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Crossing the finish line: Industry experts give key advice on nailing the due diligence process

Crossing the finish line: Industry experts give key advice on nailing the due diligence process

The fundraising process does not end after the term sheet has been signed, what follows next is a long process of getting the books in order

From left to right: Kevin McSpadden, Chief Editor, e27; Christian Idiodi, Global Head of Product Management at Merrill Corporation; Gladys Chun, General Counsel at Lazada; Varun Mittal, ASEAN Fintech Lead at Ernst & Young; Genping Liu, Partner at Vertex Ventures

In the frenzied world of startups, founders 0ften publicise their new funding to media outlets as soon as they sign the term sheet with investors. In truth, the term sheet does not denote a done deal. There is a long, unsexy but necessary process called due diligence — a process whereby the investors verifies the company’s books and operations are in order.

At a panel entitled “Fundraising due diligence — what are investors looking for” at a networking event co-hosted by SaaS provider for due diligence Merrill Corporation, e27 and WeWork, industry experts spoke at length about what investors and entrepreneurs should note during the due diligence process.

The panel was moderated by Kevin McSpadden, Chief editor at e27, featured:

  • Christian Idiodi, Global Head of Product Management at Merrill Corporation;

  • Varun Mittal, ASEAN Fintech Lead at Ernst & Young;

  • Genping Liu, Partner at Vertex Ventures;

  • Gladys Chun, General Counsel at Lazada.

But before an entrepreneur embarks on the final road to getting the money in the bank, they should first know what kind of investor they are in partnership with.

According to the panel, there are essentially two kinds: non-strategic investors and strategic investors.

Non-strategic investors will see key components such as certain representations on the board, specific clauses, warranties and investor rights clearly outlined in the contract.

Chun gave an example of how a dedicated legal compliance team had to be set up for Tesco’s investment into Lazada as Tesco is listed on UK stock exchange and they have certain compliance related requirements, for example, they wanted certain UK-based clauses to be included in the contracts with vendors, and also to ensure Lazada has measures in place to ensure compliance with UK’s globally-reaching Bribery Act.

Strategic investors, on the other hand, want to play an active role in shaping their investments’ business. To do that, these investors would go to great lengths to fully comprehend the scale and scope of the startups.

For example, if the company is an e-commerce company leasing warehouses, non-strategic investors would typically ask the company macro-level questions such as its lease commitments, or how much they have to pay for the warehouses.

For strategic investors, they would want to understand micro-level operational details such as how many customers a warehouse can service within a certain space or the maximum transaction volume a warehouse can handle if the business scales up.

“Strategic investors also focus on the companies’ technology IP. They want to know how it is unique and whether it can be patented,” Idiodi said.

Start being organised early

Whether you are a mid-stage startup or a young company in the midst of running its seed round, it’s always prudent to start planning the due diligence process early, the panellists said.

Entrepreneurs need to grapple with a whole array of legal, tax, cost and other compliance issues. For example, registering a company in a new jurisdiction would require abiding by a different set of laws.

Then comes the process of uploading company documents. It may seem like a simple process, but those documents can be a big hassle when a) there are many of them and b) they are disorganised.

Chun gave an example of how entrepreneurs may accidentally disclose highly confidential information to investors if they fail to blackline all mention of it across different documents (which can be easy to miss). They also have to ensure all documents are signed and dated and enforceable.

Mittal, who in his role at Ernst & Young, has been helping fintech companies handle due diligence, said that in one instance, the investor even requested that the startup’s developer dashboard to be exported so that they could examine the quality of the work as well as their internal communication process.

Founders have to “define the roles of the people who are facing the investors … and work out who uploads what documents, and when and where,” said Mittal.

Entrepreneurs should not underestimate the importance of organising information well and preparing the necessary documents for due diligence in a timely and orderly fashion.

A startup could lose its funding (even after the term sheet has been signed) if the VCs discover that its founders are cavalier about due diligence because it simply shows that they are not mature enough to handle the next stage of the business.

One way to make the due diligence process painless is by using enterprise-grade software that is specifically designed to upload and manage large volumes of data.

An example of such as tool is Merrill’s DataSite One. Unlike consumer-grade cloud storage software such as Google drive, Merrill’s DataSite One provides customers with extensive speed customizability, scalability, round-the-clock support and high-grade security.

