436: Due Diligence During Fundraising
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In today’s episode of The Startup Chat, Steli and Hiten talk about due diligence during fundraising.
The fact is, no investor in their right mind is going to invest money in a startup that has sketchy numbers. Investors will want to know everything about how your business is doing and if you can give them the answers they need then that can kill the deal.
In this episode, Steli and Hiten talk about what due diligence is, how it can happen, what fundraising is about and much more.
Time Stamped Show Notes:
00:00 About today’s topic.
00:36 Why this topic was chosen.
01:41 How due diligence can happen.
02:10 The problem with due diligence.
03:00 What fundraising is about.
04:07 How due scrambling during the due diligence process can ruin your confidence.
05:06 Why your emotional state is the most important thing to manage during the process.
05:44 Why trust is super important.
06:19 How problems can arise when you scale.
06:55 The number one thing that founders tend to neglect.
3 Key Points:
- This is a place where, if you’re looking to raise funds, things can go wrong.
- If at any time you scramble during the due diligence process, it ruins your confidence
- The most important thing to manage during that time is your emotional state.
Steli Efti: Hey everybody, this is Steli Efti.
Hiten Shah: And this is Hiten Shah, and today on The Startup Chat, we’re going to talk about due diligence during fundraising. One of the reasons we’re talking about this, the main reason, is because this is a place where your fundraising, if you’re looking to fundraise, can go wrong. It goes wrong because what happens is, you get into your fundraise, and it could be any stage, it could be a pre-seed round, a seed round, series A round, later on. You’ve got you know your term sheet and now you’re like, okay, I’m going to sign this thing. You sign this thing, and then what everybody calls due diligence starts. That typically happens for most rounds. I think pre-seed, seed round, sometimes it doesn’t happen unless you have a lead investor. During this period, basically your company is getting assessed almost in a different way. Again around everything that’s going on in the business, whether it’s some of the metrics that you have, if you have those, the money and how you’ve been managing it, and the cash flow and what’s going on there, and whether the numbers that they heard from you a pre-diligence, or not even pre-diligence, but during the fundraise process, is actually true. Are those things actually what’s going on in the business? Now, another aspect of due diligence is oftentimes, you have a data room, and you have a bunch of your financials there, you have a bunch of your case studies from customers, and you have a lot of your data there about your business, whether it’s your retention or your growth or your engagement. That is already being shared with folks during the fundraising process even before term sheet sign. So there’s a bunch of different ways due diligence can happen. Now, the problem… And then, Steli, I want to hear your take on some of this, because I think there’s a lot of problems with diligence and where things can go wrong. One of the biggest problems is you just don’t have that material all together. You’re not ready. You’re not actually ready to raise money if you’re not ready for due diligence.
Steli Efti: Yeah, that’s probably what’s probably a really big problem, because what happens is, focus all your energy on fundraising. You focus all your energy on the story, on relationship. You start the process, and then when due diligence starts, you scramble. One of the things that needs to be kept in mind here is that fundraising, to a big degree, is about communicating confidently the story of your company, outlining the future of it, and getting people excited to want to be part of that bright future. So for you, in order to tell that story confidently, you need to have a good grasp over the numbers, and you cannot get into a scramble where they ask you things you don’t have answers to or you. Or even worse, they ask you things, you think you have the answers, you give those answers confidently, and then they discover or you discover in the process of putting the material together and financials together that you were wrong. That the numbers aren’t what you remembered your buddy saying in an email 18 months ago, or whatever. The numbers that you thought were correct because somebody on the team was putting together the accounting numbers in a spreadsheet or QuickBooks, and all of a sudden you realize some of these numbers don’t add up, or your accounting practices were wrong, or the way that you did the financial numbers, run your metrics, was not industry standard or wrong. If at any point during the due diligence process, you panic or you scramble, it’s not just about finding that number, it’s that it ruins your confidence. It instills lack of confidence for the investors as well. Now what you want to do is, you want to create an upward spiral of confidence and excitement between you and the investor. What is happening is, very quickly, that can turn into a downward spiral where they look at something, they get confused and ask you, which then confuses you, and you go try to figure out what really is going on, which then you go back to them all confused and apologetic that the thing that you told them wasn’t really true, which then makes them even more critical, so they want to dig into more numbers and ask you for even more stuff. And then all of the sudden, the whole thing collapses on into itself. You make a presentation, all of a sudden your voice cracks a little bit and you’re a bit more sweaty than usual and you’re just a little bit more giving people ranges versus specific numbers and direction. I think people forget that the most important thing to manage during that entire time is your emotional state, is the excitement and the confidence that you communicate through direct verbal communication, non-direct verbal communication. If during the due diligence process, you or they or both sides figure out that something wasn’t prepared, something isn’t right, it’s going to kill the mood in the room, and therefore it’s going to kill the deal.
