I think of due diligence as an investor’s process for confirming either their intention or full-blown commitment to invest in your company. After initial conversations, presentations and email exchanges, a given investor decides they want to invest. After that, they get a chance to request more detailed information to make sure what they understood and what you communicated is valid. This article will demystify the different phases of due diligence, while also explaining how small rounds invested by angels are different than rounds invested by institutional investors.
Phases of Information Exchange
You can think of the investment commitment process as having two distinct phases. The initial commitment and the full commitment. Why are two phases needed? We’ll, you should not be willing to provide a bunch of confidential and sensitive information without knowing the investor is seriously interested and excited about investing, and they won’t be willing to give a full, legal commitment without that information. So we dance the dance in two phases.
First Phase (Seeking Initial Commitment)
There is a reasonable set of information investors need in order to initially commit to an investment. We don’t often refer to that as due diligence, but in fact it is. It is just more lightweight than the second phase, which I will explain shortly. There are a couple of reasons why a full set of information isn’t exchanged during this first phase. Investors don’t need to be burdened with excessive information, and you don’t want them to have too much confidential or sensitive information before knowing they’re fairly committed to invest.
In order to decide if an investment is attractive, investors surely need historical financial results at a high level and information about any significant customers, but they don’t need expenses at a super-granular level or a detailed list of every customer going back to the beginning of time. They rightfully deserve to see a summary version of your cap table with details on key equity holders, but they don’t need all of the board consents that authorized the granting of the equity. They need to understand your high-level product roadmap, but don’t get to do a source code review of your software.
You get the idea. They need enough to generally decide if your investment opportunity is attractive compared to their investing thesis and their alternative investment opportunities.
Second Phase (Seeking Full, Legal Commitment)
After the initial commitment with a given investor, you will enter the second phase that usually is referred to as due diligence. It’s a chance for the investor to dive much deeper, so as to confirm many of their assumptions as well as validate certain additional claims that you made. It’s also intended to make sure there isn’t something “funky” or non-standard about your business that causes concern.
Since this second phase of due diligence involves exchanging more sensitive information, you often are able to gain the protections from some form of confidentiality agreement (ie – NDA or signed term sheet with a confidentiality clause included).
Skeletons in the Closet
Most startups have at least some not-so-ideal things that will get discovered during the second, deeper phase of due diligence. The range of things that could be considered “skeletons in the closet” is long. It includes things like foreign ownership, outstanding lawsuits, illogical or problematic incorporation structure, and many other possible issues that wouldn’t have likely been discussed during the first phase. What you’ll need to decide is when to disclose them.
If an investor finds something hugely concerning, disclosing it to them sooner versus later, probably won’t make a difference. They will decommit from their investment. So it is more the things that could be lightly or moderately concerning that you need to think about. To my way of thinking, it’s better for the investor to hear about the issue from you versus discovering it themselves and then asking you to explain. The later fully makes it look like you were hiding it and hoping it wouldn’t be discovered.
Remember, almost every startup has some funky and lightly or moderately concerning things about their business, either current or in the past. I wouldn’t necessarily suggest falling on your sword and disclosing your list during your first or second meeting with an investor. But if they get serious about making a commitment and plan to enter full due diligence, you’re going to want to find a way to let them know what they’re going to discover. With that, you can explain how, or why, the issue is not going to kill the company or severely impact business performance. If you’ve already worked through the issue(s) with qualified professional, like your attorney or accountant, even better.
To further help you understand the range of ways founders make claims that could exacerbate this issue, read my article titled “Aspirations, Exaggerations and Outright Lies“.
Excessive Information Requests
Investors might ask for far more information than needed during the first phase, and it’s up to you to decide whether and when to diplomatically push back. After all, if they keep asking for more information and you agree to provide it, why shouldn’t they just keep asking and asking before signing a non-binding term sheet or confidentiality agreement? Venture Associates at venture funds are notorious for this. That’s because they have to pitch your investment opportunity to one of their fund partners and they hate it when a partner asks a question they don’t have an answer to.
One way to head this off is to create an online shared repository referred to as a data room. It’s simply an online repository of documents that you selectively share with others. In this data room, you will put all of the information you predict most lead investors will need for the phase of due diligence you’re in (first phase vs second phase).
Using a data room hints at what you’re initially willing to share and also minimizes the chaos of servicing multiple different investors’ requests for different types of information. Instead, just grant them access the data room. If an investor requests something extra, and you agree it’s useful and appropriate for the due diligence phase you’re in with them, give it to them and then decide whether future prospective investors would benefit from having it in the data room.
