What is the purpose of DD?
By this point, investors most likely will have carried out enough research to understand your business. They might have spoken to key management members, asked about your product and hiring roadmap, delved deeper into key metric trends, spoken to your customers and (very likely) competitors, and analysed your financials (historic and future projections). DD is then the opportunity for investors to ensure they realise the value anticipated from the investment into your company. It is the process by which investors seek evidence that all that has been discussed is true, and ensures that there are no problems hidden under the bonnet that may produce disappointing outcomes for investors post completion of the round.
A term sheet will likely include a closing condition that says that the company and/or its shareholders (particularly founders) must give customary warranties to the investor acquiring a stake in the company, including customary limitations on the company’s liability in respect thereof. These warranties are essentially promises that the founders/company make to new investors about the state of the company. Any misrepresentations found post completion of the deal results in penalties for those issuing the warranties. It is possible for founders/companies to take out an insurance policy to cover against this risk.
Due diligence and warranties go hand in hand. Warranties promise certain truths about the company, whilst the due diligence process is the opportunity for investors to reassure themselves of the true state of the company.
DD and warranties are customary in shareholding offerings. When it comes to early stage investments, warranties tend to be standardised, but they can still be negotiated between the investor and the company/founders, and likely will help an investor map out further areas for due diligence.
Who is involved in the due diligence process?
It tends to be the case that the lead investor carries the bulk (if not all) of the DD. So for the purpose of this section, we will look at how investors carry out DD, assuming they are leading the round.
What is covered?
The information you provide under each section will be bespoke to your business, but you can use the following guidelines to understand what investors might ask to see from you. This list is not exhaustive.
Commercial: contracts with main suppliers and a summary of their terms.
Corporate: company registration documents (including those of subsidiaries), company structure explanation, cap table.
Customer / Clients: client contracts (if B2B they will want to see the contracts with the clients that make the bulk of your revenue). Investors might also ask to reach out to a few of them with your consent and/or help (or might reach out directly).
Finance: historical data (statutory accounts, management accounts, and explanations for any differences between those), a thorough explanation and evidence of all items in the balance sheet (e.g. debt agreements, convertible loans, information on creditors, etc).
HR: contracts of key management members and directors, template contracts, summary of employees and contractors including tenure and status (full-time, part-time, etc), employee option scheme details, employee handbook, pensions, details on employee perks (including health insurance), details of pending and past employment tribunals.
IP: evidence and description of IP (including ownership of brand name, URL, patents, etc).
Legal: proof of GDPR compliance and processes in place, information of pending legal cases, outcomes of past legal proceedings, T&Cs of your website/product.
Product: product roadmap, consumer generated data (e.g. sign ups by cohort, engagement, etc).
Tech: what is your tech stack; what is yours vs 3rd party, contingency plans if 3rd party providers go out of business.
How you can prepare beforehand
Using the guidelines above, start putting together a data room with the information you know you have and will be requested from investors.
They might ask for further information, but the purpose of starting early is to speed up the process.
Specialised software vs DIY tools
There are multiple virtual data rooms (“VDR”) software providers who you can use for this process, from those who specialise in data rooms for financial transactions (e.g. Datasite, Citrix, Drooms), to those who offer broad cloud storage solutions (e.g. Box, Dropbox).
Best thing to do is to approach a handful, ask for a demo and a quote. You cannot go wrong with any of them, it is just a matter of preference. Your choice will ultimately depend on functionality (e.g. Q&A functions, more on that below) and price.
Once you have given investors access to the data room, they will go through the materials and ask relevant questions or ask for further documentation.
Some VDR providers have a Q&A functionality where investors can post questions and you can keep track of answers. If your choice of VDR doesn’t have this, you can rely on excel to keep things on track. The important thing is to make sure you don’t lose sight of questions and that you answer them in a timely manner (usually the term sheet stipulates that due diligence should be completed by a specific date).
Congratulations on closing your round! As you will have discovered, the VDR you have put together is an important archive that holds important information about your company. Once you go through this process once, you are able to build up on this for future rounds (equity or debt).