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Due Diligence Checklist for Pre-Seed Companies
One of the most common questions I get is what due diligence looks like for pre-seed companies. Here's a short summary of the key things I focus on for pre-product companies.
One of the most common questions from limited partners, co-investors, and founders is how we think about doing due diligence on pre-seed investments. I’ll be honest - it’s hard to do, and our process evolves with every investment we make. Over time, I’ve come to believe that corporate hygiene is the most important thing we can check on with pre-product, pre-launch companies. We don’t have customers to call, previous years of revenue to audit, or much in the way of historical information to analyze. I’m including a list of the key questions we ask companies before investing to share some insights on what we focus on and hopefully get some new ideas around things we should ask or think about.
Founders and Key People
Most of our diligence focuses on the people who founded and are currently managing the company. We ask all of these questions to every new investment:
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Are any previous founders no longer actively involved with the company?
I always ask this company to understand if any former founders might have equity in the business, think they are entitled to equity in the business or might have left where the circumstances of their departure are unsettled. For me, it’s important to know what the cap table looks like and whether there is work to be done to address any outstanding issues around founder ownership. In several cases, we have had to work to rebalance cap tables when a departed founder still owns a large portion of the business at the early stage.
Is there any member of the founding team who would be unwilling to submit to a background check if requested?
When asked, we have had a few founders disclose things that will likely come up in a background check before investing. As an investor, knowing these things in advance is always better than finding out on your own. Above a certain dollar threshold, we also do a criminal background check on the founders as part of the diligence process, regardless of the answer to this question.
Are the founders subject to any form of equity vesting?
In keeping with the theme of corporate hygiene, this one is a big one for me. I want to make sure that the founders have a vesting schedule in place. We see a decent amount of co-founder turnover between pre-seed and Series A, so having a vesting schedule in place provides a framework for handling founder departures and ensuring that the go-forward team has enough equity in the business.
After addressing some of the core questions around the founders, the next big area of inquiry is how the company’s equity has been allocated. We ask a handful of questions to get more clarity around decisions the founders have made around distributing equity to date, in addition to looking at the cap table:
What is the equity ownership breakdown for the founding team?
One of the first things I like to understand is the equity ownership breakdown for the founding team. We aren’t looking for any specific allocations, but I do think it’s important to understand who owns how much of the company and how that relates to their role and contributions toward building the company.
Is there any entity or individual (accelerator, advisor, partner, or advisor) who owns or will own more than 5% of the company based on their current equity ownership position or promised future equity stake?
I am consistently surprised by the number of companies with an accelerator, advisor, or other person to whom they have made a significant equity commitment. In some cases, there are accelerators or other people close to the business, but not working at the company, who own a meaningful chunk of the company. I feel it’s important to understand how much those people own and why before investing - the cap table will tell you what these entities own, but the narrative of why they have that ownership is also important. In extreme cases, we work with founders to rebalance equity and correct things that we think will get in the way of future financings or otherwise feel unfair.
Are there any advisors or consultants who have pending equity grants? This can include advisory agreements that have not vested, performance-based advisory agreements, or other contingent equity grants.
Similar to the point above, we sometimes find companies who have made promises to advisors contingent on closing a round or securing a new investor. Sometimes there are also individuals who have been recruited to join once the round closes. I like to know about these pending grants to get a complete picture of what the post-closing cap table will look like.
In the world of SAFEs, we want to see the complete cap table.
One challenge with the SAFE is that each SAFE effectively stands alone on its own (unlike a convertible note, where you will get a schedule listing all people who are on the note along with you). In addition to the questions above, we also ask for a cap table that shows all equity and outstanding SAFEs that have been issued, including any that will be part of the round that we are joining or leading.
When it comes to corporate structure, I am looking to make sure the company is as clean and simple as possible. We also collect a handful of documents around corporate formation, but those aren’t worth going into here.
What is the current legal structure for the company?
We want to invest in Delaware C Corporations. Anything other than that complicates things. We make exceptions for Canada, where we understand the benefits of being a Canadian company and some of the associated tax benefits related to doing so. For the most part, anything other than a Delaware C Corporation comes with more complexity and work for us to do.
Is the company currently subject to any litigation, regardless of merit?
It’s rare that pre-seed companies are subject to litigation, but this question is on the list because it has come up in the past. By far, the most common type of litigation that we see in pre-seed and seed-stage companies relates to claims made by former employees or founders. These legal issues are not always show-stoppers, but we do want to assess the risk before proceeding.
Does the company currently have a Board of Directors?
Generally speaking, pre-seed companies don’t have a lot of governance issues that require Board approval or involvement. However, I have found cases where pre-seed companies have expanded the Board to include other people beyond the founding team. In those cases where there are non-founders on the Board, it’s important to understand who they are and why they are on the Board.
Finances and Expenses
Most pre-seed companies don’t have complicated finances, but I do want to make sure we understand how the company has set up its finances and how the invested capital will be used.
Who is your primary banking partner?
We like to know who people use for business banking, as well who they will use as a backup in case they need to move funds.
What is the company’s current cash balance?
This was not something I used to focus on as much as I do today. I often meet companies that are raising money on SAFEs, closing investors as they get commitments. We have had cases where companies have mentioned that investors have closed and funded $500K of a $1 million round. Upon closer inspection, though, that $500K was closed over several months and the amount remaining in the bank is lower as the company has burned some of that cash in the interim.
Are the founders currently taking a salary? What salaries do the founders plan to take after the financing has closed?
We see a wide variance in terms of what people pay themselves, both before and after they close financing. We ask this question because I really do care about this. It’s my view that the company should be able to pay the founders a reasonable salary to meet their basic needs, even at pre-seed. It is far more common that I find founders planning to pay themselves too little than too much. In some cases, it also turns out that company’s runway planning is based on the founders continuing to draw a $0 salary, which is often times not feasible for very long. This is a conversation worth having if I feel the proposed founder compensation feels out of band in either direction.
A Note on Reference Checks
We do reference checks at Precursor, but my view on them has changed over time. I think there are two things that most investor reference checks are trying to answer:
Did this person do the things they said they did at their previous employers and were they good at their job?
Will this person make a successful founder?
We primarily invest in people who are first or second time founders. While I think there is some merit in asking the first question about previous employment and competence, I have found that the second question is a highly problematic one and I have generally stopped putting much weight on it. Many people, including past managers and colleagues, are not good at predicting which of their former colleagues have what it takes to become a great founder. I have found one notable exception; when the founder we are evaluating reported directly to the founder and CEO of the company, I do put slightly more weight on that person’s assessment of the prospective founder’s fitness and readiness to become a great founder. We have backed a number of very successful founders where their previous managers and co-workers did not have any sense for the latent entrepreneurial capacity that person possessed.
If you have any other good due diligence questions that you ask of pre-seed founders or have been asked as a founder, please share them!
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