Then & Now: No Nonsense Due Diligence

Recap

A few years ago we wrote about due diligence (DD) in the spirit of better communication to entrepreneurs who pitch us at M25, LPs that invest in us, and co-investors who trust us when joining a round alongside us. Though our goal remains the same, our process has evolved from our learnings.

Let’s play “two truths and a lie” to recap some takeaways from our last post.

• Due diligence should be relative to the size, scale and history of the company.
• We have to meet founders in person before investing — no exceptions.
• Our diligence is generally completed in a month or much less.

If you guessed truth, lie, truth — you’d be right! We made several investments without meeting founders in-person before COVID, and the majority of our changes have come in the form of our diligence’s sophistication, not its speed or amount.

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Here’s what we believe‍

1. Our DD isn’t elongating a decision process, but simply confirming (or overturning) the factors behind a decision that was already made. M25 will not offer a term sheet unless we have strong conviction in the potential of the team and business.

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2. Founders should not have to jump through hoops — they are entitled to a transparent, straightforward due diligence process.

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3. LPs deserve high quality due diligence that underscores their GPs’ value as responsible managers of their capital.

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Here’s how we do it

Truly, every deal is unique, but we typically follow this process from a timing perspective.

We’ll complete market sizing and understand the competitive landscape before offering a term sheet and then confirm our findings with the founders during DD. Oftentimes, we’ll explore the product and financials prior to offering a term sheet — this is deal dependent. We play at a pretty early stage, so there aren’t always financials to analyze or a product to demo. We’ve developed qualitative questions that help us determine the team’s product aptitude and use quantitative analysis to understand the financial acumen of the founders. Once we offer a term sheet, we confirm customer sentiment, where appropriate, as well as gain a better understanding of what makes the founders tick (and catch any red flags).

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Internal Analysis

As the name implies, internal analysis is primarily conducted by our team. We often utilize our extensive network of co-investors, industry experts, and founders to enable comprehensive diligence across industry verticals.

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✅ Market Opportunity‍

We conduct bottom up market sizing internally, using data from sites like Statista, The Bureau of Economic Analysis, and Gartner, to name a few.

• We look for big markets ideally with a SAM of $5B+. We dig in to understand the current vs. future market opportunity and provide our feedback to founders.
• Market growth is an important part of our analysis. Of course, we want to see growing segments with the potential for this startup to define a category.

✅ Competitive Landscape

• We establish a position on market sentiment, identify comparables, and define and score the factors we believe are most important to win, amidst the competitive landscape.
• It’s also important to understand how fragmented the space is and the amount of funding in the market, which can sometimes act as a competitive advantage.

✅ Product Analysis

• When a product exists, however early, we go through a demo. While we like to understand the tech stack, current state of the product, and the makeup of the team, our focus is understanding three dimensions: outcome-orientation, repeatability of the software, and to what degree the team embraces product best practices.
• We dig into the North Star Metric / KPI, data intake & the decision-making process, user / buyer personas, and the roadmap too.
• In particular, we gain a full understanding of the current-state product prioritization process, what the priorities are following the capital infusion, and go to market plans.
• Finally, we gauge the need for the product and how much it has PMF or early signs of strong demand.

✅ Financial Review

We review the past six months of monthly P&L and twenty four months of forward looking projections. Where financials exist, we want to know:

• What does revenue retention look like?
• How is revenue recorded?
• What are the unit economics?
• What does the pipeline look like?

Where financials don’t exist, we pressure test the assumptions:

• What do you believe your CAC will be? Why?
• What does your payback period look like? How?
• What sort of LTV will create a viable business? Why?
• What gets you to a 4x CAC to LTV ratio? How?
• Can you spend on growth to support your revenue targets?

Ultimately, we want to understand if our founders will be able to financially support strategic goals. It’s meaningful to understand the cap table and align the team’s and their future teammates’ incentives.

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External Analysis

We conduct external analysis by talking to customers, learning more from people who know the founders professionally, and bringing in our legal counsel to take us from term sheet to final close.

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✅ Customer References

• We like to speak with a couple customers to get a sense of how they like the product and to understand their relationship with the founders.
• If the team sells to a couple different buyer personas, we talk to both — think both sides of a marketplace or SMBs vs. Fortune 500s.
• The structure of these calls is highly dependent on the business model and industry. For example, customer success’ effectiveness can be highly relevant to a B2B SaaS business but not a marketplace business.

✅ Founder References

• We typically talk to two or three references, depending on the number of founders.
• This person can be an old boss, advisor, co-worker, or someone who has known the founder professionally for a couple years.
• We look to learn about their relationship, the founder’s strengths, and potential areas for future growth.

⛔ Team Meeting

• We don’t require a meeting at the founder’s office but absolutely make it a point to have the founders meet most or all of the M25 team, creating a strong relationship from the start!

✅ Legal Review

• The legal review is the last piece of our process. We look at everything from the articles of organization, investment documents, cap tables and any special documents like IP agreements, employee agreements, etc.

Bear in mind, this process is M25-specific. Every investor is unique — we believe in radical candor throughout the process. Our intent is for entrepreneurs to reference this post while working with us and other investors, for our co-investors to get a purview into how we conduct diligence, and for our LPs to better understand how we confirm our investment decisions and act as prudent stewards of their investment in us.

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We’ll leave you with this. Due diligence is not a process where founders are left in the dark with no idea when they’ll come to the light at the end of the tunnel. Rather, it is a process to confirm your investors’ conviction in you that starts, begins, and ends with transparency.

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About the Authors

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Victor Gutwein

Victor grew up in northwestern Indiana before moving to Chicago to study economics at the University of Chicago. Victor has a passionate history with startups, including a vending machine business and kick scooter company, along with being on the board of UChicago’s first student-run venture fund. A Kauffman Fellow (Class 22) and former leader in Hyde Park Angels, Victor founded M25 in 2015 and quickly grew it to become the most active venture firm in the Midwest. Victor lives with his wife and two kids on the South Side of Chicago and loves staying active with running, biking, swimming, backpacking and any team sport you’ll let him join. If he can’t convince you to break a sweat with him though, he’ll usually succeed in getting you to try out a Euro-style board game (like Settlers of Catan) with his friends.

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Luke Skertich

Luke grew up in the Western suburbs of Chicago and earned his Bachelor’s degree in Bioengineering at the University of Illinois at Urbana-Champaign. He developed a keen interest for academic research in undergrad, which laid a solid foundation for his approach to product development in tech. Before coming to M25, Luke found a passion for exciting entrepreneurial ventures. He worked as a Product Manager at three B2B tech start-ups in Chicago, spanning the benefits administration, fintech and human capital management spaces. Luke is actively involved in fundraising and volunteering for Easterseals DuPage & Fox Valley. He is currently an MBA candidate at the University of Chicago Booth School of Business with concentrations in Finance, Entrepreneurship, and Strategic Management. In his free time, he enjoys travelling, science fiction novels, hiking, woodworking, & staying active.