Introduction

Commercial due diligence for venture rounds is typically conducted as a joint effort between the investors themselves and individuals from their network. Some funds have specific advisory boards or networks dedicated to this purpose – comprised of individuals with specific, sector expertise that they can call upon.

Occasionally, funds may also wish to formally appoint a consultant, possibly an individual or a firm, to conduct a more formal exercise. This may be applicable in the case of larger rounds, more complex businesses or a novel market.

What is commercial due diligence?

Commercial due diligence (also referred to as CDD) is the diligence stream that focuses on the commercial elements surrounding a company, in particular – the market in which it operates, it’s positioning within that market, for example, in relation to competitors, the strength of the product or service and the customers it currently serves.

The objective for investors is to verify the legitimacy, strength and potential of the product or service and thus bring confidence in the future growth prospects and value generation of the business.

What is the process?

Investors will begin assessing the commerciality of the product or service from the initial meeting. Unlike financial and legal due diligence, the scope of commercial due diligence is more variable and tailored to each individual business. It is not usually organised into a specific scope and may comprise a number of different activities and workstreams.

In practice, it may comprise:

• Discussions with industry experts (either privately between the investor and the expert, and/or between you and the expert)
• Customer referencing
• A review of market reports and statistics
• A demo or trial of your product
• Discussions with existing portfolio companies in a similar space

Common scope areas

Market outlook

Areas of interest:

• The principal characteristics of the target market, for example, what it comprises, where the boundaries are defined (for the current product and as the company grows), what the target demographic is, which geographies it encompasses or could encompass, and how large the market is.
• Drivers of growth in the market, historic rate of growth and forecasts.
• Specific market headwinds and risks, how they are impacting the market and how they are, or may, impact the business or competitors. These may include any relevant regulatory constraints, trends in pricing and costs that could impact margin.

A large addressable market that is growing is an important feature for venture investors.

Positioning within the market and competition

Areas of interest:

• Who are the key players within the market and which are the company’s key competitors
• How and why the business is differentiated from these competitors and how it is positioned to compete

There is arguably some fatigue among investors of the top-right-quadrant graph, which plots competitors on two axes and features the company in the top right. It is difficult to be explicit about the nuance of how the business is differentiated through a graph such as this. This could be used to set the scene, while a table that lists the more detailed features of competitor’s offerings, alongside your own, may be more helpful in answering the question of why and how you are different.

How compelling the company’s product or service is

This is assessed through a trial or demo of the product, and usually discussions with certain customers.

Areas of interest:

• What are the most compelling elements of the product or service?
• How “upset” would customers be if the product or service was withdrawn – can they manage without it?
• What is the customer acquisition rate, conversion rate and churn rate?
• What are the key selling messages and to what extent are they resonating with customers?
• What are the key reasons for churn and which aspects make customer losses unlikely or infrequent?
• How streamlined is the technology / customer experience and where are the quirks?
• What are the key areas for further development and improvement?
• What is the longevity of the product or service?
• How good is customer service?

Quality of the business model

There is some overlap here with financial due diligence, but the objective is to understand the legitimacy of the business model, either in generating a profit or equity value. From a commercial perspective, areas of interest are as follows:

• Is the revenue model / pricing appropriate, could it be improved?
• What is the potential for further revenue streams or price inflation?
• What is the cost of customer acquisition?
• What other costs are required to generate and service revenue?
• To what extent is revenue recurring and predictable?
• What are the other drivers of value, such as data and customer relationships, and how may they contribute to return on investment if not through profit?

Checklist of items to prepare for commercial due diligence

• Relevant and recent market reports
• Customer testimonials, either in written form or the contact details of customers that would be willing to speak directly with potential investors
• Competitor table
• An illustration and / or commentary on the business model
• Walk-through demo, site visit or products to try
• Statistics representing the key KPIs for the business, which are not necessarily financial in nature, for example: cost of customer acquisition, customer concentration, churn rate, user uptake

Introduction

Legal due diligence for venture rounds is typically conducted by the investor’s legal advisors, i.e. the firm that is also preparing the investment documentation.

