Due Diligence Data Rooms

Once you have intrigued a potential investor (especially a potential lead investor!), they will want to dig into due diligence on your startup to make sure that you are indeed a solid potential investment. This is where due diligence data rooms come into play.

What is a Due Diligence Data Room?

A due diligence data room is typically an electronic repository of information about your company that investors want to review as part of due diligence. This digital repository can be housed in a variety of places. For example, you might create a Dropbox or Google Drive folder, establish a data room in Carta, use a tool like DocSend or Gust,  or even send materials via email. Each tool has pros and cons, and I will not focus on all those tradeoffs here. Most likely, you will have a tool that you already use that can adapted for this purpose – and often, using something that you are familiar with is quite efficient and effective so long as it can be shared in a controlled manner with potential investors at the right point in the process.

What is the Purpose of a Data Room?

The fundamental purpose of a data room is to provide lots of documentation about your company to potential investors for review. This data is often detailed and confidential, so you do not want to share it publicly or too soon in the potential investment evaluation process, even though it is almost certain to ultimately be required.

Savvy investors will not simply throw money at a startup without evaluating how well that startup is being set up and run. Therefore, not only is a data room a way to share documentary evidence about your startup’s status and progress, but it is also a way to evaluate the sophistication and capabilities of the startup management team. Poor execution during due diligence raises questions in potential investors’ minds about whether they should place their bet on this team.

What to Include in a Data Room?

There is no single set of items to include in a due diligence data room. Instead, it varies based on the stage of the startup and the purpose of the data room in question. At the highest level, data rooms are often assembled for two different audiences, which impacts what is included in the data room(s):

• Data Room About a Startup’s Business: 
  
  First, the potential investing team evaluating the startup as a business will need an investor-focused data room to dive into more details about the startup. Such a data room will likely include more detailed background information on the same topics that you would typically highlight in your pitch deck. For example, details on topics like analysis of the size of the market, evidence that the product works as intended, evidence of the unmet need, insight into the market dynamics, information about the product manufacturing process, background on relevant regulatory issues, intellectual property licenses, and other such information about the core dynamics of the business. This will also likely be the first set of data room information the investors will request.
  
  Note that the emphasis and scope of what is included in a startup’s business data room will vary depending on what stage of development the startup has achieved. A pre-seed or seed-stage startup will likely have a data room highly focused on evidence of the need, potential market size, product development progress, and intellectual property. A Series A, B, or C will concentrate more on demonstrated traction metrics, customer mix, and financial results. The point here is that the focus of business-oriented data rooms evolves as the startup develops, which is one reason that just downloading checklists of what to include may be useful for inspiration but will have to be tailored to both the startup’s stage and progress as well as the lead investor’s areas of greatest interest.
  
  
• Legal Due Diligence Data Room: 
  
  Later in the investing process, the lead investor’s legal team will be called in to conduct legal due diligence. This often requires a startup to set up a “legal due diligence data room,” which will be populated according to a legal due diligence checklist provided by the lead investor’s legal counsel. A legal data room is all about the contracts and other legal documents that make up the life of a corporation. For example, legal due diligence will include a deep dive into the startup’s legal documents, ranging from certificates of incorporation and bylaws to stock option plans and grants to leases to legal documents for past investment rounds to commercial and supplier contracts to NDAs and so on. A legal data room contains a great deal of privileged information, and you will generally want to keep access to it much more limited. For example, you may be asked to provide copies of the employment agreements, invention and disclosure agreements, and consulting agreements for every team member. That is not something you likely want to deliver to every potential small angel investor coming into a round, and it is too much detail for many syndicate partners. The lawyers will be looking for holes in the startup’s structure and legal forms, and they will generate a list of issues and concerns that will be shared with the potential investors for discussion with the startup’s leaders and counsel.
  
  Note that usually and optimally, this work is done only by the lead investor’s counsel, who will evaluate on behalf of the lead investor. Then, the lead investor will share the high-level results of this due diligence with other syndicate investors so that the legal fees for due diligence are only expended once. By the way, the startup will be charged back for those investor legal fees after closing, so you must be fulsome in your response to the legal due diligence checklist because every back and forth will drive up the legal fees you will end up paying. It is also essential to encourage all investors to rely only on the lead investor’s counsel for legal due diligence review and ask that any syndicate members who wish to do their own legal review not bill you back for their legal expenses for such duplicate work.

Tips on How and When to Prepare and Share a Data Room

• To proactively prepare, develop an organized internal data room of information that you are likely to be asked for so that you are ready to respond when a lead investor engages in due diligence. While there certainly are common threads of what investors will be asking about, do not get over-invested in building out a data room based on publically available checklists you find as, ultimately, each investor will have their own due diligence checklist that you need to align with.  
  
  What you can do is prepare in the background so you are ready to tailor your responses to the preferences of the investor in question. Remember that a data room is about persuading an investor, not about being efficient on your side. However, once you have a lead, you can often reuse the data room based on their checklist for follow-on investors.
  
  
• Do not proactively share a data room before it is requested. Investors diving into due diligence (usually a potential lead investor) will typically have their own checklist of what they want. Due diligence is about drilling down into the details and should happen after the potential investor has become intrigued by the overall concept. When a lead investor gets serious, ask for their due diligence checklist so you can tailor what you put in the data room to align with their areas of concern and avoid opening unnecessary cans of worms by oversharing in an area that has not been highlighted. You may likely have to develop some custom answers to specific questions they have in addition to providing already existing documentation.
  
  
• Organize your data room to reflect what the lead investor is asking for. Set up folders to match the categories on your lead investor’s due diligence checklist to make it easy for them to locate the information they are looking for as well as confirm that you have provided what they have asked for. If you can make the diligencing investor’s job easier, it conveys a sense of competence and organization that reflects well on you.
  
  
• Investors (especially VCs) will want to keep copies of some due diligence documents. VCs often need to download information from your data room to provide backup records for their investment analysis, so it is important not to be surprised by that need and to make the process easy and straightforward. This is another reason not to proactively share a data room, although you might have a data room “lite” that you can share more broadly.
  
  
• Maintain your data room throughout the fundraising process. Fundraising is often not a quick process, so you may need to update documents in your data room with the latest information, such as updated financial results and projections, new publications, and other materials as you syndicate your round. The ability to make updates is one of the reasons for using a data room instead of just sending emails.
  
  
• Do not forget to take down and archive your data room once your fundraising round is closed. It can be helpful to reference that information if later questions arise about what was shared, and it can even provide a starting point for a future round data room. However, you should not leave the data room full of confidential information available once you are no longer maintaining it. After closing, let your lead investor know that you will be taking the data room down so they can get what they need.

Data rooms are a vital tool for navigating the due diligence process in fundraising. Being smart and savvy about them can create a good impression on potential investors as you build their confidence towards making an investment.