“Our due diligence process is a little different from most funds,” might be the way the conversation starts. Allow the hair on the back of your neck to stand-up, as it’s the correct autonomic response.
The investor may go on to inform you that they need to pay to develop a financial model for your company, analyze the market opportunity, and conduct a legal review if you have any existing patents, contracts, or licenses. This work costs money, right? And you have been working so hard to find an investor, so spending some money to confirm your own opinions about your business might seem to make sense.
A reputable venture capital fund will conduct all due diligence at their own expenses if they decide to present a term sheet to your company. If you are asked for a due diligence fee before receiving a term sheet, that is a GIANT red flag. How do I know? It happened to my start-up, and it nearly caused my company to fail.
Here’s how it went down.
My company had been around for 7 years. We had launched a product, developed a follow-on product pipeline, and the sales revenue from our first product was growing. We were closing in on being break-even, and we had lived off of only angel investments up to that point. Our expansion plans required growth capital.
We identified potential new investors. You name an investor type, and we spoke to them. Like any typical company, we kissed a lot of frogs, and had our time wasted on pointless phone calls and meetings more times that we can count.
Then it happened. We met a “venture fund” at an investment conference, and their business development contact liked our business model. Their scout had been sent to the conference to find “deal flow.” Our company was making a difference in the lives of our customers, and we had a promising upside for investors. The road is long trying to find an investor, and we had numerous bad experiences, so we felt refreshed knowing that someone wanted to learn more.
Soon after some initial pitches with lower level team members, the VC’s managing director requested a meeting with our management team. We had first spoken with the analyst responsible for our market focus, and she recommended we meet with her boss.
As we spoke with the managing director, our team believed we were going to secure a term sheet. We had nailed it! And then the managing partner sprung the trap. “Here’s how we work. We have to pay for finance experts, market analysis, legal review — and that typically requires an investment of $14,000 in up front expenses for the fund. Our policy is to have companies pay that money in advance and once the due diligence process is complete, we issue you a term sheet, and then develop the stock purchase and voting agreements.”
We called references. They checked out.
Other companies in similar business, and related markets, were past the term sheet stage, and working on completing the legal agreements to close the investment. The up front payment seemed odd, but we received positive feedback from other companies who were advancing through the fund’s process. The managing partner told our management that we were the last company selected to enter the due diligence, and since the fund was new, they had not closed an investment yet.
We made a decision to pay the fee.
At first, the process went along fine. We received a valuation model, based on a market analysis. We followed a due diligence checklist, and we received a draft term sheet. All the first due diligence steps were rapidly completed, and we moved into the legal document preparation phase.
Our lawyers got involved and prepared documents. The fund’s attorneys did not make their presence known. All communication went through the managing director. Our deal was complicated because we had already raised a substantial investment in a Seed Round, and we had notes that were converting into the new round. We required a 3-way negotiation on the voting agreement.
“Red-lined” legal documents were exchanged, and yet there was still no evidence of any attorney representing the fund. The deal was essentially done. From start to finish the process took about 4 months to get to “final” documents.
And that is when the fund’s excuses and the delay tactics started. The managing partner supposedly traveled to Europe and had to cancel an investment committee meeting intended for final sign off and then funding. Then we were told the “limited partners” found some items they wanted to change in the voting agreement. Nothing they proposed was onerous, but with every change came a 2-week delay in the process because the investment committee met every other week. We started the process in February, and we had reached mid-October. Nearly double the time it takes to close a typical deal once document preparation begins.
Our outside corporate counsel started to suspect foul play.
The managing partner made more excuses. “One of our limited partners is out of the country.” Both our attorney and our investors were getting worried that closing the deal was never going to happen. We made a decision to contact other companies who had started the process before we did (yes, those same references we had checked months before) to see if they had closed and what to expect. No one had closed! We identified 7 other companies who didn’t close with the fund after going through the entire process, just as we had. Every company was informed that “funds would be released over the next few weeks.” To our knowledge no company ever closed…as each company either slid into failure waiting on funds that were never coming, or found other sources and simply walked away. We heard later that one company filed legal action and pressed criminal charges against the fund in the fund’s home state.
During our follow-up with the other companies who were duped by the fund, we discovered that all our company names were included on the fund’s website, with a statement that the fund had made an investment. This was not true, but the fund was making this statement to attract more companies to their deal flow, and make them comfortable paying the up front due diligence fee.
We reported the fund to the FBI and the SEC.
Despite the fund committing fraud against many companies, across numerous states, the FBI stated the issue was a state matter since no federal statute covers this category of crime. We were too far away to bother with this approach, as we did not want to make a career of fighting against a fraudulent venture firm. The FBI agent we spoke with also felt the SEC would also take no action since the investment had not closed. Essentially, all the companies had no recourse. So founders must be careful from the outset.
In the end, our company survived, but we look upon the situation as a lesson learned. We will never again pay an upfront fee for due diligence, nor will we pay retainers for anything related to capital raises. Too many people offer effort and fail to show results. That is never a good use of precious funds.
Action Steps for Founders.
- Although the situation where a fund may ask you to pay a due diligence fee is rare, you should never be afraid to dig into the fund on your own. You have a right to know more information. Ask as many questions as you need to.
- Check the fund’s history on a reputable database. If the fund is new, be extra careful.
- If a fund asks for an up front fee for due diligence, run away and never look back. They are purporting to be a fund, but it’s a scam.
- When negotiating the legal agreements, set-up a call between your attorney and the fund’s attorney to make an introduction. You have a right to know who their counsel is.
- Ask the managing partner about the mechanism for funding. Are the funds committed, or do they have a pledge fund? If they have a pledge fund, every LP can invest, or not, on a deal-by deal-basis. That means you might go through the entire process and never close, like my company did. In our case the fund would not disclose if they were a pledge fund when we asked. Lack of transparency is a red flag.
- Ask specific questions. If you get vague answers, or a lack of commitment to timing, or process, your company is taking a risk. Do not spend money on mounting legal fees without specifics, and a high confidence you will close on funding.