Three Things to Watch Out For in Due Diligence
I've written two articles outlining similarities between dating and investing. And guess what? I just discovered another one.
Imagine this for a moment: you meet someone who seems great. You want to jump into a relationship with them.
After a few months of dating, you realize this person isn't actually a great partner. They're narcissistic, or they party way too hard, or they keep flaking on you last minute.
That's when you realize... oh wait. I saw all these red flags months ago! I just didn't pay attention to them.
This happens in investing all the time. Investors see a company that seems promising. They invest a bunch of money and time into the startup.
But within a few months the company starts having all sorts of problems. Problems you could have predicted during the due diligence process, but didn't because you didn't pay attention to the red flags.
Today we're gonna talk about what to watch out for during the due diligence process.
To understand these concepts, I interviewed Aravinda Seshadri, founding partner of Venturous Counsel. Venturous Counsel is a uniquely mission-driven law firm that provides seasoned, practical, actionable and mindful legal advice for startups and investors.
Aravinda is the smartest cookie in the box. Here's what I learned from her.
Red Flag #1: the cap table
Looking at a startup's cap table is a standard step in the due diligence process. And when you see the cap table, you should be able to put it into one of three categories: "Ideal", "Concerning", or "Big Red Flag".
🥳 The "Ideal" cap table is one where pretty much everyone who has been issued equity is actively contributing to the company.
This means employees, contractors, strategic partners, etc. The reason this is ideal is everyone who stands to benefit from an exit is actively working to make the company more valuable.
😕 The "Concerning" cap table is one where ~30-50% of the equity is issued to people who are no longer involved in the company.
This could be a problem for a few reasons.
Since so much of the equity is unavailable, it could be hard to attract new talent.
It also means new investors will get a smaller piece of the pie. And that pie will shrink even more as the company continues to raise.
Lastly, it means incentives are misaligned. The people who stand to benefit the most are not actively supporting the company. And the people who ARE working on the business have less equity than they should, which means they may not be as motivated.
Now, should you automatically decline to invest if the company has a "concerning" cap table? Not necessarily.
But you should do the math on how big an exit the company would need to have in order for you to get a return on your investment. Consider dilution when you do this math.
🚨 The last category is the "Big Red Flag" cap table. This typically happens when you have an ex-co-founder who got booted out of the company, doesn't have any kind of separation documentation, and is out for blood.
Let's say the company was started by two co-founders. Each co-founder owns 30% of the business.
Then the founders start fighting and one of them decides to leave.
The problem is, the co-founders didn't discuss what would happen to their equity in the event of a founder breakup. So the ousted founder walks away with 30% ownership of the company.
The reason this is a "Big Red Flag" is because angry co-founders can lead to time-consuming litigation. Which can destroy company morale. And can can eat up all the money the company just raised.
It is possible for co-founder arguments to get worked out post-breakup. But not only is that rare, it doesn't change the fact that the resolution is hugely distracting and super expensive.
Ok well that was a joyful section. Let's move along.
Red Flag #2: the IP is vulnerable
For most startups, their most valuable asset is their intellectual property, or IP. It's critical that they protect that asset.
The problem is... not all founders are organized enough to remember to have everyone sign a document protecting the IP.
So let's say the founder hires a team of 10 people plus another 10 contractors. Everyone has a hand in creating the product. But only 3 people signed a document stating that their work is owned in-full by the company.
This documentation can be collected retroactively. But the longer it takes for the founder to collect those forms, the harder it will be to do so successfully.
Aravinda's tip: Ask to see documentation that protects the company's IP. And if they don't have it yet, ask them to collect it by a certain date before you invest.
Red Flag #3: bad leadership
This one is harder to suss out if you don't have a relationship with the founder yourself, like if you're investing through an SPV.
But hot damn is it an important one.
See, working for a startup is exhausting. It's long hours, low pay, and moving targets. Keeping A-players motivated and passionate requires strong leadership.
Now, many founders (especially first-time founders) are not inherently good managers from day 1. But they can learn tactics to become good managers.
So what you're looking for in your due diligence process is answers to these questions:
- Is the founder trustworthy?
- Is the founder open to learning from others how to be a great leader?
- Does the founder put her employee's development ahead of her own anxiety and fears?
If you think the answer to any of these questions is "no", it may be worth reconsidering your investment. Because even if the product is amazing and the growth looks good, employee retention can make or break a company.
One way to dig into these questions is to ask to speak to a few other members of the team... ideally early employees and/or other leaders on the team.
The founder may be hesitant to make those intros at first. And a little resistance is normal – after all, anything that breaks focus from the company is a distraction.
But assuming you're only asking for about 15 minutes from one to two people on the team, this shouldn't be a deal breaker.
If the founder is adamant that you don't speak with anyone else on the team... well that might be red flag itself. A founder that barricades her team from her investors is probably doing so to protect herself from something.
Can I even do all this due diligence?
I get it. Most early-stage investors are writing such small checks that they don't feel entitled to ask too many questions.
Especially if it's a hot deal that's already oversubscribed.
You definitely don't want to ask for so much that the founder thinks you're annoying and leaves you off the cap table entirely.
But if you want to avoid these flags, Aravinda recommended language you can use that might make the asks a little less obnoxious.
Don't call it your "due diligence". Instead, tell the founder that you have a few small things on your checklist that you do for all your investments. They won't take long.
By changing the language just a bit, you're reframing expectations and making the whole process seem more reasonable.
And if you're investing in an SPV, you can always ask the syndicate lead about these things instead.
Chief Flag Waver,
PS: Big thanks to Aravinda from Venturous Counsel. She is a brilliant and talented human who does amazing work for her clients. If you're looking for legal representation for your fund or startup, we cannot recommend her strongly enough.