Keys to mastering investor diligence

Jason Yeh
August 1, 2023

What’s the deal with due diligence? pt. II

Last week, we took a deep dive into the essence of due diligence - understanding its core purpose, unraveling complexities of the process, and the psychology that’s going on behind the scenes.

Today, I’m giving tactical advice for founders managing diligence and insight into my own process for an opportunity that recently came my way. Hearing how I thought about it should help get into the mind of investors.

How Diligence Evolves by Stage

The level of diligence conducted by investors changes depending on the stage of your startup. The later stage a company is, the more data there is to scrutinize. In the earlier stages, when there's less product and data, diligence will be more subjective and focuses on the founder, the team, and the market.

As founders' stories develop and the startup evolves, so does the diligence. A back-of-the-napkin pitch early on in the company’s journey will likely emphasize the founder's background and vision. So in order to diligence that, an investor will ask “Who knows this founder? What have they done before? Is this real?”

As the company progresses from just an idea to seed, Series A, and beyond, the narrative shifts to include descriptions of what products they’ve launched, how much traction they’ve gained, and the need for funding to scale. This varying level of detail calls for different levels of diligence, such as verifying whether the company is actually growing at the rate it claims to be, analyzing unit economics / whether the business model is sustainable, and assessing customer satisfaction.

The summary: when stories change, the type of diligence changes.

A Personal Experience with Early-Stage Diligence

A great way to illustrate what diligence feels like at an early-stage is to walk  through how I approached a deal that I was considering as an angel investor.

It all started with a warm introduction from a highly trusted source I deeply respect. This referral instantly put the founder on my radar, and it gave me a positive bias going into our first call. Key learning moment!

On the call, I could tell the founder was polished. He had a great presence & I could tell he was running a fundraising process. I could sense the pressure coming from all sides because of that. It seemed that he was juggling back-to-back with investor meetings and that other people were already committing capital.

The thing is, the company had barely gotten off the ground! An initial team had formed and they were essentially fundraising off of a deck.

For this type of investment, my diligence revolved around seeing if this founder was truly exceptional, if the current team was solid, and if there were any red flags.

My quick diligence process

The first thing I did was find out if I knew anyone who worked with him, and it turned out I did.  From there it was easy to text that person to double-check my positive gut feeling. While the feedback that came back was relatively positive, it wasn't full over-the-moon positive.

Next, I wanted to dig into an aspect of the company that caught my attention.  I saw that the founder was working with a family member.  That’s not necessarily good or bad but I wanted better insights into that dynamic. I set up a call with the family member to understand and read between the lines how this relationship would play out.

Lastly, I wasn’t an expert in the space so I needed to understand what smart people think needs to happen for the big vision to come true.  This part of diligence was doing market research to gauge the potential of this opportunity and its alignment with a larger vision.  That meant some googling and some talking with friends who knew the space better than I.

The outcome

After these three diligence checks came back (the reference call, the chat with the family member, and the market research), I didn't have a feeling of, "I need to do this deal!" And that’s important, because that’s the level of excitement every investor wants to have when they write a check.

It’s not like I wasn’t tempted.  If some other messages from the founder or other parties I respect hit me while I was doing diligence, the momentum of everything might have gotten me interested. But that didn’t happen. I didn’t lean in.  It was a pass for me.

This is how diligence can feel at the earliest stages. Notice that a single detail or conversation that doesn’t confirm an investor’s positive gut feeling can have an outsized impact on the decision to invest. Conversely, if there’s a small detail that the investor particularly cares about and the founder happens to nail that element, it can wield significant influence in sealing the deal.

An Uncomfortable Truth…

Here’s an uncomfortable truth that every founder should know: an investor  can always find a reason to say no during diligence.

No matter how competitive the deal is or how massive the opportunity, there will always be something that could potentially raise concerns. As diligence progresses, the chances of finding those points increase.

So, what does this mean for founders? First, it aligns with the principle of "investor skydiving" I mentioned last week. It also means you need to do everything you can to drive past the potential no’s and into a yes.  

To do that, being great at managing a managing the diligence process is key.

Managing the Diligence Process

Here are some practical tips to keep the pressure on and stay in control:

  1. Be Organized and Prepared: Have your diligence materials ready in advance. Being proactive and providing prompt answers to their requests gives them less excuses and room to delay or prolong the process.
  2. Create Leverage: Aim to have multiple credible processes running simultaneously. This way, when you engage with investors, you can mention that other diligences are underway, which puts some positive pressure on them to move efficiently.
  3. Initiate an open discussion with the VC about their diligence process and requirements: Clearly state your timeline and the need to keep things tight, since you don’t want to waste anyone’s time. Ask them what they need to gain conviction in the deal or make a decision, aligning both parties on a collaborative timeline.
  4. Use time constraints: part of stating your timelines is going to be making sure the investors can’t take all the time in the world. They have to feel pressure from other processes AND the founder’s confidence around maintaining deadlines around the process.  Remember that the longer a process drags on, the more opportunities an investor will find a reason to say no.
  5. Control the narrative: understand the underlying questions VCs want  to answer during diligence and fit your data / answers into a narrative that fits your purposes.
  6. Don’t be afraid to pushback or ask questions: If the VC asks for specific information you don't have, don't rush to create it immediately. Instead, inquire about the exact nature of their diligence. You might already possess materials that address their questions, saving time and effort. You want to have agency and confidence around what your materials are, not feel like you have to run around creating a random variation of data that you already have. This helps with signaling that you’re confident, that other people are looking at the deal, and that you don't have time to go jump through hoops.
  7. Check-in Regularly: As the process progresses and you get closer to decision points, communicate with the VCs about the importance of reaching a conclusion quickly. Express the need for both parties to arrive at a decision, and encourage timely responses. Part of the check-in should be sharing that other processes are moving too!
  8. Timely Term Sheet Request: As you approach the final stages of diligence and investors are getting closer to a decision point,  mentioning that you'll be asking for term sheets by a specific date. This creates a sense of urgency and encourages serious engagement.  You can do this collaboratively and float a timeline to get feedback before you draw a hard line in the sand.

Important last thought on diligence: don't be afraid of a pass. Stay focused on finding the right investors who believe in your vision and are committed to moving forward. Diligence can be nerve-wracking, but maintaining control over the process will lead to better outcomes and help you be chased instead of chasing.

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