Demystifying the Due Diligence Process

05.21.14
Features

Whether you’re an entrepreneur who has been through multiple financings, or you are currently contemplating raising outside capital for the first time, the idea of putting your company through a round of due diligence in connection with a capital raise can be extremely daunting. Executives that have already been through it know that it is a huge time commitment for a company and senior management, and first-time capital raisers may feel a certain anxiety about what exactly it will entail. The truth is that due diligence is no easy task, and the exact details of your business that any particular investor may want to vet out will vary, but there are core areas that the vast majority of investors will dig into as they learn more about your business and you can stay ahead of the game if you make sure to have readily available information in these areas.

Financial Information

The first of these items is the financial information of the business, which will likely include historical and forecasted annual and quarterly financial statements for the past few years, revenue breakdown by product or service offering, details surrounding the cash flow of the business (such as capital expenditures and any working capital arrangements), customer backlogs and future financial projections. The key here is that investors are interested not only in your historical performance, but how that performance evolved over time and how it compares to expected numbers. Although most recent performance is one of the biggest benchmarks used for valuing your company (more specifically the last twelve months, or “LTM” financials,) investors need to know how fast your company is growing and the likelihood of that growth continuing at a similar pace in the future. To do that, they need not only to see what your actual performance has been in recent years, but also which products really drive the top line of your business. The more you can help them understand the drivers of your business and convey a sense of predictability around your numbers, the happier investors will be.

Product & Market Information

In addition to the intrinsic characteristics and performance of your product lines, investors will also want to understand the external competitive dynamics surrounding your industry. You will need to be able to show how your business compares to other existing competitors as well as explain any barriers to entry for potential new entrants. What is your company’s value proposition and why has it been able to maintain a sustainable competitive advantage in recent periods? Key patents and intellectual property rights are some of the documents that should be well prepared for this stage of due diligence.

Capital Structure

Investors will also want to know what their ownership position looks like relative to both other equity owners and any creditors. Information needed for this analysis includes current shares outstanding, a list of all stockholders and potential options/warrants that may be exercised, a summary of all debt instruments of the company with key terms and covenants, and any other significant liabilities that are present in the business (whether they are reflected on or off the balance sheet). If there were previous financing rounds, they will also most likely want to see a schedule of the financings with the date, amount invested and implied valuation for each round. Any potential investor will need the above information to understand how they could potentially structure a new investment to avoid any unexpected dilution or adverse events with creditors down the road (such as being in breach of a covenant).

Customer & Supplier Information

Another main item that will be explored is how your business interacts with customers and other key partners in the delivering of its product or service. What does your company’s supply chain look like? Does it rely on any key third parties to deliver its services to customers? If so, what alternatives are available should those key partnerships disappear? Investors will also want to know as much as possible about major customers, but this can vary widely depending on the make-up of your customer base. In a consumer-facing business, it may be less emphasized compared to a B2B business that generates a significant amount of revenue from only a few customers. If your business falls more into the latter category, you will want to have all of your customer contracts, data on historical revenue per customer and any other information that will let an investor better understand your customer relationships.

Management & Personnel

Although the majority of interactions that investors will have with a company will be with the C-level executives and senior management, they realize that a business has many moving parts and key personnel that are needed for the company to continue to succeed. Some items that will be required include a detailed organizational chart explaining how different departments are structured and interact with each other, historical and expected headcount by function and location, summary biographies and experience of key members of management, and employment agreements and compensation schemes. Investors will also want to feel comfortable that any key employees are planning to stay with the business and remain properly incentivized with significant upside post transaction.

While the items mentioned in this article aren’t exhaustive, they cover the main areas of a business that investors will dedicate the majority of their time trying to better understand in connection with a growth capital investment. If a company is proactive in generating and organizing information about its financial performance, product, place in the industry, capital structure, and the people that make the company tick, then any capital raise is going to be materially easier and less distracting to the ongoing business. It will ultimately also allow investors to better understand the company and potentially contribute towards a more attractive company valuation.

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