Due Diligence Framework
Prepare your company like a Boy Scout before hitting the fundraising trail so that nothing slows down or kills your deal
Feld and Mendelson emphasize that huge issues in fundraising can be avoided simply by being prepared before approaching investors. This framework covers both proactive preparation, what founders should do before fundraising begins, and reactive preparation, what investors will look for during their diligence process.
Proactive preparation starts with corporate structure. Any company seeking venture funding must be a C Corporation registered in Delaware. LLCs, S Corps, and other structures must be converted before approaching investors, as VCs cannot invest in pass-through tax entities. The company must be qualified to do business in every state where it operates.
Intellectual property is often what distinguishes a company as a compelling investment opportunity. Founders must demonstrate a clear, documented chain of title for all IP. Every person who has had contact with the company's intellectual property, including employees, contractors, and advisers, must sign agreements with confidentiality and IP assignment provisions. A common source of IP issues is when founders begin working on their new venture while still employed elsewhere, as proprietary information agreements with previous employers can create ownership disputes.
The capitalization table must be accurate and current, showing every person or entity with ownership or rights to company securities. Financial records, budgets, customer lists, and employment agreements should be organized in a data site before fundraising begins. Board and shareholder actions and minutes must be properly documented.
The fundraising materials themselves, including the elevator pitch, executive summary, presentation, and demo, must be clear, concise, and able to stand on their own. Whatever you send a VC is often both your first and last impression. VCs evaluate how well you understand the financial dynamics of your business, not whether your projections are accurate, since 100 percent of startup financial projections are wrong.
During formal diligence after a term sheet is signed, never try to hide anything. If a VC forgets to ask about something early on, assume they will ask before the deal closes. Full disclosure builds trust, and hidden issues that emerge later will permanently damage the relationship.
- Any company that will receive venture funding must be structured as a C Corporation registered in Delaware. VCs cannot invest in pass-through tax entities.
- A clear, documented chain of title for all intellectual property is critical. Venture deals have failed to close because of something as simple as one missing IP assignment agreement.
- Every person who has contact with the company's intellectual property must sign confidentiality and assignment agreements, including employees, contractors, advisers, and founders.
- The only thing known for certain about startup financial projections is that 100 percent of them are wrong. Focus on the assumptions underlying the forecast and the monthly burn rate rather than precise predictions.
- Never try to hide anything during due diligence. Deal with messy issues up front. If you get something past a VC and get funded, it will eventually come out and your relationship will suffer.
- Whatever you send a VC is often both your first and last impression. It must be clear, concise, interesting, and able to stand on its own without a verbal walkthrough.
- Get Corporate Structure RightEnsure the company is a C Corporation registered in Delaware, qualified to do business in every state where it operates. If the company is currently an LLC or other entity, work with counsel to convert before approaching investors. Organize all original corporate documents including the Certificate of Incorporation, Bylaws, and all board and shareholder actions and minutes in a data site.Pro tipUse a simple, inexpensive tool like a Dropbox, Box, Google, or Carta folder as your data site rather than an expensive enterprise-grade solution. The key is organization and ease of sharing, not sophistication.WarningThere is not a single investor who has rejected Delaware as a state of incorporation. Some accept California or New York, but you cannot go wrong with Delaware.
- Lock Down Intellectual PropertyEnsure every person who has had any contact with the company's IP, including founders, employees, contractors, and advisers, has signed appropriate agreements with confidentiality and IP assignment provisions. If a founder started working on the venture while employed elsewhere, get a signed release from the previous employer if possible, or ensure a clean break was made. File any patents or trademarks that are part of your protection strategy.Pro tipAdvisers may express concerns about signing the same IP terms as employees. Work with counsel to craft an agreement the adviser is comfortable with that still leaves no ambiguity about IP ownership.WarningA common and devastating issue is when a former cofounder who left the company never signed an IP assignment agreement. This can derail an entire financing or acquisition.
- Prepare the Cap Table and Financial RecordsCreate and maintain an accurate capitalization table showing every person and entity with ownership or rights to any company securities, including options, warrants, and convertible notes. Organize financial records, budgets, major customer lists, and employment agreements. Review all documents for proper execution, addressing signature issues before they surface during investor diligence.Pro tipIf you do not have a great financially oriented founder, find someone who knows cap tables and venture capital financings to help. This person needs to understand both the math and the structural implications.WarningDo not wait until a VC asks for these documents to organize them. Slow delivery during diligence signals disorganization and can stall the closing process.
- Create Compelling Fundraising MaterialsPrepare at minimum an elevator pitch (one to three paragraphs for email), an executive summary (up to three pages of substantive description), and a presentation (10 to 20 slides). The executive summary should cover the problem you solve, why your product is better, why your team is right, and high-level financial data. If possible, build a prototype or demo, which most VCs respond to more strongly than any document.Pro tipWork hard on the presentation flow and format. Find a designer to make slides visually appealing, especially for consumer-facing products. This effort pays off many times over because form matters a great deal in investor presentations.WarningDo not create materials so complex that you need to talk the investor through them. Whatever you send should be processable alone early in the morning in the darkness of a home office.
- Prepare for Post-Term Sheet DiligenceAfter signing a term sheet, expect the investor's lawyers to request capitalization tables, material customer agreements, employment agreements, board minutes, and more. Have all documents organized for quick delivery. Be fully transparent about any issues. The most likely situation that derails financings is when VCs find unexpected bad facts after signing. A signed term sheet should lead to money in the bank as long as there are no smoking guns.Pro tipDo your own reverse diligence on the VC simultaneously. Ask for introductions to other founders they have backed, including those whose companies did not work out. How the VC handled messy situations reveals their true character.WarningNever try to get something past a VC during diligence. Even if you succeed, it will eventually surface and permanently damage the trust in the relationship.
Feld and Mendelson describe seeing venture deals fail to close because something as simple as one IP assignment agreement was missing. In one scenario, a cofounder who was no longer with the company had never assigned their intellectual property rights. The missing agreement created legal ambiguity about the ownership of core technology, making it impossible for investors to get comfortable with the risk.
A founder began developing their startup idea while still employed at another company. The Proprietary Information and Inventions Agreement they signed with their employer specified that any IP connected with the employer's business belongs to the employer, even IP created on personal time. During investor diligence, this was identified as a major risk since the former employer could claim ownership of the startup's core technology.
This framework emerged from Feld and Mendelson's observation that many promising deals failed or were significantly delayed because of avoidable corporate housekeeping issues. They enlisted their friends at Cooley LLP, where Mendelson once practiced, to help articulate the key preparation steps that would prevent these problems.