Hiten Shah: That’s exactly right. That’s the reason you need to get this right. Diligence is something that if you don’t get it right and you don’t have your ducks in a row about the business, how can you expect the investors to trust you? It does boil down to trust, and it can be easily lost during this phase. The prep you do to make sure that all your ducks are in a row are really important. It’s the one thing that I think founders don’t realize. One of the reasons is, at the earliest of earliest stages, there’s not much diligence There’s a little bit here and there, but there’s not much, because you might not have any revenue, you might be pre-product even, or you might be really early stages of a product. There’s not much data or anything like that. But what ends up happening is that the more you grow, the more you scale. There will be information that’s really critical that you want to share with investors during diligence. That’s information like your financials, data about your company and your business, your team members, how much each person is getting paid, all those kinds of things. Revenue that you’re making, how it’s coming in, who’s paying you. All these things can be part of the diligence process depending on how much your investors want to scrutinize you. But also, this is just good practices as a business, to be able to have easy access to this information. It’s the number one thing that I see founders just not paying any attention to because they feel like it’s not important, they don’t think about it. But at the end of the day, good management of the information about your company is really what I’m talking about. Organized, structured. I see so many companies with a whole bunch of folders in Google Drive or Dropbox organized and set up correctly, and then at some point, someone’s not maintaining it, because the founder gets busy or the person who’s maintaining it gets busy, and then it goes crazy. Then they’re scrambling to get it all together again, if they ever did it in the first place, right before a fundraise.
Steli Efti: One quick thing before we wrap up the episode. I know I need to have grasp over my numbers. I know I need to be prepared for due diligence if my startup and I want to raise money. Now, as you said, when you have been around for six weeks and you have a landing page with no users and a team that just started, there’s not a lot that you have to prep. That’s the beauty of doing seed rounds, they are very simple. But eventually, hopefully, as you succeed, you might want to raise a series A, series B. You now have a bunch of employees, you have customers, you have revenue, you have taxes, you have tons of metrics, different revenue streams, different products. There’s complexity, there’s a real business there. Now if we go out to raise money, you need to realize that there’s going to be due diligence, there’s some prep work you should do. What are some simple preemptive things that founders should know about or founders should do in order to be in a better position when they do fundraising? And when they have to go, inevitably, through some due diligence from investors? What are some sure-fire quick tips that are easy to implement, but lots of founders forget and then they pay a big price on that?
Hiten Shah: Love that, as always. One of the tips that I have around this is really basic, and I know we can go back and forth for a bit, but one of them is have an org chart. Even if there’s only three or four of you, just have an org chart. Have some structure and save that, put it somewhere. That should also include your hiring plan of the people who you want to hire next.
Steli Efti: I love that. The next tip that I’ll give is a more generic one, but I think it’s an important one, is don’t ignore your finances. Don’t ignore the areas that are not exciting to you. Embrace it. It’s not rocket science. Lots and lots of other people have figured this out. Don’t allow yourself the excuse, this isn’t my thing. I’m not paying attention because it’s not fun, I don’t have a finance background, I don’t have a degree, I’m not very data-driven, I’m more creative, I’m more responsible for sales or I’m more responsible for engineering and technology. It doesn’t fucking matter. If you are one of the founders, you’re responsible for the business. And being responsible for the business means being responsible for the data, being responsible for your finances, being responsible for your documentations, being responsible for the household of this business to be in good order. Don’t allow yourself these little excuses that then empower laziness, which then create panic, scramble- induced moments when you realize, shit, my in-laws are showing up this morning and the house is a dumpster and I want to impress them and I have to run around and I have 10 minutes to make this not look as terrible. You’re not a teenager, you’re somebody that’s a founder that has taken a lot of responsibility, and you are asking for people to give you a ton of money. So you better show that you can responsibly deal with it. So one part of it is to change your attitude around money, change your attitude around the legal side of things, the tax side of things, the metrics and numbers side of things. Even if it’s not your favorite thing, tell yourself that you should at least get proficient at it, and that you will spend some time, the time necessary, to have some level of competence and control over these things. If you can overcome some of the emotional barriers that you might have, everything else that we said today is going to be much easier to deal with.
Hiten Shah: All right, that’s two tips so far.
Steli Efti: Yes.
Hiten Shah: So tip number three is a final tip. And this final tip is from our first sponsor.
Steli Efti: Ooh, look at that.
Hiten Shah: And their tip would be, use their product. So go to pilot.com/startupchat and check out our first sponsor. They’re basically a bookkeeping service that includes professional bookkeepers who look over your finances and set you up for success. During due diligence, financials, because you’re dealing with investors, is a key part of the diligence. Making sure all those things are right and your ducks in a row is really important. When we’ve talked to Pilot about this, they came to us and we talked to them about it, one of the biggest things we heard is that folks use Pilot before a fundraise in order to get their ducks in a row. This fits really well with something that we both believe, which is you should have your ducks in a row if you’re fundraising, and due diligence is such a big aspect of it. Why would you go manage your finances yourself and risk screwing that whole process up and screwing your fundraise up, just because you can’t get that right? So go to pilot.com/startupchat and check out the offer they have for you, which is a 20% discount for six months on Pilot Corp for the first 100 Startup Chat subscribers.
Steli Efti: There you go. And Ask yourself, has Hiten Shah and Steli Efti ever recommended something to me in 450 episodes, four years of podcasting, that wasn’t good for me?
Hiten Shah: There you go.
Steli Efti: There you go, ask yourself that question. If the answer is no and you don’t have your accounting bookkeeping already in stellar position, pilot.com/startupchat, check it out, take advantage of it, and we will hear you very soon.