EGD News #189 — Due diligence on your startup
In 2013, the investors asked for a data room when we raised the Next Games pre-seed. I was, “Doh, we are a new company, and there are no legal docs yet. That’s going to be the smallest data room ever.”
There’s a lot to unpack on how wrong I was. The investors are doing their due diligence to protect the company, the founders, and any investor participating in the company’s financing.
Even if you’ve been working on the company for just a few weeks, you’ve probably made several decisions on how the company will be structured, how it will operate, and the incentives for all parties involved, including founders, employees, and advisors.
Startups have thousands of risks that could cause grave danger to the company’s growth. Many risks can be existential. Understanding the likelihood and existence of such risks as early as possible will make the company more ready for VC financing. Keeping track of essential items is in the founder’s best interest.
In this piece, I will explain what those items are.
I’ll share a checklist that you can use to make your startup more attractive to investors. If not attractive, then clarify details related to the company. These details should be revealed when the investment is about to happen, not a few months after the investment, possibly causing a rupture in the relationship with the investors.
I’ll also explain why these matter to the investors and why the founders need to care about these details.
Preparation
With the due diligence, I’m coming from a good place. I’m not trying to make the founder do extra work. These due diligence questions are ones that any great investor should be asking.
Also, I would like to have all the due diligence-related documents in a data room folder on Google Drive or Dropbox. It can be called a “Data room” and should contain subfolders for the areas below.
Now, let’s cover the areas and questions.
Corporation
“What is the current legal structure for the company, and where is the company incorporated?”
It’s not always evident that founders have incorporated in the same country they live in. Often, non-US people might opt for a Delaware C-corp, and it’s good to know for legal reasons. Legal documents, SAFE notes, and other investing agreements vary widely between countries.
“Can you share the cap table with all notes converted?”
There have been several instances where I’ve seen a rebalancing needed in early-stage cap tables. Sometimes, the CEO has significantly less ownership than the other founders. An early angel investor might own a bunch of shares and is very inactive. There’s a lot that the cap table can uncover that just doesn’t come up in a regular conversation.
“Is there a shareholder’s agreement that all shareholders have signed? Can you share that in the data room?”
I’ve previously written about shareholder’s agreements. You can read about them here. I want to know if the founders appreciate governance and have agreed to make things clear if disputes arise.
“What is the company’s current cash balance? Who is your primary banking partner? Can you include a bank statement or two in the data room?”
The bank statement will tell me if the company is running on fumes and if their story checks out. Knowing the banking partner helps me understand how they will move cash around. And it also shows that the company already has a bank account.
“Can you share a target full-time headcount, monthly burn rate, and estimated runway in months after raising the full round?”
These numbers will uncover details the founders might be leaving out, intentionally or unintentionally. Maybe their estimates are over-optimistic, or they’ve not understood the costs involved. In any case, asking these is about uncovering issues that might not arise otherwise.
“Is the company currently subject to any litigation?”
You never know if the company is having legal issues. By asking this question, I ensure that the company has disclosed all such problems and that there are no unpleasant surprises.
“Does the company currently have a Board of Directors? How about advisors?”
Early-stage companies sometimes have boards, so I need to understand who is on your board. The same goes for advisors. I want to know whom I’ll be working with.
Founders
“Are any previous founders no longer actively involved with the company?”
Sometimes, co-founders leave very early. The co-founders might have not seen eye to eye. If this occurred, I would ask why they parted ways; were they compensated when they left, and are there agreements regarding intellectual property rights?
“Are the founders subject to any form of equity vesting?”
Founders should start vesting their shares immediately to protect the company. If a co-founder leaves, the vesting will ensure that a co-founder can’t immediately leave with shares.
“Are the founders currently taking a salary? What salaries do the founders plan to take after the financing has closed?”
A pre-seed startup should be able to pay its founders a salary that covers basic needs. Nothing more. I’ve seen setups where founders take a salary equivalent to what they got at big-co. That’s not setting the right tone for compensation, which should be oriented toward long-term goals and equity ownership.
Final words
I’ve previously written about checklists for founders to follow to get into a better position to raise venture capital. Here are the previous pieces: