The Lack of Due Diligence is Appalling and Foolish

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There has been a disturbing trend I've noticed in early stage investing. That is when there are no professional investors (ie. venture fund) in the round, then I often find that I am the only guy asking for due diligence materials.

To me, this is appalling. How can you know that you're investing in a real company? How do you know what has transpired in the past won't catch up with you later to nip you in your ass? How do you know if you're just transferring your cash into someone's personal bank account?

Fallacies:

1. "If all these prominent individuals are investing, then obviously these guys are legit."

Apparently, in some of the early stage rounds I've encountered even with prominent individuals, I'm still the only guys who asked for due diligence materials. So I guess that statement is only a fallacy when I'm NOT in a round since you can be sure I did ask and review them.

2. "If they came through a prominent organization [ie. Ycombinator, Techstars, TC Disrupt winner, etc.], then they must be legit."

Well, mostly true for some aspects but not others. For example, they may have been incorporated but not had any board meetings, or had their initial founder stock purchase plans created. How do you know there isn't something beyond the basics that is wrong with them?

Still prominent organizations must do some level of due diligence themselves to protect themselves from liability issues later on. But I will tell you that it is by no means complete or as buttoned up as it should be.

3. "If they say they are a DE corp, then everything must be OK."

A lot of guys go to those online instant incorporation services and just pay a few hundred bucks to create a company in DE. After reviewing some of them, they are always barebones docs and may not be complete (ie. Articles of Incorporation are filed and generic By-Laws created, but no further docs created like Board Meeting Minutes or Stock Purchase Plans). There is also no advice given on how many shares to create - for example, it is a better practice to create 10MM or so common stock shares to prepare for the future. This WILL create work and costs to fix later on.

To me, it is imperative that you do your own due diligence. I gather materials on every deal and review them with my lawyer. You never know when you might find something that is wrong with the deal.

Here's an example. I met an entrepreneur who got referred to me by a venture capitalist. I thought that since the venture capitalist was investing, the due diligence would just be customary and there would be no issues. Boy, was I wrong.

First, the entrepreneur didn't want to give me typical due diligence materials. This was strange. Every startup before this gladly handed over the docs. But he didn't. I went through several email exchanges with the entrepreneur to convince him that this was standard procedure that it happens all the time. He kept saying that these were confidential and was happy to hand them over AFTER I put my money in. Finally he relented and was going to send me materials. But all this time, my confidence in this deal was dropping like a rock.

Then the kicker was when we were looking at signing me up as advisor. I saw the consideration and it was 1000 shares. Hmmm, I thought, it's a bit low isn't it? But then I realized that he had only created 1,000,000 shares of common stock in the whole company. Whoa. This was the second red flag - I could see when the next round would come in and then another venture fund would demand cleanup of the corporation and then there would be a tremendous dilution of my advisor options. In reviewing this, we also realized that there were only 1MM shares authorized but they had allocated out 1,111,000 shares, 111K shares over the authorized amount which is not good that they have not gone through the process of authorizing them.

I ended up not investing on the state of the materials I managed to get, and the reluctance of the entrepreneur to give them to me.

And this also when a prominent venture firm had gone into the round too. They had apparently looked at the materials and decided it was worth pursuing despite the issues. But we have to make our own decisions on the information and I decided to decline because these issues had fallen past the threshold that I was willing to stomach in a deal.

If I had not done my own due diligence, I would never have found these things out.

It is fortunate for us working on early stage that due diligence is fairly simple: the startup has not been around long enough to have more complex due diligence. I could not imagine the legions of lawyers poring through an acquisition of a major company by another. Thankfully we don't have to do that here.

Whenever I do a deal, I ask for this list:

1. Articles of Incorporation

2. By-laws

3. Lawyer, law firm contact

4. Stock purchase agreements

5. Current employee list, their occupation/function, and bios if possible.

6. Current investor list, cap table

7. Current advisor list

8. Latest product plan

9. Business plan if any.

10. Your latest pitch deck

11. Financials to date, plus projections

12. Site/product performance to date if any, and projections, ie. # of users, sales, etc.

13. Board and shareholder meeting minutes and written consents, if any? Organizational resolutions?

14. Stock option plans and agreements

15. Office address/location

16. What is your website/product/etc.?

If they don't have it, I ask them to just note that. Basically, this list clearly depicts exactly what I'm buying with my investment dollars.

Remember that buying stock in a company is more than just the guy who showed up with his Powerpoint and demo-ed his product to you. It is an entire operation that encompasses product and people and must follow the laws of the country it's operating in. Unless you ask for due diligence materials, you will never get a clear picture of what you're buying with your money.

And given my experiences, depending on others to check on the legitimacy of what you're buying is foolish. So make sure you do your own due diligence and if you have to, pay a lawyer to help you out.

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About this Entry

This page contains a single entry by DShen published on September 25, 2010 4:19 PM.

What Startups Need Most Of Today was the previous entry in this blog.

Location Biases (or I'm a Silicon Valley/NYC Tech Investing Snob After All) is the next entry in this blog.

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