I'll start off with a bold statement: First-time founders are bad at managing the diligence process.

This largely stems from the fact that founders often don't know what the diligence process entails and are uncertain about what to expect. At a high level, they understand that investors will want to "dig deeper" before deciding to make an investment. But a simple explanation of why due diligence exists can help founders better prepare for the process.

The Purpose of Due Diligence

Due diligence is about dotting your I's and crossing your t's when it comes to the hypothesis an investor creates while considering making an investment. That hypothesis is derived from a limited amount of data and information provided by the founder. Investors know this limited information can be misleading because it’s been carefully curated and packaged by the founder to present the opportunity in the best possible light, wrapped in the most compelling story.

An investor's job when performing due diligence (essentially, additional research) is to validate elements of the story the founder told, confirming that it fits their mental model of what makes a good investment and the circumstances needed for the investment to be successful.

Preparing for Due Diligence

As a founder preparing to enter the due diligence process, you should understand that everything you’ve shared in your initial pitches will need further validation. This layer of validation will give the investor more comfort and excitement to make the deal happen. 

As you prepare for due diligence, think like an investor and objectively assess the pitch you delivered. Consider what additional information would be helpful to have and what confirmatory evidence would support your pitch. Start lining up these ideas to provide them in a data room or to guide the investor's research.

A Side Note on Diligence

Much of due diligence is focused on looking for reasons to say No. If you've reached the diligence process and an investor isn't already inclined to do the deal, it's going to be difficult for diligence to be the reason that they say Yes.

It's crucial that diligence continues to provide excitement to keep going; ideally, the investor will discover more exciting information that confirms what initially made them interested in doing the deal.

Beware of Isolated Data

Be cautious of data without a narrative wrapped around it. Data on its own can be interpreted in many ways. Wherever possible, provide context and narrative around the information you share. Examples on how to accomplish this include scheduling a meeting to walk the investor through the data room, providing context for any references given about your team, and creating a "data deck" that complements the data with commentary- the story of your business in numbers and anticipating/answering every question that investors will have about how your business works (listen to our latest Funded episode with Bobby Pinero, the CEO of Equals for more details).

Avoid Extended Diligence

Extended diligence can be detrimental to an otherwise successful fundraise. With more time and elements to consider, it's easy for an investor to become nervous about a deal they were initially excited about (see my essay on Investor Skydiving). To prevent this, instill a sense of urgency and process. Establish time blocks, guidelines, and deadlines to push towards a decision.

Structuring the Diligence Process

By creating a structured diligence process with a checklist for both you and the investors to follow, you'll be better prepared to enter due diligence and successfully secure a term sheet. Remember, an unbounded diligence process is a recipe for an eventual no— proper preparation and management of the process are essential to maximize your chances of success.

Takeaways

1. Understand the purpose of due diligence: Recognize that due diligence is about validating the investor's hypothesis formed during your pitch. It serves to confirm that your company is a good investment opportunity and fits their model.

2. Anticipate information needs: Put yourself in the investor's shoes to objectively assess your pitch and identify any areas where further validation or information could provide more comfort or excitement around the investment.

3. Provide context when presenting data: Avoid leaving data open to multiple interpretations by wrapping it in context and narrative. This could include scheduling meetings to discuss the data, creating a data deck with commentary, or offering relevant background information on your team's references.

4. Establish time blocks for the diligence process: Prevent extended diligence from harming your fundraising efforts by wrapping the process within guidelines and deadlines. Strive for a focused and efficient process to maintain investor excitement and avoid an eventual no.

5. Create a structured diligence checklist: Develop a checklist for both you and the investors to follow during the diligence process, making sure all necessary information is provided and expectations are clear. This will enable you to navigate the process more effectively and increase your chances of securing a term sheet.

Be chased,
Jason

Very true. My first boss in VC helped me understand it was way easier to just have a policy of being helpful than it is to be calculating about it. Go help some people...

It takes going through dark times to build some of the skills that allow you to manage them more effectively in the future

lol. Happy New Year, everyone!

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