Investors frequently ask me about our due diligence process and what we look for in a startup. We have recently started to make a portion of our due diligence findings available to investors. While the Due Diligence Summary Reports do provide some insights into our process, they still do not paint the full picture. A significant portion of our due diligence work must still be left out of the published reports due to compliance and confidentiality reasons.
In the six months that I have been at SeedInvest, I have led due diligence on over thirty companies. These companies had all made it past our initial Screening Committee. This essentially means that the companies had already passed a “sniff test” – a light due diligence that the Venture Team does before a deal is presented to the Screening Committee to ensure that there are no blatant red flags. You might expect that a company which entered formal due diligence would not have many more skeletons to uncover. However, this is rarely the case.
Over half of the companies that I have analyzed have had at least one significant red flag (revenue, customers, partnerships, product, team, use of proceeds, corporate structure, financing history, valuation, etc.) which needed to be corrected or explained before proceeding with the transaction. Often times, a company will decide to revise the terms of their financing round based on what we uncover before they launch on our platform. There are some instances, however, where the issues I uncover are just too serious, and therefore the deal has to be killed.
Many of the mistakes that I see do not stem from bad intentions; they are just naive errors that the founders could have avoided by structuring the company more carefully and taking advice from lawyers, accountants and mentors early on.
Seven of the thirty five deals that I have performed due diligence on have been killed outright. Below are a few high-level examples of deals that did not make it through the due diligence review process:
Initial Understanding: Company had four team members.
Due Diligence Findings: Company was one guy working from home. All other team members had other day-jobs, no equity in the business, were not being compensated, and had no firm plans to join the company.
Initial Understanding: Company had 1,000 customers.
Due Diligence Findings: Company had collected 1,000 e-mails, not customers. They only had 75 users participating in a private beta.
Initial Understanding: Company was planning to use one third of their round to pay back an old line of credit. They then wanted to open up a new line of credit to be guaranteed by the company to fund their manufacturing.
Due Diligence Findings: Company had not applied for their own line of credit yet. I requested that the company apply with the bank to see if they would be accepted – the company was denied.
Initial Understanding: Company’s wholesale margins were 30-35%.
Due Diligence Findings: Actual wholesale margins for 2014, after markdowns, were 10%.
Initial Understanding: Company was raising at a $9.5M pre-money valuation and claimed this was fair to investors.
Due Diligence Findings: Company had raised $7.4M in total, dating back to 2012, and had a down-round financing in 2014. 2014 total revenue was under $10K.
Initial Understanding: Money company spent to date was on product development.
Due Diligence Findings: Significant portion was spent on travel, entertainment, rent, salaries, meals, and other expenses for founders.
Initial Understanding: Company was raising $6M at a $10M pre-money valuation.
Due Diligence Findings: Company was raising $6M at a $5M pre-money valuation. Company had previously raised $5.2M dating back to 2008, and had a down-round financing in 2013.
Initial Understanding: Company had a typical CEO and management team structure.
Due Diligence Findings: Management team represented less than 1% of the equity of the company. CEO was not a founder, and was not even an employee of the company.
At SeedInvest, we like to say that the companies we present to our investors are “highly vetted.” The process we put our companies through to be considered “highly vetted” is no small task, for the companies or us. While this may lead to fewer companies being listed on SeedInvest, it results in a curated list of investment opportunities that we can stand behind and prevents our investors from being exposed to unnecessarily suspect investments.
This post was written by James Han on July 30, 2015
Skeletons in the Closet: Due Diligence Findings