During due diligence: how to run an investment due diligence

Session 2: “During DD”

The second part of our Due Diligence series was led by Anna Daviau, Nauta’s CFO, and Xavier Sansó, Founding Partner at Metrix Partners  

As a quick reminder this is part of a three-session webinar to shed light on what a good Due Diligence process should look like and what are the best practices that will help you nail the process for your SaaS startup.  

If you don’t have much time to go through the full webinar video (which is highly recommended), we have prepared a brief summary for you below.

Takeaways from the session 2, “During DD”

How should I run a DD process? How can I optimize my chances for success? Are there best practices that I should be aware of or specific details I should be paying attention to? Indeed, there are, and we have learned them after having participated in many deals and building up on past experiences. In the end success in DD is defined by: (a) your ability to negotiate and close a round, and (b) your ability to run a robust process, which by the way is contingent on having done a good preparation.

But…what is a Due Diligence? On this webinar, by DD we mean all the activities that kick-off immediately after signing a Term Sheet (TS), and that help the investor limit historical risk. Due Diligence is not only an audit, it implies performing some checks and identify issues (financial/legal/tax/tech) that may lead to future cash outs in the company (i.e. fines, tax adjustments, potential lawsuits). This cash out can have an important negative impact on the value of the investment.  

In the session we briefly discussed a large and strategic deal that Metrix advised on: Facebook’s acquisition of PlayGiga, the first acquisition ever of Facebook in Spain. This is a prime example on how to land an investment and how to manage a complex DD process.  

The most important learnings that came out of advising in that transaction, among many others, are the following. When you start a DD there are four main topics that are relevant:  

The importance of having a solid and rigorous process.  

DD is a human-to-human interaction. Communication is key!

It is important to be aware at every moment that the result of the DD should be a final reporting and the closing of the deal. If it takes too long, the DD can be counter-productive.  

DD can be time-consuming and it is expensive, but it should not be considered a waste of time or money. We need to see it as a value-adding effort that the company makes at a very specific moment in time.

Section 1: Process, process, process  

Follow the process and play the game. It is very important to understand the timings the VC has in mind.  

In general, this tends to be the standard timeline:  

1st step (2- 4 weeks): Business Due Diligence and preparation before inviting you to an Investment Committee presentation.  

2nd step (1 week): Investment proposal and Term Sheet (TS) negotiation

3rd step (6 weeks): External Due Diligence, after signing the TS. This step includes:  

Drafting of the final investment agreements, managed by the lawyers, and based on the TS signed.  

External DDs that are run in parallel (Financial / Legal / Tax / Tech)  

4th step: Signing of the Agreements. Congrats you have got your deal closed

If you are wondering what an external DD includes, below follows a brief explanation of each:

Financial DD: Ensuring that the accounting and invoicing processes of the company are correct and scalable. Checking that the historical figures presented during the business DD are accurate.

Legal DD: Checking that cap table is ok, that there are no issues with IP, that customer contracts include standard clauses, that employment agreements are in place and in accordance with regulation, among others. If you are looking for checklists, you have got Cooley’s (for smaller rounds) and Upcounsel’s (for larger rounds)

Tax DD: VAT treatments, transfer pricing analysis, corporate income tax  

Tech DD: This part is very important and useful for founders and tech teams. It includes not only code reviews or basic pen tests, but also sharing product development and tech best practices. Identifying what processes are not scalable and where bottlenecks can appear. It will allow you to iterate and move faster across your software development lifecycle.  

Section 2: Build a relationship. Communication is key!

It is very important to understand that DD is not about checking off tickboxes. It is much more complex than that. You are trying to build a long term relationship with the investor.

Communication is key. Be transparent and sincere with your potential investors.

Bear in mind that the founder is not the only one doing the heavy lifting. Please have empathy and be patient with the other side of the table! The investor also have their own processes, their own journey which they do to help you, and to better understand you.  

Section 3: Focus on closing the deal!

Stick to market standard clauses! Both the founders and the investor will have to give way on specific areas to close an agreement. Once the most important parts are sorted and you are comfortable enough with the deal, move on. You can spend ages negotiating and optimizing a deal, be practical! You have got a business to run.

It is very important that you understand your red lines early on. Negotiate everything in the TS, and agree on as much as you can in that phase. Do not open negotiations later when drafting the agreements. Avoid having the closing delayed!

Prepare the DD in advance, as much as you can. In general the documents required are pretty standard. Your main job consists of gathering everything and being organised. This will send a good message to the investors, because it means you want to close the deal fast.

Section 4: DD will add value to your business.

The process is exhausting and time-consuming but it will give you the chance to talk to top advisors. You will pay for most of this cost, so try to make the most of it and embrace it so that you can tidy up your house as much as possible.

At the end of the process, the external advisors will share their conclusions and results. The investor should help and work with the company to solve and improve all the issues raised (some of which may come as a surprise to you).  

These conclusions can give you external views and opinions that can be very useful to make the company more scalable and fundable in the next phase. Take it as an opportunity to identify the weaknesses of the company and remember that it can create value for the future.  

No company is perfect, there will always be red flags. You have to communicate them and provide actionable measures to fix them (before or after the deal closes).  

DD is not a one-off process. It is a good training for future DD’s. And if done appropriately, they are never a waste of time.  

As a quick reminder, this is part of a three-session webinar to shed light on what a good Due Diligence process should look like and what the best practices that will help you nail the process for your SaaS startup are. You can check out chapter 1 (Before DD) & chapter 3 (After DD) of the Due Diligence Series below.