Finding the Cash in Due Diligence

Some companies get showered with financing offers while others end up empty-handed. Do the heavy lifting, be prepared, and get rewarded

by Christine Comaford

Before you can land a loan, an investment, an acquisition offer, or an agreement with an investment banker to take you public, you'll need to prove you have a solid business. This is where the due diligence (DD) process comes in. Despite being ridiculously time-consuming, you have to use it to demonstrate your worthiness—it's simply required if you want to raise cash. But good DD prep enables a company to extract more cash with less dilution. Here's how to make the process work for you.

The DD Mind Game

You are on one side of the table, eager to close the deal. Across from you is the funding source, who has at least as many reasons to nix the deal as to ink it. This is why DD is key. With adequate preparation, you'll be able to simultaneously reduce your source's fear and increase their greed for gain.

First, be open and cooperative, as the funding source will note your reactions—both what you say and your body language (see BusinessWeek.com, 2/7/07, "It's Not Your Mouth That Speaks Volumes")—to their requests for information. Assign one person to be the contact during the DD process. Choose a detail-oriented staffer, such as someone in finance or operations. Do not assign someone from sales or marketing.

Some funding sources will obsess over every area of your business; others will focus only on the potential deal breakers. The entire DD process generally will take three to 12 weeks, depending on the transaction, with the least amount of time for a loan and the most for an acquisition. The process for investments from venture capitalists or angel investors usually lands in the middle of this time frame.

Phase I: Pre-Due Diligence Prep

Before you formally begin the process, the funding source will need the basics: executive summary, business plan, financing pitch (see BusinessWeek.com, 2/20/07, "Make Your Financing Pitch Sizzle"), financial model, and current balance sheet. Next they'll want résumés and contact information for your founding team and key executives, an organizational chart, and customer references. They'll need Social Security numbers because they'll be doing background checks, looking for criminal records, bankruptcies, foreclosures, and any personal or financial trouble patterns that might predict a problem in the future.

Now it's time to understand ownership, so pull out the capitalization table and shareholder roster (Are your shareholders investors? If so, are they accredited or qualified? If the majority are neither, funding sources will be concerned); stock-option grants and vesting schedule (a red flag flies if the source sees that the stock of key executives or founders has mostly been vested—the thinking goes they won't stick around without another grant, which will likely dilute everyone involved); and contact information for directors, shareholders, your attorney, and your accountant. If you're outsourcing Web development, engineering, manufacturing, or any significant aspect of product or service creation, funding sources will want to make sure your company owns all the intellectual property before they dive in further.

Phase II: Scrutinizing Your Business

Let's say you've made it through the preliminary due diligence above. You're developing trust and rapport with the funding source, and the process is moving along nicely. Now it's time for further business details. Have the answers to the following questions handy. Yes, they are in your executive summary and business plan. No, the source may not have read it or retained the info.

1. Who is the customer? Where is the pain or problem? How severe is it? (If your company is a "pleasure play," what is the pain beneath the pleasure? For example, the pain beneath social networking plays is isolation, feeling invisible, not feeling connected to others.)

2.