5 Steps to Being “Diligence Ready”?

A typical fundraising process goes something like this: founders decide they need to raise outside capital to continue investing in growth. They speak informally with current investors to gauge interest in participating in a new round. They then cast a wider net and introduce themselves to new venture capital firms. In some cases, founders are proactive and in others, they’ve been solicited by junior analysts at those firms charged with keeping up with new companies the firm may want to invest in. Either way, the process is expected to take a few months. 

But then one of those firms gets more aggressive. They don’t want to keep talking. They want to lead the round. They prepare an early term sheet. While the deal terms are negotiated, they want to start looking under the hood. They ask you to set up a data room and fill it with every significant document, contract, policy and financial statement since the beginning of time. This is called due diligence. It’s the process new investors undertake to make sure they understand what they’re investing in, how far along the product is, what’s the cash burn, how long is the runway, how do customers feel, what’s the competition up to, etc.

You thought you had a few months to get organized and now you’re scrambling. You spend all your time chasing information that should have been at your fingertips instead of running the business. The concept of being “diligence ready” was designed for these moments. It’s a management philosophy that says any company expecting to raise capital is always on a fundraising footing – meaning a diligence process can begin on a dime when the pace quickens. 

Below are the top 5 areas that you can organize ahead of time to make sure you’re “diligence ready.” 

Organized Contracts 

Keep your contracts in one place – a centralized repository with an organized file structure. All customer and key vendor contracts, material technology licenses, partnership agreements, intellectual property documents, insurance policies, employment agreements, company formation documents and stock, convertible note, option, warrant and other equity-related agreements should be included. The easiest way to do this is to set a document retention and organization policy from the beginning using one of the many cloud storage solutions available (Google Drive, OneDrive, Drop Box) and charge someone with owning it. When this is done right, you flip switch, and this is most of your data room. 

Historical Financial Statements

The first thing investors or acquirers will look for are your historical financial statements. They may even ask for this while they’re waiting for the data room to populate. 

There are three main financial statements you should have at the ready: 

  • Income statement – Shows revenue for each product or service you’ve sold, all expenses incurred by the business, and the resulting profitability or loss (most likely a loss at this stage)
  • Balance sheet – Presents everything the company owns (assets) and owes (liabilities), as well as how it’s been financed to date (liabilities & equity).
  • Cash flow – The simplest statement that shows where cash came from (customer collections, financing, grants) and where you spent it (payroll, marketing, etc.). The key metric here is your cash burn, showing how much it costs to run the business each month. 

All statements should be shown either monthly or quarterly for at least the prior two years. This will help investors see trends and ask about patterns that might require more context. Finally, be sure that any accounting policies and judgements are transparent. 

Convert Historical Financials to Accrual Accounting

Most early-stage companies keep their books on a cash basis in the early days. It’s simple and easy to manage. The tradeoff is limited insights that won’t survive a serious diligence review.  Cash-basis accounting only deals with money you collected and money you spent. [See our post on Cash vs. Accrual Accounting discussing why cash isn’t sufficient at a certain point.]  Accrual accounting — sometimes called GAAP accounting – records revenue as earned and expenses as incurred. It “right sizes” the business to reflect how it performed in each period. 

If you haven’t already made the switch to accrual accounting, now’s the time. VC investors can only truly assess – and yes, value – your company if they see how much revenue you’re generating and the costs to service that revenue and acquire new customers.  

Short and Medium-Term Projections

While historical financials are important, investors value the business based on what it’s going to do next month, next year and over the next five years. Projections that lay out your expectations are critical for assessing how big this opportunity is. 

The standard financial model forecasts income statement and cash flow accounts, as well as key operating metrics over a three to five year period. These projections should be rooted in reasonable assumptions and easy to adjust to show multiple scenarios. It’s common to show three scenarios: A base case reflecting assumptions that are optimistic but realistic and upside and downside cases that present possible but less likely outcomes. 

A comprehensive, well organized financial model is not easy to produce. And it’s even more difficult to build one that can be handed off to investors who want to test your assumptions and run their own scenarios. But not having one is a non-starter and it’s best to have a working forecast model that can easily be updated to reflect changes in the business.  

Capitalization Tables

Make sure your cap table is current with all investors and share classes shown. VCs want to understand how distributed the current ownership is, who makes it up and how dilutive a new fundraising will be. 

Conclusion

Every investor or acquirer will have their own diligence list of items they want to investigate. Being “diligence ready” gives founders a massive head start and minimizes the distraction of hunting down and preparing these items while also tweaking your pitch deck and selling the story. 

All our clients are in some stage of fundraising and we do our work with an eye toward helping them get to “diligence ready.” In fact, we have an entire pricing package designed to help founders prepare for fundraising. If you’re thinking of raising money in the next 12 months, hop on a call with us to see if we can help.