Depending on the complexity and extent of the scope, you may choose to answer the questions yourself, or you may ask your legal advisors to do this on your behalf.

What is legal due diligence?

Legal due diligence (also referred to as LDD) is the diligence stream that focuses on your contracts and agreements. Investors are keen to ensure that your business is operating with the appropriate agreements, protections and processes in place.

What is the process?

The investor’s appointed law firm will typically issue a questionnaire with a series of information requests and questions. You and your appointed law firm (if applicable) will then provide the answers and supporting information and there may be some discussion back and forth to clarify certain items.
This exercise will usually result in the investor’s lawyers preparing a short legal due diligence report, summarising the responses, their views on them, any key risks or matters that should be dealt with prior to completion of the transaction.

You may be asked to provide a warranty over the accuracy of the contents of the legal due diligence report.

The scope of legal due diligence

Exactly what is included within an LDD scope will vary between investors; however, there are a number of core areas that most investors will review.

Corporate

This involves confirming the current ownership of the company’s equity and corporate structure. The investor’s law firm will run a search of Companies House for each corporate entity (limited company or otherwise) and review the latest annual returns to confirm the accuracy of the share cap table.

It is worth ensuring the company’s annual return is up to date and any subsequent changes in the equity capital have been documented in the company’s statutory book as appropriate.

Employment

This entails confirmation of the employment status of key members of the team (and in some instances, all members of the team).

Investors or their appointed law firm will ask for copies of service agreements (also referred to as service contracts or employment contracts) so that they can review the terms and check their suitability. Areas of interest include:

• Notice periods – are these too long?
• Restrictive covenants – are these set appropriately in order to protect the company?
• Salary – are these set appropriately to sufficiently incentivise while not being inflated. These will be considered alongside the equity stake of the individual, for example, a founder with a significant equity stake or a team member with options may be content with a lower salary.

If you do not have a service agreement, you will need to put one in place as part of the transaction. Before having this drafted, you may want to ask your investor if they have a template that they prefer to use.

Investors will also ask for details of any other incentive schemes in place, such as bonus arrangements or option schemes.

Finally, they will ask if there are any outstanding or unresolved disputes with employees or former employees.

Contracts

If part of the scope, this involves a review of any key contracts, for example, customer contracts, supplier contracts and / or leases.

This helps investors to understand:

• The quality of contracted earnings, i.e. how secure they are and how easy it is for customers to terminate.
• If there are any onerous clauses that could pose a risk to the company.
• If the company has provided any indemnities against certain losses

Customer, supplier and financing contracts can sometimes include “change of ownership” clauses, which require that the relevant party is notified of any change of ownership or control of the business. In some cases, this clause may also require that the other party consents to any change of ownership prior to completion. Even a minority equity investment can sometimes be considered a change of ownership and therefore it is a good idea to do a quick search of any key contracts for these clauses and notify the relevant parties before completion of the deal.

Intellectual Property

Investors will want to ensure that all IP is owned by the business and not by individuals or employees. They will also review what, if any, arrangements you have in place to protect your IP, such as patents.

Health and Safety

Among other sectors, health and safety is of particular importance to businesses operating within construction, engineering, food production, manufacturing and leisure. An investor may ask to review your health and safety policy to ensure that you take these responsibilities seriously.

Insurance

Investors may wish to review the company’s insurance policies to ensure that there is appropriate cover in place.

Anti-bribery

Investors may wish to discuss your approach to preventing and reporting bribery and may review your anti-bribery policy, if you have one.

Checklist of items to prepare for legal due diligence

• Corporate structure organisation chart – if the company comprises more than one entity, listing the ownership and the statutory directors of each entity.
• Share cap table
• Key customer contracts (signed and dated)
• Standard terms of business
• Key supplier contracts (signed and dated)
• Leases (signed and dated)
• Employment contracts or service agreements for key members of the team
• Health and safety policy (if applicable)
• Anti-bribery policy (if applicable)
• Staff handbook or any other company manuals

Introduction

Equity investment is all about partnering with people. Understanding how you and your team operate is important to potential investors.

