September 26, 2018 – As an EIR for ITEN one of my responsibilities is to review the requested Due Diligence documents or Deal Rooms created by ITEN companies participating in the Investor Readiness Program- aka Mock Angels. Recently I have had similar conversations with multiple ITEN companies regarding the creation of their Deal Rooms so I figured I would write a post about preparing for Investor Due Diligence by creating a Deal Room.
Some quick background on myself, as the Head Analyst for Tech Coast Angels- San Diego I was responsible for coordinating the Due Diligence document requests and immediate review of all Due Diligence materials for the deals our members were interested in. In my four years with the organization I participated in over 75 initial Due Diligence Meetings, coordinate 15 full Due Diligence efforts which culminated in the creation of 10 Due Diligence Reports which lead to our members investing over $8M in those investment opportunities.
What is Due Diligence?
Due Diligence is a third party, or independent, review of a company and their Due Diligence materials which generally occurs as part of a merger or acquisition process or prior to an investment or IPO. As it relates to companies seeking investment, the Due Diligence process is generally conducted by the Lead Investor and culminates in the creation of a Due Diligence Report or Summary which can be shared with additional prospective investors interested in participating in the round. Conducting a Due Diligence process prior to investing allows the prospective investors to:
- investigate the risk associated with the investment
- confirm their own hypotheses regarding the investment opportunity
- assess the management and determine how they think and develop their strategies
In 2007, Rob Witbank conducted a study- Returns to Angels Investors in Groups, which demonstrated that the median amount of time an Angel Investors spent on Due Diligence is 20 hours with a mean of 60 hours. And that when an Angel Investor spent less than 20 hours on Due Diligence it led to only a 1.1x return but when they spent over 40 hours on Due Diligence it led to a 7.1x return on their investment. The study clearly demonstrates that the more time investors spend on Due Diligence the higher their return on investment will be. As such entrepreneur’s need to be prepared for investors to spend a significant amount of time conducting Due Diligence on their investment opportunity.
What is the purpose of a Deal Room?
Historically “Deal Rooms” were actually rooms. Rooms that held the physical documents (corporate legal documents, financial documents, etc.) for a business’s undergoing a merger, acquisition, major investment, or an IPO. Access to Deal Rooms was limited to those participating in the deal and removing documents was prohibited. In an age where just about all documents are digitized “Deal Rooms” have migrated to the cloud.
If your company is undergoing a merger, acquisition, IPO, or seeking an investment you will likely be asked to set up a virtual Deal Room so that the prospective acquirers or investors have access to the documents they will need to assess the viability of your business.
The most common questions I get regarding setting up Deal Rooms are:
- What are investors looking for while conducting their Due Diligence?
- What should be included in the Deal Room?
- How do I protect the documents in my Deal Room?
The first two are complicated and I’ll address them below but answer to the last one is pretty straightforward…..you can’t. You can certainly control access to your deal room by password protecting it but the reality is that once you have given someone access to your Deal Room there is not much you can do to stop them from downloading its contents and sharing them with others, including your competitors. Thus, you should be far enough along in to any M&A or funding discussion that you have developed enough trust in your acquirers or potential investors before you provide them with access to your Deal Room and Due Diligence documents.
What are investors looking for while conducting their Due Diligence?
The first is that by asking for a broad range of documents related to all aspects of the business it will greatly reduce the amount of time they have to spend conducting Due Diligence on the investment opportunity. Being given direct access to a Deal Room full of company developed Due Diligence Documents allows them to quickly survey all aspects of the company and identify specific areas or concerns they want to dig into deeper prior to making their investment decision. Thus, it is in the company’s best interest to provide as many documents as possible to prospective investors.
The second is that reviewing the provided documents allows a prospective investor to peer inside the head of the management team. And more importantly, the content of the individual documents reveals how the management team thinks and where they place the emphasis of their time and energy. For example, a well-organized and overly comprehensive Deal Room suggests to prospective investors that the management team is hyper-organized. Additionally, when investors request market research data to support the problem, market opportunity, relevance of the solution, etc.- if the company provides a dozen links or so to semi-relevant articles it’s not nearly as impressive as if the company had provided a fully curated list of articles dating back to the inception of the company that are organized by relevance with main points pulled out of the article or the inclusion of a short summary/commentary for each article. The latter shows that the company has been tracking relevant market data for a significant length of time and thus places a high value on monitoring the market and any changes or new trends in their market. While simply providing a list of links could suggest the company did a quick Google search to fulfill the Due Diligence document request, which is not very impressive.
What should be included in a Deal Room?
- Corporate & Deal Structure
- Technology & IP
- Marketing & Sales
You can then sort their documents accordingly. This is a very simple structure/architecture that will allow prospective investors to find the documents they are looking for in a quick and efficient manner. Each folder can be comprised of subfolders and companies should feel free to add an additional folder or two if they relevant to a unique aspect of their business- for example a “regulatory pathway” folder for medical device or diagnostic companies. Below is short list of commonly requested Due Diligence documents for each folder. Keep in mind that not all documents will be relevant for all companies and that due to your market or business model investor may request unique documents to review that are not commonly requested with other investment opportunities.
Corporate & Deal Structure
- Business Plan and Executive Summary
- Board Minutes and Company Bylaws
- Management Team/Founders’ Bios and Organizational Chart
- Updated Cap Table
- Stock Agreements, Debt Agreements, Voting Agreements
- Permits and Licenses
- Employee Agreements
- Consulting Agreements
- Management Agreements
- Stock Option Plan
- Non-Compete Agreements
- Outline of Exit Strategy and Comparable Companies with Recent Exits
Technology & IP
- Patent Documents
- Freedom to Operate Analysis
- Additional Policies to Protect IP
- Functional and Technology Product Specifications
- Technology Specific Documents
- Copies of Primary Research Articles for Life Science Companies
- Appropriate Review Articles (Market or Competing Technologies)
- Documents Associated with Required Regulatory Pathway
- Outline of Advantages Over Competitive Technology
- Trademarks, Trademark Applications or Service Marks
- In-Licensing Agreements
- Out-Licensing Agreements
Marketing & Sales
- Go to Market Plan
- Market Reviews and Research Data
- Recent Press Releases
- Advertising and Marketing Materials Currently Being Used
- Sales Contracts
- Target Customers and Prospects List
- Top 10 Customers with Historical and Projected Revenues
- Pricing Information
- Side by Side Competitive Analysis
- Supply Chain, Manufacturing or Delivery Agreements
- Marketing and Advertising Agreements and Plans
- Prospect Sales Funnel
- Previous Financial Documents
- Income Statements and Balance Sheets
- Audited Financials if Possible
- 5-year Financial Projections (Excel file)
- Including Financial Assumptions
- Breakeven Analysis
- Sensitivity Analysis on Cash Flow Scenarios
- Post Funding Salaries of Management Team
- Previous Tax Filings
- Company Credit Report
- Physical Asset List
- Deeds, Leases, Interests in Real Property
It is important to keep in mind that Due Diligence efforts are highly individualized that can be influenced by numerous factors; the size of the round or check, an investors experience, the number of investors involved, risks associated with the investment opportunity, and thus there is not a one size fits all guide to preparing for an Investors Due Diligence effort. And that ideally the Due Diligence effort should match the capital raise, i.e. the Due Diligence effort for a $250k round should be less complex than a $1M round which in turn should be less complex than a $5M round. And the same goes for the investor check size, i.e. the Due Diligence effort for an investor writing a $10k check should entail less effort for the entrepreneur than the Due Diligence effort for an investor writing a $100k check. Unfortunately for entrepreneurs that is rarely how it works out.