a venture capital due diligence process and that there are no “written in stone” timelines or methodologies for conducting diligence. At the very least, this will hopefully give management teams a better sense of what to expect from institutional investors and ease frustration along the way.