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Due Diligence Is No Mystery

An investor's perspective on what to expect when seeking venture capital

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When getting funded, the due diligence process can be excruciating for the business. But if you know what to expect, it will be far less painful. Venture capitalist Ziad Abdelnour of Blackhawk Partners recently sent the following letter out to his list explaining their due diligence process in more detail. While each investment group may have its own variations, this offers tremendous insight from an investor's perspective.

If you ask ten funded entrepreneurs what happened during the VC/private equity due diligence process, you will get ten different answers. Some will say they lost valuable months answering endless questions for groups that never produced a term sheet. Others may admit they gained valuable insights to their business.

I am uncertain when the due diligence process gathered so much mystique, but among entrepreneurs, there is still an urban "myth status" about what happens behind close doors.

We believe it shouldn't be a mystery. Understanding due diligence improves the information flow between private equity groups and potential entrepreneurs. Better information leads to better investment decisions and better long term partnerships.

In my opinion, due diligence is:

  • A process designed to get a 360 degree view of the business.
  • An evaluation of an entrepreneurs' ability to ascertain strength AND weakness.
  • An opportunity to validate true customer demand.
  • The beginning foundation of trust and partnership.
Due diligence is NOT:
  • Slow torture in the form of a lengthy checklist.
  • A stress test for the executive team.
  • A chance to prove we are smarter than you are.
  • A justification to ding your valuation.
  • A delay tactic until another fund takes interest.
What You Can Expect

All private equity groups go about due diligence in their own way, but there are a few key areas entrepreneurs should always expect. At Blackhawk, our due diligence process focuses on three primary areas: market, technology and team.

1. Market

A good venture fund can do a lot to help a company, but we can't make customers buy products. Ninety-nine percent of what comes through our doors are nice-to-have products presented by entrepreneurs as must-have.

Customers can't just have a need for your product or service. That need must be important enough to them personally to cut through the 100 other priorities currently occupying their day. Customers buy for personal reasons not just for the good of the company.

Entrepreneurs must challenge their prospects to get to the real truth. After a customer states they have a need for your product, you might probe further: I appreciate your enthusiasm but you must have at least 50 other projects right now. How realistic is it that you would even find time to evaluate our product let alone buy? If your prospect truly must-have your product they will defend their pain. If they don't stand up to the plate, then it will not yield a real customer.

Blackhawk would ask prospective customers the following questions to understand that level of personal pain:

  • How long have you been dealing with this problem?
  • What have you done to date to address this problem?
  • What is the real impact on the organization?
  • Can you quantify this?
  • What happens if you do not fix this?
  • Of your top 10 priorities, where does this fit?
  • How much would they be willing to pay?
  • How important is this to you personally?
We validate these answers with dozens of customer calls. We'll talk to the entrepreneur's reference list (undoubtedly well prepped), but more importantly, we speak with prospective customers, technical leaders and industry contacts where we have prior relationships. No validated pain, no deal.

While this is the foundation of our market assessment, of course every private equity group assesses the opportunity in terms of projected market size and potential competition. The presentation with the proverbial bar chart sloping up and to the right, however, does not impress. We are less interested in Gartner and IDC market predictions than realistic bottoms-up, total addressable market (TAM) analysis based on your target customers.

We often see the obligatory competition slide with the company logo in the upper right hand corner of a standard two-by-two matrix. This is helpful but not sufficient. You must articulate beyond four quadrants your competitive barriers to entry, your unique differentiators and your future competition. The kiss of death is for us to find unanticipated competition you neglect to mention. Know potential entrants cold.

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