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In the world of startups, the term “due diligence” refers to an audit of a company that’s performed in order to discover possible business liabilities or deficiencies in light of a planned business transaction, such as a merger or an investment.
Due diligence offers a systematic way for venture capital firms to analyze and vet startups in order to mitigate uncertainties and risks before they decide to invest in them.
During the due diligence process, a startup’s management team must exhibit complete transparency, since any discrepancies discovered may jeopardize the deal. This entails being open about pending lawsuits, patent disputes, disgruntled employees, or business mistakes in hopes of establishing trust between the company and its potential investors and making the VC funding process smoother and faster.
Keep in mind that investors won’t simply rely on the information that your team provides them. They will perform external and independent checks that may include interviewing former and current employees and partners or even reaching out to customers to get feedback on your product and experiences with your company.
Due diligence can be an exhausting and time-consuming process, which is why founders must be well prepared and able to dedicate adequate time and resources to ensure that the process is a smooth one, as a failed due diligence process can significantly devalue a startup.
When Is Due Diligence Carried Out?
The process starts once the term sheet is agreed upon between the startup and the investor. At that point, the investor will send over a venture capital due diligence request list. This will let you know what documents they’ll need and what information and access you should provide.
Due diligence is typically a lengthy process. If you have all the documents prepared, it could take weeks. If you need to compile key documents or explain certain irregularities in the information you provided, it could take months.
What VCs Will Look At When Carrying Out Due Diligence
Investors will strive to be as thorough as possible in their analysis and leave no stone unturned in their search for potential liabilities. However, to complete the due diligence process promptly, they’ll have to focus their efforts on a few crucial segments of the company.
Broadly speaking, there are six key areas investors most commonly scrutinize:
Venture capital firms, especially those looking to invest in early-stage startups, will put the founder’s and management team’s backgrounds under a microscope. For many investors, who they are investing in is just as crucial a component of why they’re interested in a startup as the product or service itself. After all, funding isn’t just about money and valuations, it’s a business partnership.
The human element is a crucial cornerstone of successful collaboration and VCs will typically want to work with someone who they believe to be the right fit in terms of both vision and personality. Even if the valuation, financials, and product are just right, the VC might pull out of the deal if they identify red flags in the startup’s past that don’t sit well with them.
For investors, the past financial performance of your company is the best indicator of future performance, more so than your forecasts and predictions. They’ll want to take a deep dive into your financial statements, scrutinize any debt you have accrued, and check your agreements with existing partners and investors. A history of bad deals, unreasonable burn, or unwise debt could jeopardize your funding.
Keep in mind that you’ll be asked to provide complete financial records during the due diligence process. Here’s a list of documents that investors will likely want to see:
- All approved financial statements
- Your latest available financial statements
- Annual tax statement extracts from the register on floating charges
- Annual balance sheets and the latest available balance sheets
- Your profit & loss statements
- Your annual budget, including a full breakdown of your expenses and salaries
It can be complicated for early-stage startups to prepare this documentation, especially if they’re outsourcing their Chief Financial Officer (CFO) role or haven’t appointed one yet. This is why it’s a good idea to start preparing the paperwork before the due diligence process begins; practically as soon as you start thinking about raising capital.
Traditional businesses typically gain a competitive advantage through pricing, market position, and scale of operations. On the other hand, startups are valuable because of their potential to disrupt traditional industries with innovation. This focus on innovation means that a startup’s product and how groundbreaking it could be is why investors show so much interest in the startup ecosystem.
Expect interested VCs to take a deep look into how your product works, how it is manufactured or developed, and how you plan to get it to your consumers.
Additionally, investors will want to know that you actually own the rights to your product or service. They’ll look into your patents and intellectual property ownership. Intellectual property litigation or disputes will be a red flag for most institutional investors. No one wants to become embroiled in an IP lawsuit, as they are almost always long, complex, and costly. If you do have IP issues, it’s best to be upfront during the due diligence process and make all the patent and legal documentation easily accessible.
When conducting the due diligence process, investors won’t just look at your business. They’ll also be interested in the viability of the market you’re entering and your overall position in it.
They’ll probably ask for reliable information on how large that market is and how much of it you’ll be able to capture. Not only will they ask for this information, they’ll probably perform additional research on their own as well.
If they decide that there’s not enough room for growth due to a small potential consumer base or the fact that your product isn’t the right market fit, they may back out of the deal.
Startups often have complicated ownership structures. Multiple co-founders, angels, and early-stage investors may all have equity. Additionally, deals made with them may have certain stipulations that will affect how the startup is viewed in the current stage of funding.
This is why any deals between the company and previous investors will be carefully scrutinized during the due diligence process. Investors will place a special emphasis on debt, the share structure, and other contractual stipulations.
