This article is the eighth in an ongoing series on Deal Leadership. To learn more about leading a deal efficiently, download this free eBook today Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.
Do you know what the magic moment is when an entrepreneur can say to her team that she is in diligence with a potential investor? It’s certainly not at the first meeting with the investor. And, most likely it’s not at the second meeting. At Launchpad, we take care to be clear about when a company is in diligence and when they are not. The reason for this is twofold.
First, there is the signaling risk - we take a good number of companies to the deep dive stage, but only about half of them into diligence. If a company in the deep dive stage is running around town saying they are in diligence with us, they run about a 50% chance of giving themselves a black eye and having to explain why our “diligence” came out negative.
Second, we don’t want frustrated expectations or surprises that can leave a company pissed off and feeling misled. If they are in a situation where they have about a 50% chance of moving forward, we want them to understand that so that they have the right perspective.
So we go out of our way to make the probabilities as clear as we can by sharing historical averages and making our process as transparent as possible. Overall our ratios look something like this:
less than 50% of the companies reaching out will be scouted,
less than 50% of the companies scouted will come out positively,
about 1/3 of the companies with positive scouting reports are invited to pitch,
about 2 out of 3 pitching companies earn a deep dive,
about 50% of the companies earning a deep dive make it into and through diligence to investment.
In practice, this translates into something in the neighborhood of a 3-5% hit rate. So it pays to be clear with the company about where they stand. Only if all goes well at the deep dive, can the entrepreneur report back to her team that she is in diligence with Launchpad. Most early stage investment organizations have a slight variation on this process, but it is pretty typical that it will take 2 to 4 meetings with the entrepreneur before investors are ready to do the heavy-lifting involved with diligence.
Diligence focuses on discovering and understanding the key risks in a company. This is achieved by asking lots of questions and reviewing many documents. If diligence is fundamentally the review and evaluation of information, it stands to reason that the information needs to be collected first. Some bits of information will always be trickling in throughout the process, but most projects start with an initial information request for a big batch of the basics.
The trick to doing that well, and to keeping the process speedy and efficient, is coordination. By that, I mean coordination of requests and coordination in storage. If your goal is a professional and efficient experience for both CEOs and investors, you don’t want a chaotic process where everyone is playing off a different sheet of music.
Let’s get Ham’s insights on how to orchestrate this.
Ham, you’ve said that it all begins with the initial information request. What do you mean by that?
When pulling together an initial information request, you want to ask each member of the due diligence team to provide you with his/her list of required information before you do anything. That way you can engage the team members in the process and make sure they are thinking through their project. And, you want to avoid having each member hassle the CEO individually for this information. That’s not a good experience for the CEO, nor is it calculated to get everything you need. So one consolidated initial information request is key. For a list of the types of information we typically ask for, the column titled “Information Request” in this due diligence checklist provides a great starting point.
What do you do with all that information?
Everyone needs access to it. First, start by setting up two shared folders using Dropbox, Google Drive or some other tool that allows you to create a shared cloud folder to serve as a data room. The first shared folder will provide access to both the company and to all members of the diligence team. This allows the company to deposit documents, and all of the diligence team members to review the documents. Remember, some information is useful to more than one individual. The company should deposit all documents requested by your team in this folder.
A second shared folder should be set up for investor notes, draft reports, interview notes, etc. This allows all the investors on the team to see each other’s progress. This folder is visible only to the diligence team. The company does not have access. It pays to be careful about permissions and carefully labeling links when you share these folders - a pro tip is to name them descriptively, for example “Investor Only NewCo DD Folder.”
Why is it so important to have a private investor-only folder? Wouldn’t it be helpful to get the company’s feedback on key issues?
Well, you definitely want, and should get, the company’s take on major issues that crop up, but if you let the company read your report and notes and involve them in your report creation process, three things happen:
You are not writing the investor’s story, you are rehashing the company’s take on things. Diligence reports are supposed to be of investors, by investors and for investors.
You are going to chill the honesty of the team members, and that is not a good thing. You want candor and straight talk. If they know the company is going to read what they write, they are going to worry about ruffled feathers and their reputation, etc.
The CEO is going to get distracted and bent out of shape over all sorts of little things. Early stage diligence does not turn on little things. With early stage diligence, the point is to get the overall big picture right. The exact assumptions going into each model are not critical, it is the overall conclusion that matters, and it is usually right, even if one small detail is off.
Once the information requests are out, what comes next?
The team members are going to need to speak to the company, so the deal lead’s role is to facilitate those meetings in an orderly fashion or at least provide some oversight to see that they are set up in an orderly fashion. For new entrepreneurs, it can be very overwhelming and nerve-wracking to have a bunch of investors swarm all over them about a bunch of different topics, so there is a role for the deal lead to coach them through the process. Sometimes with larger, more built-out company teams, it works best to let individual diligence sub-teams meet with different people in the company separately. For example, the team building the financial model can meet with the person at the company who created this model. Or, the customer/go-to-market team can meet with the founders most responsible for sales.
Other times, when the company is just a small team of 2 to 4 individuals and all the diligence sub-teams want to speak to the same couple of folks, it can make sense to build a stack of meetings where the founders meet with different sub-teams sequentially across a day or half day. That way it is efficient and different sub-teams can sit in on each other’s meetings if they want to.
What about subsequent follow up meetings?
Once a little bit of relationship and rapport is built up, it’s ok for sub-teams to coordinate directly with the company to set up follow-on meetings or calls. The deal lead’s job is to make sure one of those teams is not spinning its wheels and taking up tons of founder time obsessing about an issue for which there is not a good answer. Some investors, particularly new and inexperienced ones, get confused and think it is the company's job to explain all the risk away, and they can get frustrated or even combative and badger the company about why they don’t know something. The deal lead’s role is to keep an eye out for such inappropriate behavior and remind the investor that this is early stage investing and some things are best guesses. That’s why valuations are low and the potential for return is high!
Even where there is no frustration, professionalism and respect matter. They should be a hallmark of all interactions. Don’t be too skeptical, scornful, or disrespectful. It’s important to been seen by the entrepreneur and her team as adding value in all exchanges. Diligence team members are effectively brand ambassadors for your organization. Remember, reasonable people can differ on many aspects of building an early stage company and there often is not one single right answer. Helping a CEO discover key risks and giving guidance on ways to address those risks go a long way to building your value in the eyes of the entrepreneurial community.
There is nothing worse than trying to run a good process and then finding out that the CEO is really upset because one bad apple on your team misbehaved and made everyone in your organization look bad. As deal lead, you have to stay on top of what’s going on. Make sure you are cc’ed on all the emails (no matter how painful an impact on our inbox - remember it is temporary!) to make sure nothing is getting out of hand. You have to manage the quality of the entire process end-to-end, especially with diligence teams containing new investors who have not done it before or whom you don’t yet know and trust.
Want to learn more about leading a deal efficiently? Download this free eBook today Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.