Killing me softly with your Due Diligence – By Deepak Srinath

(This post was originally published on the VC Circle blog on October 14, 2011)

Why does it take so long for a venture deal to close after a term sheet is signed? This is a question entrepreneurs often ask in despair. This interminable state of Due Diligence (DD) kills entrepreneurs and I can’t think of too many reasons an investor would want to drag the process (other than issues with availability of funds).

For those of you who may not be familiar with the Venture Capital investment process, after a termsheet is signed an audit firm and a legal firm are usually appointed to do a financial and legal due diligence on the firm. Sometimes there is a business diligence or a technology diligence added to this, but more often than not the fund does this on their own. Based on the findings of the DD, there may be a renegotiation of the terms (unlikely in early stage firms) and the lawyers then draft the definitive agreements which usually comprise the Share Subscription and Share Holders agreements along with a bunch of other letters, board resolutions, etc.

Every time we sign a termsheet for one our clients, I make it a point to ask the fund how long they expect the Due Diligence (DD) and agreements drafting to take. The standard reply is that if all goes well the deal will close within a couple of months. Every single time, this has proved to be untrue; our experience has been anywhere from 3 to 6 months. Sometimes there are genuine reasons for this, but usually it is a combination of ignorance, incompetence, apathy and ego clashes that cause this wasteful delay.

A few observations on some of these delay factors:

1. Lack of preparedness of the company – It’s easy to pass on the buck to VC’s, auditor or lawyers for dragging the deal; entrepreneurs first need to make sure their own house is in order. Bad or non-existent accounting practices and lack of regulatory compliance are very often the cause to delay.  I’ve heard many entrepreneurs claim they are so busy building the business that they have no time for accounting or compliance issues. All it takes is engaging a good CA firm and keeping your eye on them. If the entrepreneur is using an investment banker, make sure they provide a basic DD checklist in advance and get things in order.

2. Engagement model with audit and legal firms – Audit and legal firms must be engaged on terms that do not give them an incentive for taking forever. The fee for the assignment should preferably be fixed and not hourly billing. Moreover, there must be a show cause and penalty for delays beyond agreed timelines.

3. The fund partner is not driving the process- Sometimes, the senior partner in the VC fund does the deal and leaves it to the junior associates to handle the DD. The juniors are not able to drive the process and exercise control over the firms doing the DD. Partners should stay involved or delegate authority to their juniors and communicate it to the firms doing the DD. This way a fund can influence the DD process and make it move faster.

4. Data checklist relevancy: More often than not DD firms use a standard requisition list of documents irrespective of the target’s sector. Even though it gets clarified during the course of the DD, it always adds a couple of week’s worth of back and forth and mostly redundant work. The fund should make sure that instead of a standard template, a relevant data checklist is sent out.

5. Audit and law firms using inexperienced resources – The DD is not just about gathering data; it requires some judgment calls on what is important and what is not. Inexperienced resources getting stuck on issues that are irrelevant or minor have caused much delay. The fund should make sure that the DD firms they appoint provide adequate supervision of junior resources.

6. Lawyers playing ego games – My lawyer friends won’t like this, but I’ve been in situations where the lawyers representing the fund and the entrepreneur start playing games of one-upmanship and endlessly debating technical terms that have very little impact on the terms of the deal. This is a really tricky situation because even if the fund and the entrepreneurs sense this happening, there is a perceived risk in asking their lawyers to let something pass and move it faster. Nevertheless, funds and entrepreneurs need to be aware of this and discuss it with their lawyers.

7. Simultaneous drafting of definitive agreements – It could be helpful (especially in early stage deals) if the lawyers are instructed to draft the definitive agreements in parallel to the DD. If changes are required based on the DD findings, they can always be incorporated. This can save a few days, instead of waiting for the DD to complete and then start drafting.

8. Lack of trust between the fund and the entrepreneur – In the deals I’ve worked on, when the level of trust has been high between the entrepreneur and the fund, deals have closed much faster. When the entrepreneur goes into a deal wary that he is going to get shafted, every single point is debated endlessly and deals take forever to close. Trust is something that gets built over time and through a lot of intangible actions. I can only urge entrepreneurs not to get into deals where they don’t trust the fund’s intentions completely.

Ideally, all venture deals should close in less than two months. Hopefully, this will become the norm rather than the exception as the VC space becomes more competitive and entrepreneurs more aware.

 

 

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About Deepak
Venture Capital and M&A advisor, Entrepreneur, Startup enthusiast..

2 Responses to Killing me softly with your Due Diligence – By Deepak Srinath

  1. Ravi says:

    Nice post Deepak. Indian (origin) VC’s can be kindhearted sometimes, especially if friends and family are involved. I have personally seen a deal wherein the entire process of TS, DD, SPA, Funds Transfer etc. concluded in less than four weeks, just in time to avoid bankruptcy, and thereby, bailing out a good old buddy of the VC.

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