Investors vary in their risk appetite. Some may be willing to invest in risky ventures if the potential reward is considerable. Others may be warier and only invest in businesses they feel will be sure-fire successes. However, both types of investors will value companies that have a mature plan to deal with potential risks should they arise.
Most venture capital funding contracts will stipulate that a directors and officers insurance policy must be purchased within 90 days of securing funding. D&O will protect the company’s management team from claims of mismanagement that could arise from their business decisions. If such a claim is brought forward, directors and officers could be held personally liable. Investors will expect a seat on your startup’s board of directors and they’ll want to know that their personal assets are protected in all cases.
We’ve put together a short video that explains which policies are absolutely vital for any startup that is interested in raising a round of funding, check it out:
While other types of insurance will not be considered a requirement, having a solid coverage plan could protect the company from the costliest and most likely risks. Transferring the risk of property damage, employment risks, cybercrime, and professional errors to the insurer through insurance will send a strong message to investors that your company is ready to handle all eventualities.
Common Issues That Can Arise During the Due Diligence Process
Keep in mind that each of these areas that will be investigated could make or break the deal.
Your startup could be in a fantastic position to corner a market and might have incredible momentum, but if the investor doesn’t feel good about one aspect of your business (regardless of its supposed importance in the grand scheme of things), the deal could be called off.
Remember, these are deals that are worth millions of dollars. And there are thousands of startups looking to receive funding from VCs, who typically only fund a handful of companies each year.
If the investor doesn’t feel 100% confident in your startup, they probably won’t move ahead with the funding. Let’s take a look at what red flags may crop up during the due diligence process and how you could address them before it starts.
Contracts/Agreements: All employees and founders should have legally binding, standardized agreements in place. Young companies may function in a less clear-cut fashion, relying on handshake agreements or insufficient contracts. This will be a concern for investors, who typically want to have everything in writing, clearly outlining the agreed compensation, equity, and duties of employees, founders, and investors.
IP Trouble: Does your startup have full control over its intellectual property, code, branding, and relevant domains? Sometimes licensing can be complicated and IP agreements may not offer full, unimpeded IP ownership. They may have limits on how IP can be used, transferred, or could simply not offer sufficient protection. If this is the case, your startup will need to attempt to resolve these issues, either in or out of court. Of all the possible problems that can be encountered during the due diligence process, IP issues are typically the most time-consuming and difficult to resolve.
Lack of Verifiable Documentation: It’s important to make sure that all crucial factors that determine the company’s value and growth are recorded and verifiable. Sometimes startups don’t have an efficient record-keeping system or may not have ready access to their patents, partnership agreements, or full financials. Creating a data system and storing all important documents should be a priority for startups. Having all the necessary files on hand will make the due diligence process smoother and may even help attract investors in the courtship stage.
Lack of Resources: It can be hard to allocate the time and resources needed for due diligence. It’s often perceived as a boring, burdensome process that needs to be prioritized to the detriment of more important matters. To reduce the chances of the due diligence process needlessly dragging and having any negative effects on your workforce, it’s important to keep your team engaged and involved. It may seem like you’re alone in the whole process, and it can be hard to rely on others. Keeping your team informed and helping them understand how the process works and why certain steps need to be taken will allow you to delegate and increase the efficiency of your responses to the demands of due diligence.
Potential Benefits Of Due Diligence For Startups
Even though due diligence is typically carried out by investors to limit their risk, it can also offer huge benefits for the startup being audited. Due diligence will offer an impartial and detailed assessment of where the company is at and will give the startup a good breakdown of its strengths and weaknesses.
Sometimes, early-stage startups won’t have sufficient business plans or may have burn-rate and cash flow plans that are too ambitious. Due diligence can point your attention to those types of issues and also uncover unexpected risks or product misalignments that you might not have been aware of previously.
Spotting a critical flaw in your business that you’ll need to address isn’t pleasant but can be extremely beneficial for the future of your business. Most investors are extremely experienced and well-versed in the process of building and growing a startup and will not only be able to point out what your startup deficiencies are but how you can address them.
Due diligence for startups may seem like an intimidating prospect. However, it’s important to keep in mind that it’s a normal and even essential part of any venture capital deal. It’s a process in which you should be looking at your potential investor as someone who wants to offer guidance and make your business better, not as someone who’s trying to dig up dirt on your company in order to cause it harm.
Assuming that you accurately represented your company during the investment pitch, due diligence shouldn’t be a stressful or challenging process. Sure, you’ll be asked to produce a massive amount of documents and may need to have hundreds of talks and meetings with the investors, but if everything checks out, you could be looking at a bright and exciting new phase in your startup’s growth trajectory.
It’s also wise to note that due diligence is a very costly and time-consuming process for the investor. The fact that they are willing to invest so much time and money into analyzing your startup means that they are already fairly committed to the deal and have a very positive opinion about you and your company.
Take a look at our comprehensive overview of what you can expect (and look out for) when fundraising from Series A to Series C venture capital.