Due Diligence Reveals All - To The VC

by Jeff Bussgang

Earlier this year, I wrote a blog about how to prepare for the financing process, focusing in particular on follow-on financings.  Some readers have pointed out to me that I left out a very key element of the due diligence process:  what the process itself reveals about the nature of the entrepreneur to the VC.  Many entrepreneurs I know underestimate the importance of their small and large actions during due diligence and the signals their behavior send to the VCs.  In truth, the due diligence process itself is a gauntlet that tests the entrepreneur and informs the VC about their mettle and whether they have the character and skills to build a great company.

VCs don't typically enter a true due diligence process until after the 2nd or 3rd meeting.  That's when they start talking to experts in the field, customers, management team members, conducting technical reviews and combing through financial models.  Broadly speaking, there are three stages to the process:

1) Sniffing around.  During the "sniffing around" phase, the VC has decided they like the company enough to make it one of their top 3-5 "new deal" priorities, spending proactive time on the company squeezed in alongside the time they spend on their portfolio.  This typically involves the following activities:

• Conducting follow-up meetings with the team to identify and probe on the key issues
• Putting the team in front of "friends of the firm" who have expertise and can provide insight into the opportunity
• Making 3-5 reference calls with analysts, customers or management team members to get an initial read.

In addition to the substantive questions around market size, competitive advantage, technology and team qualifications, the VC will ask themselves a few key questions about the entrepreneur during this phase:

• Is the entrepreneur defensive when I probe on important questions or are they thoughtful, earnest, insightful and authentic in their answers?
• Is the entrepreneur on top of the details of the business or do they appear to be flying by the seat of their pants?
• Has the entrepreneur done their homework about the market and really researched deeply the customer need and competitive set or do they appear naïve and uninformed about the challenges ahead?

2) Digging deep.  During the next phase, the lead VC partner has decided to make the company a top 1 or 2 priority and begins thinking deeply about the company and the opportunity during shower time and drive time.  For the VC, this typically involves the following activities:

• Briefing their partners in some detail on the pros and cons of the investment opportunity and the important financial terms of the deal
• Mapping out a detailed due diligence plan to probe on the key diligence issues and risks
• Exposing some if not all of their partners to the company to get other informed opinions around the table
• Making 15-20 reference calls with customers, management team references, perhaps even competitors and others who can provide insight into the market

During this process, the VC will ask themselves the following questions about the entrepreneur:

• Are they open in revealing customer references and management team references or are they hesitant and defensive?
• Do they provide thoughtful, detailed responses to the key diligence questions promptly or do they appear to take the posture that the VC simply "doesn't get it"?
• Does good news and momentum continue to build as the process wanes on or do they seem frozen in time?

3) Making the case and negotiating the deal.  Once the lead VC has decided he or she is convinced, they now have the obligation to convince their partners, or "make the case".  The entrepreneur must answer whatever the hot buttons of the other partners are as well as make it through the dreaded Monday morning partners meeting, where the fate of the deal is decided based on their performance in a tight 60 minute presentation.  In parallel, the lead VC partner will typically be negotiating the main business terms of the deal with the entrepreneur.  Again, you learn a lot from someone during this process.  In particular:

• Is the entrepreneur cool, thoughtful and confident in how they present to the partnership or do they seem nervous and anxious in a "step up" moment?
• Is the entrepreneur persuasive and mature in making the case for their important business points during negotiations or do they seem immature and irrational as they make their arguments?
• Is the entrepreneur quick to pick up on sophisticated deal terms by bringing in good advisors or do they seem commercially naïve and unable or unwilling to bring in helpful expertise?
• Finally, do you complete the process and still say to yourself:  "I'm excited to do business with this person and jump into the roller coaster with them for the next 5-7 years” or "boy am I glad that's done, I can't wait to get to the next deal!"?

In these trying economic times, entrepreneur should expect that the due diligence process will become more rigorous.  Further, the competitive power has shifted to the sources of capital (i.e., VCs), which means deals will likely move slower and more deliberately than in the past.  Remember, the deal isn't done until the money is wired and the VC will be evaluating you and your actions all along the way.