Killing Me Softly With Your Due Diligence

By Deepak Srinath

  • 14 Oct 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 that an investor would want to drag the process (other than issues regarding availability of funds).

For those who may not be familiar with the venture capital investment process, let me tell you that after a term sheet 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 its 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 term sheet for one of 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. But 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 is easy to pass the buck to VCs, auditor or lawyers for dragging the deal. But entrepreneurs first need to make sure that their house is in order. Bad or non-existent accounting practices and lack of regulatory compliance very often cause the delay. I have 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 the service of an investment banker, he should make sure that 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 weeks' 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 which are irrelevant or minor ones 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 have been in situations where the lawyers representing the fund and the entrepreneur start playing games of one-upmanship and endlessly debate technical terms which 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 that such a thing is 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 respective lawyers.

7. Simultaneous drafting of definitive agreements: It can 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 be complete and then start drafting.

8. Lack of trust between the fund and the entrepreneur: In the deals I have worked on, when the level of trust has been high between the entrepreneur and the fund, the 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 become more aware.