Well, one of the many options entrepreneurs have to raise money is to obtain funding from a venture capitalist.
This can happen with either party seeking out the other, but in the end, both parties must sit down and scrutinize the investment opportunity in order to determine its economic viability. This process is calleddue diligence.
Due diligence attempts to separate sound investment opportunities, from risky, unprofitable ones.
How Long Does Due Diligence Take?
This process is bound to pose many, many questions about the nature and mechanics of the business. Due to often staggering amounts of information to be researched and processed; it may take anywhere from a few weeks, to several months.
How Should Entrepreneurs Approach Due Diligence?
Some entrepreneurs may view due diligence as a long-winded, intrusive funding process biased toward people doing business a certain way, but it needn't be seen as so.
Venture capitalists are themselves businessmen and are after the same thing entrepreneurs are: profit. Due diligence is not intended to hinder progress; it is there to help ensure profit for all parties involved.
For any entrepreneur, due diligence provides the opportunity to step into the investor's shoes, take a long critical look at his own business, and ask, "Would I put money in this?" With sound planning, good management, and roots in a growing market, one should be able to answer with a resounding, "Yes."
What Will Venture Capitalists Look at During Due Diligence?
Here are some of the basic criteria venture capitalists consider before conducting further research into a business:
Accounting and projections.
Entrepreneurs are good at creating a concept, but not everyone pays attention to their numbers. Investors, however, will. A lot of attention will be devoted to the accuracy of the entrepreneur's accounting, as well as his interpretation of the figures. They will also look for recent financial records, usually within the past two months, to determine how well the business is currently doing.
Here are the important documents investors review, according to advice by experts David and Laura Gladstone:
- Audited financial statements since inception
- Income statements, balance sheets, cash flow statements
- Records of all changes in equity position
- Accounting methods and practices
- Company-prepared monthly or quarterly statements
- A three-year budget and financial projections
- A complete and current business plan
- Accounts receivable aging and accounts payable aging
- Product or service pricing plans and policies
- Revenue and gross margins by product or service
- Extraordinary income or expense details
- Explanation of any material write-downs or write-offs
- A summary of all bad debt experiences
- Details of any outstanding contingent liabilities
- Accountant report on the company's financial condition
Furthermore, investors will pay attention to the entrepreneur's detailed projections for the near future. Disregarding any speculations, investors will look for sound, relevant, and believable profit margin projections based on current data.
There not only must be solid financial planning, but such profits should be growing over time. Venture capitalists look for a return on investment of at least 25 percent, and some expect to see anywhere from 50 to100 percent return on investment per year.
At some point, venture capitalists expect to get their money back. This is called aliquidity event, which for small businesses, can happen in three ways:
- The business goes public.
- A third party decides to buy the business, settling all its debts.
- The company may buy out the venture capitalist, returning the investment.
There must be an existing demand for the entrepreneur's product or service, preferably one that will expand over time. How many competitors are there in the field already? How established and how well are those competitors doing? Investors will consider these questions. They will then ask how the entrepreneur plans to distinguish his business from his competition.
Apart from the planning and market projections, venture capitalists will also appraise the leadership itself.
As both parties seek to be in partnership, the investor must be able to trust the management will do its job right. They will look for people who are honest, hard-working, strongly motivated, emotionally stable, and experts in their field.
A final set of criteria relates to legal due diligence, usually handled by the venture capitalist's attorney. Management should be able to turn over the key contracts for the business, as well as important employment agreements.
Management documents and other pertinent information include: corporate documents; previous securities issuance; tax status; contracts and agreements; government regulatory documents; management and personnel documents; property and equipments lists; research and development documents; and company internal and external publications.