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During my many years working for a large enterprise software company, I participated on dozens of due diligence teams. I had the valuable experience of sitting on both sides of the table during these projects. I ran diligence teams where my company was looking to buy other companies. And, I handled the brunt of responding to a diligence effort when my company was dealing with potential acquirers. Needless to say, it’s a real challenge for both sides, and not everyone understands what it takes to run a good due diligence process.
No big surprise here, but everybody seems to want good diligence to be performed, but few seem to want to do it. Partly that’s because it is work, and it requires a tolerance for ambiguity and uncertainty. Also, the many diligence processes that are not well run end up being a poor experience for the participants. So what can you do to make things run smoother?
At Launchpad we run due diligence processes on early stage companies dozens of times each year. And, we’ve been going at it for over 15 years! We’ve had ample time to think about and refine the process and to assimilate great suggestions from the smart investors who have been on our teams. We believe that the goals of a good diligence process are: efficiency, insight and informed decision-making. We think the hallmarks of a good process are:
Ham has experienced diligence from both sides of the table, as well. He raised funds for several of his software startups, and he led more diligence processes at Launchpad than he probably wants to admit. So let’s put Ham on the spot for a little more perspective.
Ham, what does it mean to have a process with goals of efficiency, insight and informed decision-making?
First off, we find it’s critical to have a standard due diligence process that everyone on our team adheres to. If everyone on a diligence team understands up front what expectations they need to meet, it makes each person’s job a bit easier.
Let me give you an example from the Launchpad playbook. Let’s say your assignment is to perform reference checks for the company CEO. First off, the company provides you with a list of individuals to contact. Second, you should reach out to members on your diligence team and/or your personal contacts to see if there are any other individuals who can provide a back channel reference for the CEO. You will then contact these references and ask a series of questions based on a management assessment questionnaire. Having performed 3 to 5 reference calls, your job is complete after you write a very short (one or two paragraph) summary of your calls. Not bad… you finished your assignment in a few hours!
So take the above example and apply it across all of the areas that you need to cover during due diligence. Each area needs a well-defined process to make it efficient and easy to accomplish in a limited number of hours. Once you define a consistent process, you will be amazed at how efficiently it runs. And, when every member of the team has a well-defined job, the overall experience improves for all participants.
That leads us to the second part of your question relating to insight and informed decision-making. Having invested in 100+ companies over the past 15 years, we’ve seen lots of companies succeed and lots of companies fail. Using our post-mortem reviews on these companies, we’ve been able to go back and refine our due diligence checklist to make sure we are covering critical issues that can lead to either success or failure with our investments.
Let’s make this concept a bit more concrete. A few years ago, after doing a review of some of our failed investments, we realized we weren’t asking enough probing questions related to customer demand. When we performed customer reference checks, we usually received positive feedback from the early customers. Where we fell short in our diligence was with our understanding of customer demand beyond those early customers. This insight forced us to revise our customer reference check questionnaire. Now we ask a couple of new questions during the reference check that are intended to better understand demand through the lens of buying priorities:
On your list of the top problems in your organization, where does solving this problem fall on your priority list?
Is your company generally an early or late adopter of new solutions?
By running a consistent, efficient diligence process that is informed by our prior investment outcomes, we believe we are making more thoughtful investment decisions. In turn, this helps to set a standard for excellence within the early stage investment community.
When you talk about the hallmarks of a good process you cite “speed” as the first thing. What does that mean, and how do you do it?
At Launchpad, we have a bit of an advantage when it comes to the speed of our diligence efforts. A typical diligence team at Launchpad will have 8 to 15 people. We divide the diligence tasks across the group. We always break it up into very focused assignments. Sometimes we will assign one person to a focused task and sometimes two people.
Our goal is to have the diligence process complete and at least a first draft report written within a month of starting the process. With a volunteer group of investors, this timeframe is only possible if we have different teams work in parallel on their separate tasks. We don’t always achieve our one month completion goal, but we are usually close. Sometimes we are delayed by holidays and travel. Other times, we are delayed when the company is not able to get us materials in a timely manner.
How about “efficiency?” How do you run a meandering, discovery-oriented process efficiently?
We discussed the answer to this question during the initial question. Ultimately, it comes down to not allowing the process to meander too far. You do this by putting in standard procedures for almost every task, and a clear focus around the expected deliverables. If you arm your diligence team with the tools they need to get the job done and you show them exactly what they are expected to produce, the resulting process can be both professional and efficient.
Why do you say “conciseness,” rather than “thorough?” At first blush, wouldn’t you be aiming for thorough?
Thorough is a very slippery slope. Some investors want to dot every “i” and cross every “t”. If we did that at Launchpad, we would end up making fewer investments. This would badly undermine the diversification so necessary to generate good angel returns, and we would burn out the folks doing the diligence. It just doesn’t make sense with an early stage company to look under every rock for a problem.
Instead, you should focus on identifying the key risks that are actually likely to affect outcomes and limit your diligence to the critical areas that need further examination. So, for example, if a company has been in business for a year or so and has only a few customers, you won’t spend much time looking at their prior year financials. Conversely, if the company has licensed core technology from a university, you want to make sure that the IP agreements are in order.
The resulting due diligence report should also be concise. At Launchpad, we use this Due Diligence Report Template. The template is focused on 11 major topics that should be researched and understood when performing due diligence on an early stage technology company. Experience conducting hundreds of diligence projects and leading dozens and dozens of syndications has taught us that it’s important to be succinct in your diligence summary. Otherwise, you will end up with a long report that investors won’t read through, thus defeating the purpose of the report.
And where did you come up with “respect” of all things? Isn’t the point to turn a skeptical and jaded eye on the claims of management and see if they are what they are cracked up to be? What does respect have to do with it?
In my view, respect is one of the core principles that guide how I conduct myself in business and in life. Therefore we insist that it be an unwavering hallmark of our organization - in all situations, and without exception. Not only is it the right thing to do, it is good business. Great teams have choice in picking investors, and they want to work with investors who respect them.
That does not mean you need to tip-toe around. It’s okay to be demanding during the diligence process. A CEO should expect to answer tough questions. At that same time, the CEO should expect to be treated in a respectful manner.
And, this goes both ways. Members of the due diligence team should be treated with respect, as well. Although the startup community seems to be a large and rapidly expanding world, in reality, it’s quite small. CEOs talk to other CEOs. Investors talk to other investors. It doesn’t take long for a disrespectful individual to lose credibility in the community. And deservedly so, in our view.
How unique is this process? How did you arrive at it?
I don’t believe that our process is entirely unique. Perhaps at the detail level, but in terms of broad themes, we are probably typical of a well-run process. VCs and angels have been investing for decades. Well-run organizations have put in place processes that work well for their particular ecosystem. What we’ve built at Launchpad works for us because it is based on lots of:
Observations about what works and what doesn’t, and
Great suggestions from many smart people on many smart teams.
And finally, we ask the entrepreneurs for feedback on how things went for them. It’s amazing what you can learn when you ask questions!
How do entrepreneurs react to it?
Many assume that it is like root canal surgery for entrepreneurs. In fact, the opposite is true. Good entrepreneurs will get a lot out of a well-designed diligence process.
They learn a lot about the weaknesses in their plan,
They learn a lot about themselves and their team, and
They learn a lot about their market and how to go after it.
Finally, they really appreciate the respect shown to them for their time and the value they get.
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.