Most due diligence is done before the term sheet is signed. At this stage, the focus will shift towards legal due diligence. Lawyers and accountants can help tremendously at this stage.
One of the steps involved in closing is investors doing their due diligence.
Due Diligence Overview
A large portion of due diligence is non-legal in nature and is typically performed during the pitching process. Examples include reference checks on the founders and the team, interviewing customers, investigating the product and underlying technology, talking with industry experts, and so on.
During closing, due diligence tends to shift towards double checking legal matters. This is where lawyers and accountants are an amazing value-add. They can help with the following key topics:
Legal status of the company including incorporation details, whether it is in good standing, etc.
Financial status of the company including tax returns, financial statements, documents related to previous financings, etc.
HR-related matters including founder agreements, hiring and compensation documents, invention assignments, etc.
Contractual matters including contractor agreements, NDAs, partner, vendor, and customer contracts, licensed IPs, etc.
Governance-related matters including board consents and minutes, compensation policies, etc.
The goal of this process is to verify that the company is on solid grounds, especially from a legal point of view. This in turn gives peace of mind to VCs, who can show their LPs that their capital is being invested prudently. A common side benefit is that all sorts of small issues such as missing documents are uncovered and fixed during due diligence.
Founders tend to see due diligence as a big waste of time and money. While understandable, such emotional reactions are mostly not justified. Without a solid legal foundation, the spoils from all the hard work put into the company could be entirely forfeit.
Managing Protracted Due Diligence
Every now and then, due diligence devolves into a nightmare of never ending requests, which often tend to focus on minuscule details that don’t really matter but increase costs and delay closing time. I have three suggestions about dealing with such situations:
Get a great lawyer from a tier 1 legal firm. While expensive, having top notch representation means you will get the best possible advice from an expert, who has done this over and over again. Plus, it will help assure investors and their legal counsel that the company is in good hands, legally-speaking.
Get as much help as possible - from assistants, accountants, CFOs, corp dev / biz dev / ops coworkers. Due diligence takes a lot of time and splitting the workload will go a long way towards keeping you sane.
Push back strategically. Like all legal matters, due diligence is about tradeoffs and how much risk each side is comfortable with. Ultimately, both investors and founders succeed when the company succeeds - and to do that, the founders have to wrap up fundraising and go back to building the company.
If due diligence gets particularly bad, it is worth asking yourself deeper questions including what is really going on - e.g. are lawyers being overly risk-averse, are investors trying to buy time and potentially get out of the deal, are they unable to perform their capital call and execute the close, is it something else?
Fortunately, such cases are rather rare. VCs don’t sign term sheets frivolously and correspondingly in most situations due diligence - while occasionally annoying - is a relatively trivial checkbox to check.
Hopefully it goes without saying that if you actually did not have decent personal and professional conduct and due diligence uncovers something bad, the deal will fall through. As it should. As Warren Buffet says, it takes 20 years to build a reputation and five minuted to ruin it. Nobody wants to end up in such a situation. Stay above board - not least because it’s the right thing to do - and you will be fine.