Funding 101: What is Due Diligence?

The first time I heard the term "due diligence", as a budding entrepreneur, I had absolutely no idea what it meant.  None.  Nothing about the phrase informed me as to what it meant, and back in those pre-internet days, definitions involved a trip to the library.  So that's what I did.

And here's what I learned.  The term "due diligence" first entered the lexicon as part of the US Securities Act of 1933.  The idea was that broker-dealers - such as the finder you're maybe working with to get your venture funded - should be allowed some level of protection from being sued by unhappy investors in a project, provided the right level of "diligence" was applied in selling the investor the securities.

Back then, that level of applied diligence - codified as "due diligence" - was specially applicable to the sale of securities.  However, in the seventy years since, the basic concept of due diligence - that potential investments should be carefully scrutinized ahead of any money changing hands - has now spread to all aspects of business, from angel investments to product distribution deals. 

Due diligence - as the term applies to a venture investment - can be as simple as a handful of phone calls from your potential angel investor to people that know you and are willing to vouch for your honesty, work ethic, and genius intellect.  Or it can be so complex that teams of lawyers are needed for weeks, or even months, to sort through all the details.  This is particularly true of mature companies that have hundreds of ongoing contracts, several dozen patents, and complex liabilities.  

One of the things I've found over the years is that having a local investor in the deal can greatly ease the process of due diligence.  The idea of being able to walk down the road and kick the tires is very appealing to a VC - and that's something that hasn't really changed since 1933.  If you want your due diligence to move faster, consider finding a local partner first, then bring on the other guys later on.

How long does DD take?  As a rule of thumb, founders of early-stage investments should expect due diligence to take anything from two weeks for a simple, pre-revenue start-up, to two months for a post revenue company with customers, patents, and vendor relationships. 

Surviving due diligence - and closing your investment sooner, rather than later - is easy. The secrets of getting through the due diligence process quickly are: honesty and preparation. 

Investors hate getting exited about something only to find out you didn't tell them about that little problem you have with the patent dispute, or the million dollar parachute you agreed to pay your former partner.  Supermodels are not perfect, and investments are never perfect either - point out your flaws up front and explain why they will not impact your ability to execute.  Explain why your patent really is better than the one that looks just like it.  Talk through why it makes sense to pay your ex-founder a million bucks to get out of the way. 

As for preparation, for most of the due diligence efforts I lead, I create a password-protected portal that contains all the relevant documents, and a spreadsheet that contains all the relevant answers to questions - and links to the documents. 

For a really grown-up version of this ceoncept, I suggest you take a peek at BrainLoop - my thanks to fellow Deal Horizon member Andrew Craissati for putting me onto this service.

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John Sharp

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