How, When & Why VCs Do “Due Diligence” Pre and Post Term Sheet

Q: What methods do VCs use for performing due diligence when they are interested in a deal?

Every investor is a bit different, but I think it’s important to understand investors do 2 stages of due-diligence: pre-term sheet, and post-term sheet.

In the old days … there was more time. VCs could do a ton of diligence over weeks before getting to a term sheet. Customer diligence, IP diligence, financial diligence, team diligence, etc. But things, in many cases, are just faster now.

For later-stage deals, companies will assemble rich data rooms with a lot of this assembled. But for a seed or even Series A deal, this often doesn’t exist.

So VCs now do pre- and post-term sheet diligence, and more of it is post-term sheet.

Typical pre-term sheet diligence for Seed or Series A:

  • A couple of customer calls. Often just 2 or 3. But quickly confirm they love the product.
  • Basic financials and model review. But often only a cursory one.
  • Easy / quick back-door reference checks. If they know a prior investor, or someone connected on LinkedIn.
  • Competitive review — up to a point. This is important pre-term sheet, but if timing is compressed, it may not be as rich as one might expect.
  • Google research. Sometimes you can learn a lot. But only up to a point.

This is usually enough to come up with a valuation and basic terms — and thus a term sheet. But it’s not everything an investor needs to fund you.

The deep dives often come post term-sheet these days:

  • Bank statements & deep financial review. To make sure whatever you have is true.
  • Full background checks. To weed out creeps and other issues, and other flags. If you have something to hide here, it will likely come out later. Post term sheet.
  • Deeper customer calls. Often, as many as possible.
  • Formal reference calls. Make sure you know what your ex-bosses will say.
  • Sometimes, IP diligence. Do you own the software you claim you own?
  • Deeper competitive review, especially for Series A (and later). Sometimes, this turns up things the VCs didn’t really understand or know pre-term sheet. Make sure you truly educate them pre-term sheet.
  • Meeting rest of the team. Sometimes VCs will meet folks other than the founders pre-term sheet, but sometimes they think the founders are enough, and meet the others during post-term sheet diligence.
  • Legal due diligence. Are there ex-founder issues? Cap table issues?  Do the founders have enough unvested stock left?  Are there any issues with founders that have left the company?  Did any founders work nights-and-weekends for another company in the same general space?

So if there is bad news out there — get it out. Get it out earlier. Because with pre-term sheet diligence being accelerated, that increases the odds something hidden doesn’t blow up on you until after a term sheet.

That doesn’t help. It’s worse. It’s worse if a signed term sheet falls apart.

More here: 10 Things That Can Derail A Round Of Funding – TechCrunch

Published on June 27, 2020

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