Paying your dues: if you're looking for investor money, brace yourself for a big rigorous due-diligence process

Entrepreneur, Sept, 2004 by David Worrell

ON THE ROAD TO BUILDING HIS TELECOM technology company, Ascendent Telecommunications, founder and president Stephen Forte thought that finding funding was going to be the easy part.

It was February 2000, and Ascendent was riding high on the double wave of Internet mania and boundless telecom spending.

Ascendent's product, which marries wireless phones to traditional phone systems, had just been installed at the famous Beverly Hills Four Seasons Hotel. The company had managed to get through its first year in business with some seed capital still in the bank. Moreover, within hours of announcing a second round of fundraising, Forte received a lucrative term sheet from a large East Coast VC.

The future looked bright, but Forte's prospective investors weren't expecting the telecom market meltdown of 2001. And Forte wasn't expecting the extended--and expensive--period of due diligence that followed.

Due diligence is simply the investor's process of fact-finding. By stripping away the gloss and glitz of business plans and marketing materials, investors try to assure themselves that there won't he any nasty surprises after they write a check.

In practice, due diligence is never simple. Forte recalls where the trouble began for Ascendent. "We spent weeks in due diligence with [the VC] team," he says. "We spent probably $50,000 with attorneys going through the agreements and even installed one of our systems at their office. We had the documents Finished." But the abrupt market downturn caused the VC fund to rethink its investment. The deal was cancelled at the last second.

Fortunately, Forte found a West Coast investor who was more willing to take a chance on Encino, California-based Ascendent. The good news: The East Coast firm would ship all the due-diligence documents to the new team. The bad news: The West Coast team wanted more time to see how Ascendent would fare in the new, less friendly telecom market.

Forte, now 37, was in a due-diligence Catch-22. "You have to show sales and growth, which take time and capital. So you find yourself pushing on the accelerator, even as the wall is getting closer. We got within six weeks of our cash [running out]," he recalls. Finally, almost a year after the process started, a nearly broke Ascendent received its second round.

Getting to Know You

Forte's experiences are typical of entrepreneurs raising money from angels, VCs or private equity groups. And since investors want to know the whole story, companies will find that due diligence gets more and more difficult as they grow. The more complex your company is, the more Draconian the due diligence becomes.

Andrew Lindner, partner at venture fired Frontier Capital in Charlotte, North Carolina, says that after an entrepreneur makes it through Frontier's first screening process, they still face four different levels of due diligences--financial, market, personal and legal--which get progressively more detailed.

"The first wave is financial diligence to validate three things: Is there demand, is the model good, and is there a reason that this team can provide it more efficiently than anyone else?" says Lindner.

If the deal passes that Financial review, the Frontier partners examine the company's customers and partners, including distributors, vendors or integrators. Not all customers will be thrilled about discussing internal operations and purchase decisions with your investors. Let them know what's going on and how the additional capital from outside investors will help you serve them better.

Skeletons in the Closet

After an initial screening, a financial reality check and a thorough customer interrogation, an investor knows whether your business model is sound. He doesn't know what liabilities might be hiding in your personal past or in the legal nooks and crannies of the business itself..

When it comes to personal issues, Lindner says his team checks out both founders and employees. A thorough background check will likely include a review of your personal credit history, your driving record, and, of course, a search for any criminal or securities violations.

During this period, investors will undoubtedly ask for personal references. You can also count on an investor talking with your least favorite people, like that disgruntled employee or the vendor you stiffed. If you've got those kinds of ghosts, offer them up at the beginning so there are no surprises. "In almost all cases, we can figure out a back-channel reference, on top of stated references," says Lindner.

Of course, an undisclosed criminal past or a pending lawsuit will spook an investor. But they're also interested in the smaller personality issues. Says Lindner, "The more important thing is talking to previous investors, employers and employees to see what kind of performer and manager [the entrepreneur has] been."

Liabilities and Litigation

Finally, legal due diligence will include a complete review of your company's contracts and commitments. In most cases, investors will want to see historical records going back at least three years. That means finding three years' worth of balance sheets; major purchase receipts; correspondence with attorneys, consultants and auditors; and the like. The level of detail required can be excruciating.