Funding FAQ: Customer Due Diligence
An endless-part series on the most common questions that I get asked regarding seed stage investment.
A few weeks ago I wrote a post that shed light on the various forms of investor due diligence (DD) and how founders should operate in that stage of the fundraising process. Since then I’ve heard from a lot of founders who struggle with the specific tradeoffs around customer due diligence. This is to be expected and in fact is one of the most common questions I receive from the founders I work with at Entrepreneur First. Customer DD (a.k.a. commercial review) is the most sensitive stage of any due diligence process, so it’s no surprise to see CEOs unsure of what to do when that inevitable email hits their inbox.
While this can feel like an extremely sensitive situation the reality is the optimal path is pretty straightforward. The general rule for fundraising is be selfless with your time but very protective of your customers’.
What is Customer Due Diligence?
In case you’re new to fundraising, customer due diligence is a part of an investor’s review process where a VC (or major angel investor) will verify and validate the commercial elements of your business. Specifically, an investor wants to gauge the strength of your customer relationships and how well your product(s) serves their needs. Focus areas typically include:
- Who buys your product and why they?
- Who is your customer and is that separate to the user?
- Are your customers in love with you for solving a “hair on fire” problem or are they just browsing?
- How much weight does that letter of intent (LOI)/pilot/partnership carry?
- How responsive are you to your customers needs?
- How would they like to see the product evolve over the next 12 months?
Customer DD almost always takes the form of a 15–30 minute phone call and founders are almost never on said call. It’s very rare for a single investor to take more time than this or request a second conversation. The problem is not the time required to do a DD call but rather the volume of requests that you will likely get. At the (pre)seed stage it’s quite likely that you will only have a few customers. Every minute of their time and every exposure they have to your brand is a very precious resource.
Who should get access to your customers?
Potential leads. Anyone else is just noise. Part of the responsibility of any lead investor (Seed, Series A, etc.) is to represent the rest of the shareholders. They should be entrusted to execute a robust due diligence process and assessing all key risks, to the extent possible. If your other investors refuse to acknowledge this you either have:
- A demanding individual which may pose challenges for you later on — bad
- A lead that is not respected by the rest of your investor group — worse
Note: Angels or advisors could be brought in to facilitate customer due diligence on behalf of the lead. This is particularly common in opaque or complex industries like manufacturing, mining or pharma where domain expertise is paramount.
What do I say when asked for customer introductions?
I have been asked this so many times that I’ve saved my response. This is the exact wording that I share with all my EF founders:
“We’re at the early phase of relationship-building with our current company and we’re keen to keep disruption to a minimum and not monopolize their time. Many investors have asked for introductions and we are happy to make those. But we’re going to formalize our customer due diligence process and make those introductions once we’re received a term sheet or if a customer call is the final barrier to one. So I’d like to first ask you, what is your investment process and where are we at right now?”
This is a polite but clear response. It doesn’t refuse the request but it does show that you care value your customer and you are strategic about your business. By inquiring about the investment process, you will quickly gain a much clearer understanding of where you currently stand and what’s ahead. I’ve known some funds to speak with customer after a first meeting and others hold off until a term sheet is imminent. Some funds can make decisions in a matter of weeks. Others take up to six months! It’s also good to reframe the decision around term sheets. This is a polite way to let smaller investors know where they stand in the pecking order, which could give you a little leverage later on. It also casually lets potential leads know that you’re raising a competitive round which can help move things along.
Will I upset anyone?
There is absolutely nothing wrong with pushing back on these requests out of respect for your customers’ time. In fact I’d go so far as to say that any investor who took offense to this response is not someone you should really be working with.
Equally it is completely rational to want to speak with a customer to help get comfortable. Early stage investing is incredibly risky and any piece of market evidence is very valuable. Of course it’s because that data is valuable that you as CEO, need to defend it. The only thing worse than losing a lead investor is also losing a customer in the process.
Thanks to Jon Folland for the help in writing this post.
