Due diligence is often a cumbersome, time-consuming process that causes frustration on both sides, but ultimately an effective “DD” process is as important for startups as it is for investors.
In episode 12 of Disrupt Africa’s “The month in VC” podcast series, released in partnership with Katapult Africa, Hlayisani Capital, Atlantica Ventures, and Endeavor South Africa, we caught up with leading Africa-focused investors to discuss due diligence – what it is, why it is important, and how it changes by stage.
One key takeaway was that a good due diligence process can be as important for startups, especially those looking towards future rounds, as it is for venture capital companies. But first thing’s first, what actually is due diligence? Buyer beware, says IK Kanu, founding partner at Atlantica Ventures..
“You have to know what you’re getting into. You have to actually do your job as fund managers, having a duty to your LPs, and duty to the ecosystem too,” he said.
“There are things that maybe the founder has overlooked, because the founder may only know what they know. As fund managers it is up to us to actually do the work, which sometimes founders think is painful, but it’s part of actually building a sustainable company.”
Brett Commaille, partner and co-founder at Hlayisani Capital says it comes down to “red flags” and “green flags” in terms of getting a deal done.
“Every time you are able to change a red flag to a green flag, you are reducing risk, and you are increasing the likelihood of a better return and of a better outcome,” he said.
Ultimately, Commaille says, DD is designed to identify three things.
“First of all, we’re doing the deal because we want to do the deal, and we believe the company is promising, but is there any reason that we shouldn’t do the deal? Second of all, are there things that are red flags? The orange flags would be other things that are a problem for us. But we can remedy these things, and assuming they can be remedied we should still do the deal,” he said. “And then on the green flag side – these are things that are really positive and exciting, and reasons that we should go ahead and take the deal up.”
DD then, is actually a value creation exercise, not just for VCs, but for the company itself.
“So a lot of the companies have built things up over time and they have, especially in the early days, done things that were just in time or just to make things work, and and you may find that the day that you want to sell the company, the first investor comes in, or the first buyer comes in, and looks at the history of your company and looks at like your minutes to realise you didn’t do any corporate governance, or you don’t have minutes, or you don’t have a whole lot of things in place,” Commaille said.
“And they start negotiating down on price because your risk is high, and so for us one of the key things to get right is finding all those areas and making sure that we identify them and can correct them. They could be things like the company has a brand, and at no point have they ever protected it, but they’re trading in different markets, or making sure that there’s corporate governance in place, making sure that the product actually belongs to the company, that it is appropriately licensed.”
So, though DD can be a painful exercise, it can reap dividends, and indeed Commaille says people that take shortcuts at this stage often pay the price later on.
“Very often people want to make very quick decisions and they’re all about speed of transaction, and speed and the potential negligence around the due diligence often comes back to bite them in the end when something comes up that they should have picked up,” he said.
Does the level of DD vary firm by firm, or stage by stage? “Yes”, says Kanu.
“It varies per stage and varies per type of company. So in the earliest stages, the seed or pre-seed stages. You don’t have too much in terms of financials. You will have some traction, so it becomes about getting referrals from customers, looking at comparable companies in other regions, and actually playing with and testing the product,” he said.
“But let’s say we’re looking at a Series A company, where there are more financials, more corporate governance, more history, more traction, and maybe the tech stack has evolved to a certain point, we will then get a lot deeper into the financials, the tax, and trying to understand the legal structures that we should actually be aware of.”
At later-stage, getting a data room is key.
“We try to stress with portfolio companies to have financial reports on a regular basis, and just to get that muscle memory built in there, and to have proper governance, because at the end of the day when it comes down to a Series B or even a Series A-type diligence, those are some of the questions they will be asked, and at least you have some of the baseline documents ready,” Kanu said. “It’s more about collating it and putting it in a data room that really makes it a lot easier.”
DD can happen in a number of ways, depending on the size of VC. It can be fully outsourced, handled fully by an in-house lawyer or larger DD team, says Commaille.
“You get some venture capital companies that have two partners and no other staff, and they will usually outsource a lot of those things to the service provider, who will tackle it on a very specific mandate. People may have in-house lawyers and an in-house accounting team, and a lot of those things then get done by the in-house team,” he said.
Ultimately, though, the key thing is getting to know the founders, the managing team, and the culture of the company.
“You’ve actually got to go and spend time inside the company, see if the CEO and the management team have a good rapport with their staff, or if maybe they’re tyrants. There’s a lot of things that people can sell to you in the pitching meeting, but if you just go and hang out in the company itself you get to see what it’s really like, and how the people talk to each other,” Commaille said.
“The key about due diligence is that it takes time if you want to do it properly. It takes time and that time can make or break your investment decision. You have to allow for the time to actually understand all the aspects of the company, and then you can make an informed decision, and I think investing really is about making informed decisions. It is not about eliminating every risk, but it’s making sure you at least understand it and that you’re comfortable to invest at that level of risk.”
DD doesn’t need to hurt, though.
“We know that founders are busy, because we run a VC fund, and we also have to go through our process of fundraising. So we understand the issues around fundraising and focusing on your business at the same time,” Kanu said.
“So just having all your documents, those basic things in place, company registration documents, cap tables, some of the the meat and potatoes of those different things, make it a lot easier.”
