Due diligence can be a complex and rigorous process. To be successful, potential investors need to fully understand any risk they will be exposed to before closing a deal. That’s why it’s important to make sure you’re not doing anything that could compromise your chances of securing the financing you need with favorable terms. To do that, you need to be aware of the many pitfalls that can put the diligence process in jeopardy, and how to mitigate them to your investors’ satisfaction.
Let’s take a look at the various due diligence pitfalls you need to be aware of and avoid:
You have a major talent gap
When your company is growing, you might find there are gaps in leadership. Maybe certain key roles haven’t been filled yet or your founder or CEO is taking on multiple business-critical roles himself. It’s important to complete a self-assessment and identify where there are any gaps in your company’s talent. Be upfront about them and to develop a roadmap for investors that explains how you plan to address them.
Your product market fit doesn’t align with expectations
Investors will pay close attention to where you are on the product market fit spectrum. If they feel that the product isn’t in sync with market needs, you may have to show how you can reposition it through additional product development or R&D to inspire confidence.
You don’t have a defined (or the right) sales process
Early stage companies often rely heavily on their founders or CEO to drive the business and customer relationships, which can be of concern to investors. When this occurs, it shows you have an informal sales process with no practical way to scale. To allay investors’ fears, you need to provide your investors with a sales and marketing plan that supports your sales and growth targets.
Your numbers don’t line up
As part of due diligence, investors will review your financial model. They will be checking to see if your historical performance supports the forecasts you’ve made, how the business is doing, and how well positioned it is for growth. Setting unrealistic forecasts based on assumptions that you can’t support with historical performance is a red flag for investors and could jeopardize your deal.
You don’t have good unit metrics or a firm grasp on them
It’s critical that you not only have strong unit metrics, but also a deep understanding of what they are and why they matter. If you lack proper finance resources within your organization, and the right systems to track your unit economics, you’ll find poor support for the financial statements and forecasts that are being assessed. Recognize this gap and allocate resources to address it before launching your fundraising efforts.
The majority of your revenue comes from just a handful of customers
If your top two or three customers represent the majority of your revenue, your investors will be concerned. You need to allay their fears that losing one customer constitutes a significant risk by being proactive, explaining the rationale for the situation, and presenting a plan to address this risk going forward.
You’re seeking an overly aggressive valuation
Naturally you want the best possible valuation for your business, but if you hit the high range, investors may walk away from the deal. Higher valuations may mean additional investment provisions and protections if financial performance doesn’t materialize and could cost you more in the long run.
You have complex corporate and ownership structures
Investors like things to be relatively simple and straightforward, including the organizational structures of the companies they invest in. For that reason, it’s critical to avoid unnecessarily complex corporate structures and to provide transparency on where key assets are held.
Negative reputational risks surface
Your reputation matters, so if your management team or existing investor base has a negative one, that will raise concerns with new investors. Their research will be based on things like bankruptcy searches, legal disputes, and reference calls with past companies that you have been involved with. Be aware of possible past and present reputational issues and try to mitigate them as best you can.
You’re facing a major lawsuit
Regardless of whether it’s big or small, if your business is engaged in a lawsuit, be open and honest about it with your investors. It doesn’t necessarily mean the end of a deal, but they will want to assess the legal risk and your business’s liability. Being transparent is key.
You lack corporate compliance
As a business, you have a variety of tax obligations, especially if you sell products or services in other states and countries. Companies need to be aware of their obligations for sales and corporate taxes, along with proper registrations for employees involved with sales in different jurisdictions. If you’re not aware of those obligations or aren’t compliant with them, that’s a red flag for investors.
The sector you’re in is out of favor
Markets are constantly shifting, so if an element of your business or strategy is out of favor, your potential investors will become concerned. Mitigate this by understanding what’s driving that perception, and have your talking points ready to explain why those issues aren’t applicable to your specific business.
You have poor governance and controls in place
Potential investors will want to assess your corporate governance. Early stage companies not yet backed by institutional investors tend to have relaxed systems and governance structures, as well as lower standards of reporting and financial control. If you don’t already have good governance and controls in place, take the time to work on this before raising capital.
You’re not disclosing related-party transactions
Investors will want full transparency into any related-party transactions so that they can be confident that you will use the funds they provide appropriately. That’s why it’s important to have a clean business model and to clearly identify any third-party relationships. If those relationships are off-market, you may have to unwind them.
Your references don’t check out
As part of diligence, investors will ask you for a variety of references to confirm what they’ve heard from you. That might include references from other investors, suppliers, partners, customers, and people who aren’t on the reference list you provide. To avoid this issue, take care to manage the references you put forth as well as anyone else who you think the investor might reach out to.
Navigating pitfalls before you seek finance
Being aware of potential pitfalls that can derail deals and working to mitigate them before you start looking for investors is crucial. By knowing what those pitfalls are and taking the proper steps to address them, you can dramatically increase your chances of acing diligence and closing a favorable deal.
If you’re interested in learning more about how to successfully make your way through the due diligence process, download our new white paper, “Show me the money: A guide to acing due diligence.”