This is crucial for companies whose data is sensitive and require different sets of folders to be granted specific access rights. They have also to be arranged in an intuitive manner to facilitate access by multiple parties — and speed up the due diligence process.

Selling yourself the right way

Different investors assess the value of a startup differently, based on their own investment values or thesis. They also take into account similar players in the same vertical and find out how the potential investee measures up against them.

And it is not always about the company’s’ current financial situation or projected growth. There are many other important factors to consider, such as the strength of their team and products.

“When we invest in startups, their financials play a small role in terms of tractions and projections; everyone can submit a projection but we all know that usually doesn’t work out,” said Liu of Vertex Ventures.

He said that Vertex would draft an investment memo — to justify why it should invest in a potential startup. Then it would analyse the investee’s total addressable market size, as well as key business model differentiation, key technology differentiation, and especially the calibre of the core founding team. Finally, Vertex would examine the historical financial and projected financial statistics of the company.

Also Read: The hidden side of fundraising: how due diligence can make or break your deal

Valuation

On the subject of calculating a startup’s valuation, the panellists said that there isn’t a hard and fast rule or a formula per se to work out the valuation. It all boils down to being able to find the right investor and finding a balance by benchmarking against similar companies in the industry.

“You don’t need a whole audience of VCs to agree, you just have to find a like-minded VC. For example, if you want to buy a t-shirt that you think is worth 10 dollars but the seller thinks is worth a 100 dollars, you negotiate,” said Mittal.

“Say for example you run a SaaS company, you tell yourself that once you hit a certain revenue rate, you can trade at multiples of that. So you compare this with similar listed companies; you won’t get the same valuation but it’s something to aspire to,” he said.

“You can benchmark with similar companies in terms of revenue, or, if not revenue, you can compare the rate of how fast you can grow and what market size you can capture”

Idiodi of Merrill said that many companies need to understand what performance benchmarks they should be applying. “For example, you may be an early company where growth is focused on customer growth.” He added that companies need to look at historical trends, the industry and business to understand their value.

Holding your share cap table

One big mistake many founders make at the very early stage is that they issue convertible notes at a really low valuation (in a bid to raise funding quickly). This is bad because as they raise more funding, the loss in the valuation of their companies becomes heavier.

“Hold your share cap table really close, it means a lot as you grow through the funding rounds and you need to address issues such as equity dilution. Even that 0.001 per cent really counts,” said Chun.

Liu said that he has met many founders who gave up too much equity in their early stages. Some of these unfortunate folks’ equity in their own company even drop to a mere 10 per cent when they raise their Series A round.

“If we really like the deal, we will try to help the founder bring back their shareholding from 10 per cent to 30 per cent, but it is a difficult process,” he said.

So how do you increase the founders’ equity?

Liu said the incoming investor will have to persuade current shareholders to allocate more shares to the founders.

“There’s the ESOP (Employee Stock Ownership Plan). For each new funding round, investors will suggest creating a 5 to 10 per cent ESOP pool,” said Liu.

“So in certain situations, we persuade the company to be over-aggressive and create a very large ESOP pool and allocate a large chunk to the core founding team. It takes a lot of effort to persuade existing investors because it is dilutive. But we tell them this is a requirement for new investors because if they don’t they won’t be able to raise the funding,” he said.

“The other way to persuade them to get existing shareholders to sell their shares at lower valuations than the current one. The reason we invest in companies is because of their founders. If their founders do not own a significant equity of the company, then [subsequent] investments won’t come in and the current investors’ shares would not matter much.”

Conclusion

In conclusion, startup founders need to be well-prepared for the due diligence process.

“Understand why investors are interested in you. Seek out your core value propositions and prepare those accordingly. Add other information later. The due diligence process is not just to verify the work that you did, but also for a chance for investors to get to know you better and figure out what business processes can be improved” said Liu.

Also Read: Explore both angel and institutional investors; GrabJobs CEO on fundraising

And finally: Don’t stress out too much.

“You’ve got to breathe. You are in a good place because you have signed a term sheet and an NDA (Non-disclosure agreement), so the investor wants to invest. There is a lot of detailed work to be done but for good reason. They want to prove that your case is factual. The due diligence process is designed to create the best outcome for you and the investor. Be prepared to go for as long as it takes,” said Idiodi.

Disclosure: This article is produced by the e27 content marketing team, sponsored by Merrill Corporation. Click here for more information on the Merrill DataSite.

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