Don’t worry, I’m going to provide some checklists later in this article so that you can have a better sense for what’s standard and reasonable versus what isn’t.
When raising a round from solo angel investors, the concept of due diligence is usually pretty lightweight. Much of what they need to make their full commitment is conveyed during presentations, conversations and some email exchanges. Angel networks are generally more serious about their due diligence and likely follow what you’ll see described in the rest of this article. But since pre-seed rounds and early/small seed rounds are dominated by angel investors, I feel an obligation to share some insights about information sharing with them. What follows is my assessment of reasonable information to share during the two phases of investment commitment by a solo angel investor.
Pre-Commitment (before a verbal commitment of intention to invest, likely including the amount)
- Latest pitch deck
- Summary version of current cap table – It should have line item detail for the founders and any equity holders with 5% or greater equity. Others can be lumped into categories like “employees”, “advisors and board directors”, “investors”.
- Financial statements (P&L, balance sheet) covering at least the prior four quarters (assuming you’ve been generating revenue that long)
- Financial projections – for these rounds, usually 12-24 months is sufficient
- Investment term sheet – for angel rounds using convertible securities as the investment instrument, usually the company proposes the terms
- Investment document to execute – usually a convertible note or SAFE
- Detailed version of current cap table
- Bylaws and Articles of Incorporation (or Operating Agreement for LLCs)
- List of employees with salaries (current and any proposed increases with the new funding)
I see lots of startups create a data room for the pre-commitment list of information, but handle post-commitment requests on a one-off basis rather than create an expanded data room that is shared with all investors. The information in the post-commitment list isn’t terribly sensitive. So I usually like the posture of being more of an open book with the standardized information that comes with creating, and sharing, a post-commitment data room. You decide for yourself if you just want to share all of it during the pre-commitment phase.
For more information how to secure initial commitments from angel investors, read my article titled “Using Verbal Commits to Secure Your First Investors“
Institutional Investors & Equity Rounds of Funding
Things are different when you’re raising an equity round of funding or dealing with venture funds, family offices (early stage investment arms of the super-wealthy), or angel networks. More information is typically required during both phases of due diligence.
It’s also the case that until you get a commitment from a lead investor, you won’t have a term sheet to share. That’s because it is a prospective lead investor that presents you with their proposed set of investment terms via a term sheet and, assuming you sign it, then you can share it with other interested investors as you seek their commitment. That doesn’t mean you need to wait to pitch non-lead investors until you have a term sheet. Rather, it means you won’t have that info to share until one exists.
- Latest pitch deck
- Summary version of current cap table – It should have line item detail for the founders and any equity holders with 5% or greater equity. Others can be lumped into categories like “employees”, “advisors and board directors”, “investors”
- Financial statements (P&L, balance sheet) covering at least the prior four quarters, but longer for a Series A
- Financial projections – For an institutional seed round, usually 24-36 months. For a Series A, 36 months or longer.
- Investment term sheet – only once you have one executed with a lead investor
- Bylaws and Articles of Incorporation – including any amendments
- Prior rounds of funding, including the total amount raised and key terms for each round
- Summaries of any patent or trademark filings
- All documented board actions and meeting minutes
- All documented stockholder actions
- Corporate structure chart and a list of all subsidiaries
- Detailed version of your capitalization table
- Historical stock price fair market values for each class of stock
- List of your current employees and independent contractors, including their roles, current compensation, and any deferred compensation
- Expected new post-funding hires, including proposed job titles, hiring timeline, and expected compensation
- Any employment agreements with company founders and executives
- Signed intellectual property assignment forms
- Copies of any license agreements or important partnership agreements
- Equity incentive and employee stock plans
- Descriptions of any open or settled legal actions, lawsuits, cease-and-desist notices, employee harassment claims, or similar workplace-related claims in which the company is named as a party
- Descriptions of any side letters granting special rights to investors or service providers
- Regulatory and compliance standards the company currently adheres to and whether an independent audit has been completed
- Company’s business insurance policies
The checklists provided here are what I would consider typical or mainstream. Both might need to be longer, based on your type of company. For example, deep tech and hardware companies will surely have additional information they need to share. If you fit one of those categories, your attorney, advisors or other startups like yours can give you additional guidance.
It’s also the case that specific institutional investors you’re dealing with might simply require more information than is listed. You’ll need to be somewhat flexible in this regard, but while still thinking about the information that is reasonable to share pre-commitment versus post-commitment – and without offending an investor so much that they drop out.