From your first interaction, they will be assessing you, your approach, your ability to deliver your plan, how you work with others, how well you listen and consult and where you might need extra support.
For obvious reasons, perceived weaknesses in the founders or management team is rarely given as a reason for decline; however, it is a very common reason in practice. It is therefore important to maintain a pragmatic approach throughout the deal process – highlight your strengths, be realistic, be open about your weaknesses and areas for improvement, be thoughtful and reasonable in your negotiation and be patient with the rounds of questions and diligence.

It’s also important that, throughout the deal process, you are able to assess how well you work with your potential investors so that you can be confident their investment will result in a good and workable strategic partnership.

What are investors assessing?

Investors will be seeking to gain an understanding of:

• The individual skillset, strengths and weaknesses of the management team
• Ability and willingness to listen, collaborate and respond to challenges
• Appetite for risk and level of ambition
• How effectively you operate as a team
• Any tensions or issues between individual team members
• Areas of weakness that require additional investment or resource
• Personal ambitions and how these relate to the business, for example, in achieving personal wealth

On a more serious note, they will also run basic background checks on criminal convictions, director disqualifications or PR issues. It’s best to be up front about anything that would likely cause concern.

A note on ambition – there is a lot of conflicting advice around on how “ambitious” founders should be in their approach. This is partly because investors have a varying appetite for risk. It’s helpful to possess and portray a certain level of ambition and resilience to convey the confidence you have in your product or service, but ensure that this level of ambition is credible and is backed up by realistic and achievable forecasts for the business.

How investors make their assessment

There are a variety of means for assessing individuals and the team dynamic, some more formal than others:

Spending time together

When you're trying to juggle running your business as well as a fundraise, it can be difficult to remember to spend time building this relationship. If time is tight, this can be done in part through making due diligence sessions face to face. It sounds obvious but it is fundamental and often missed - make time to invest in getting to know your investor.

Referencing

Investors may ask you to provide references – usually at least one personal and one professional.

Questionnaires

You may be asked to complete a questionnaire that covers any historic convictions, directorships, alternative income or activities etc. which you may be asked to warrant at completion.

Psychometric testing

You may be asked to complete a psychometric test.

Consultants

An investor may formally engage a specialist consultant to spend time with you and the team and provide an assessment. Alternatively, they may introduce an individual from their network or portfolio to do the same on a more informal basis.

Common areas of weakness

Below are a few of the more common areas of weakness identified by venture investors.

Lack of clarity in roles or imbalance between the founders

It can be difficult to clearly define roles in a business that is evolving very quickly, and hence this issue is common in high growth, early stage businesses.

Ways to mitigate this

• In the instance of co-founders, have clearly defined scopes for each founder
• Have a clear CEO
• Put in place reporting lines and objectives for team members
• If the dynamic isn’t working, make changes

Limited prior experience of growing a successful business

Investors tend to favour entrepreneurs that have done it before, i.e. successfully grown and sold a business. If this is the case then highlight it, if not, it can be helpful to demonstrate track record within a relevant industry and related successes.

The need for a finance lead or finance director

It is very common for early stage, high growth businesses to lack support in finance and reporting. With new external investment and shareholder reporting, the need for support in the finance function will increase. If you intend to appoint a head of finance or a finance director, or your investor requires that you do, either as part of the process or post completion.

Misalignment in approach or personality

This can manifest in a number of different ways and is not easy to mitigate – if there is a fundamental misalignment of approach, then the partnership is unlikely to be successful.

A strong team dynamic is the best way to overcome this, if it becomes an issue in securing investment. A particularly driven and ambitious CEO, with the capacity to listen, alongside a more prudent operations or finance lead, may present a successful combination, while one of these individuals acting alone may not be considered investable.