How investors run their due diligence process on a startup
When due diligence is done, it needs to be done the right way.
There are many tools both startups, as well as funds may use to understand the business better:
- Crunchbase: the Holy Grail of authority (in the eyes of some)
- Owler: the perfect free tool to use to understand the competition
- Linkedin: seems easy, but most fail to use it the right way
- Word of mouth: works well, as long as the referrer is a legitimate one
But there’s another tool many overlook:
If something appears perfect, it usually isn’t.
The reason being that sugarcoating gets you through the door.
Things aren’t always what they seem
There are many ways in which a startup could masquerade its shortcomings:
- Using beautiful graphs which no one really reads
- Telling magnificent stories about the endless possibilities
- Telling about their current repertoire (possible clients/partners)
So, how do investors run their due diligence process on a startup?
- Asking the right questions:
a. “When did you start?”
b. “What is your background?”
c. “What is your annual revenue?”
d. “What is your burn-rate like?”
- Asking for referrals
- Fishing around for authority:
a. Press releases by known magazines
b. Reaching out to mentioned partners
c. Taking a second look at the financials/forecasts
Sometimes, investors hear sweet nothings and are enchanted.
Despite that, failure stories float around like buoys for oncoming ships.
How does an investor avoid them?
Skin in the game
A known question an investor would like to ask is “how devoted are you?”
The answer he/she is looking for is “100%”.
That is when the plot thickens.
Since startups at their first steps generate no-income, the odds of finding all founders working from home and eating ramen is slim-to-none.
There is always one founder, completely devoted to the task, with the others working at some office doing something.
Another option which could be found at the pitch deck stage, is blurred profiles.
The “when we raise funds, this person would join the team”.
That’s a red flag right there.
The reason being that if that person only believes in the startup when it has money to pay him/her, it means that person doesn’t believe in that startup at all.
Unlike team members hired for the job, founders are the dream initiators.
They should be the ones believing in the dream.
If they are only looking for the money, there is no dream.
Financials and burn-rate
Startups like to boast about how much their product is revolutionary.
They speak about how large the market is, how they are going to address it, etc.
One thing they always stumble upon is forecasts.
Their forecasts almost always make no sense.
Founders either speak about “breaking-even” within a year (which seldomly happens), or reach $1.5MM/ARR from being in the red the year prior to it.
They also start stuttering when asked about burn-rates.
Their projection is text-book “12-18 months”, but seem to forget that most startups already raise their next round within 9 months on average.
Because many of them think that investors don’t understand numbers.
Or worse: they show their poor math-skills.
How to never get a second-chance
When an investor hears of a very-low burn-rate, the main question would be:
“Then why aren’t you taking a loan from the bank?”
They may provide ample reasons for why not, none of them has to do with the simple fact that banks don’t lend money to startups.
When asked if the founders ever invested money of their own, they might say the never did and are bootstrapped.
Sometimes, an investor still wonders as to why the ask was so low from the get-go, especially in cases such as Fintech, Biotech and the likes.
They might hear that this is how much it costs to produce a prototype or that they forecast sales within the next 6 months.
But sometimes, when digging inside, an investor may discover the following:
The startup received some form of funding.
Some startups believe that government-grants are not considered fundraising, hence they shouldn’t be listed on the deck.
An investor may hear something ridiculous like “our annual expenses are $50K, which means our ask of $150K would last us 36 months”.
That’s another red flag, since expecting the same expenses 3 years in a row means these people never ran a business or worse: they would burn through that money within 3 months.