This article is part of a Grow Wire Guide on how to get VC funding. Download the full Guide as an e-book.
Receiving a term sheet from a VC investor means you are one step closer to securing financing. But there are still steps a VC must take before transferring funds: These include performing due diligence, which leads to drafting formal investment agreements.
Deals can fall apart in their later stages. As a founder, you can increase your chances of closing the deal by preparing well for due diligence, becoming familiar with the reasons that deals often go awry and taking proactive steps to encourage a close.
What is due diligence?
According to BusinessDictionary, due diligence is the “duty of the investor to gather necessary information on the actual or potential risks involved in an investment.”
The VC’s legal team will request information about the company’s financials, outstanding contracts and agreements, employees and management, capitalization table and intellectual property.
There is no standard length of time for the legal due diligence phase. It can range from “a couple of weeks if the deal is simple and if all parties are quickly aligned, to months for a complex deal,” VC Clement Vouillon wrote on Medium.
How to prepare for due diligence
Startup launchpad MaRS recommends choosing a team member to prepare due diligence paperwork using a checklist of the information that VCs commonly want to see. (You can find plenty of these checklists online.)
“Having due diligence binders ready will demonstrate to the potential investor that you are prepared. It will also speed up the review process,” the MaRS blog states.
Reasons VC deals fall apart
As an entrepreneur, it’s wise to learn about common mistakes that can jeopardize a deal’s progress during due diligence.
Nick Hammerschlag of OpenView Partners identifies reasons why a VC might pull out at the last minute in an article for Scale Finance, some of which are summarized below.
- Inaccurate information
If VCs discover inaccurate data while performing due diligence, it could cause them to pull out of the deal. Founders should avoid overpromising on product development, exaggerating the company’s customer base or breadth of partnerships and misrepresenting revenue, growth rates or other financials.
Of course, most business owners don’t purposely misrepresent data. In any case, it’s best to be honest about company details from the start of your talks with a VC, as discrepancies will be brought to light during legal due diligence.
- Failure to hit projections
A VC may reconsider a deal if a company falls drastically short of projections between the initial deal review and the legal due diligence phase.
“As ‘growth’ investors, we are looking for sustained growth, and a significantly ‘down’ quarter would certainly give us pause,” wrote Hammerschlag.
When dealing with investors, strive to be realistic in your projections. If metrics like revenue, total sales, customers, users or site traffic fluctuate by season, share this with investors so you don’t catch them off-guard.
- Legal issues
Investors do not enjoy discovering legal issues such as copyright, patent or intellectual property infringement claims. A pending legal issue won’t automatically stop a deal from going through–a founder should always tell the VC about it before the term sheet is drafted.
The phase before due diligence “is an important time to get all of the negatives out there to ensure that there are no surprises that will adversely impact the relationship or your internal [VC firm] champion,” Ed Zimmerman, a VC with Lowenstein Sandler LLP, wrote in Forbes.
- Poor product release
A VC may lose interest if a company fails to release a product on time or the product flops on the market. This is most often a risk in complex VC deals, where the due diligence phase can span months.
Poor product releases tend to trouble VCs because they’re often “factored into the company’s financial projections and our assessment/interest in the business,” wrote Hammerschlag.
- Negative references
Receiving negative references, especially in regards to a company’s CEO, serves as a red flag to interested investors.
Kirill Sheynkman of RTP Ventures is a software-entrepreneur-turned-VC. During due diligence, he often asks references about a founder’s management style, attitude, intelligence, openness to new ideas, strengths and weaknesses, he wrote on Medium. If references don’t respond positively, it gives him pause.
Strategies to help deals close quickly
Besides avoiding items that could compromise a VC deal, founders should actively pursue strategies that lead to a quick and successful close.
- Address investor doubts up-front
Asking investors about their concerns is a smart way to speed up the close process, Covestor CEO Asheesh Advani wrote in Entrepreneur. Advani recommends asking them directly about any doubts regarding the proposed deal structure, management team, business model or intended use of proceeds.
“The response to this question will usually indicate whether you’ll be able to address those concerns or not,” wrote Advani.
The VC’s response may also offer insight into what your references should address as they vouch for you. Notifying your references of investor concerns can help them prepare for tough questions.
- Participate in the final push
Resting on your laurels is not advised during due diligence. CircleUp Founder Ryan Caldbeck recommends staying “hyper-involved” in the deal at later stages, to ensure your team accomplishes the necessary tasks. During the closing phase, a founder should over-communicate with key stakeholders and remain the VC’s primary contact. Caldbeck also suggests assigning tasks from the closing checklist to your team members.
- Set deadlines
Founders should work with their legal counsel to propose deadlines for all documents that require signatures during the closing process. Agree upon these deadlines with both your internal team and the interested VC, to hold both parties accountable for closing the deal quickly.
One important deadline is the closing date, which founders should include in financing documentation given to the VC. Advani notes that while this deadline isn’t generally enforceable, “investors like to see a closing date because they like to feel that other investors are interested in your business and investing at the same time.”
🌱 The bottom line
The final stage of a VC funding deal is the time to find alignment across your internal teams, the VC firm and your legal advisors. During this time, founders should follow through on commitments to investors and provide accurate information about the company.
Stay engaged with the process until the very end, and you’ll soon see money in the bank.