Due Diligence: Everything Entrepreneurs Need To Know

Are you wondering what goes into due diligence and also what are all the items that investors or perhaps potential acquirers would want to see as part of your due diligence package?

Most entrepreneurs focus so heavily on finding investors that sidesteps how to create a due diligence package. If you are pitching your business to investors, you should already have a due diligence package in place.

Whether you are preparing for a future funding round or you’re already immersed in the pitching process, let me take you through how to create a due diligence package during fundraising.

What is a Due Diligence Package?

Whenever an investor decides to buy equity in a company, they carry out some form of due diligence. This simply means that they look at the past, current, and future standing of the company.

Sometimes, on the surface, a company appears to have a great product, only for its profitability to fall away under scrutiny. Investors carry out due diligence to limit unexpected negative surprises so that they can make an informed decision about whether to invest or not.

A due diligence package includes the materials and information that potential investors will appraise during the pitching process. But what is included in it? In essence, there is a “due diligence checklist” which guides the start-up entrepreneur in shaping this package.

Investment can dry up as quickly it appears. Investors are often looking at multiple investment opportunities at one time. For this reason, you do not want investors to be waiting while you scramble together a due diligence package for them to evaluate.

Having your due diligence package ready to go, is a must for showing that you are a serious entrepreneur and can be trusted. You don’t want to be the bottle neck and you should put this in place before you are even out there pitching.

Typically the due diligence package will come after an investor is excited after reviewing your pitch deck.

Remember that storytelling plays a key role in fundraising and you will need capital to scale things up. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

What Should I Include in a Due Diligence Package?

As described in chapter 5 of my book “The Art of Startup Fundraising”, by creating your own due diligence package, you can influence what information investors encounter about your business and brand.

It’s better that they get the bulk of the due diligence information from you and your company rather than through Google or an untrustworthy source. 

That’s not to say that you can completely control everything about due diligence, but it does mean that you can ensure that the truth about your company and its future is seen by potential investors, rather than incorrect information.

Broadly speaking, your due diligence package will contain records pertaining to 5 key areas:

• You and your team.
• The financial health of your business, including debt and agreements with existing investors.
• Your Product, along with how it works, how it is manufactured, and how it is distributed.
• The market you are entering, including reliable market research about how large that market is and how much of it you are likely to secure
• The deal agreed between you and the investor, including any debt or share structure and other stipulations

Each component of your due diligence package can make or break the deal. For example, even if all of your financial data is in place, along with the product, the market research, and the deal structure; if an investor discovers something they dislike about you or your team’s history, then the entire investment could evaporate.

That’s why it’s so important to get each component right.

There’s No Hiding in Business

Before we discuss creating your package in more detail, it’s important to remember how critical honesty is. While creating a due diligence package allows you to control the narrative to a degree, you cannot lie or exaggerate to investors.

Whether they are angel investors or , the chances are they are experienced entrepreneurs themselves. They and their representatives will go through the due diligence process with a fine toothed comb.

If you have issues with pending patents or debt, a potential investor is going to find out about such issues during the due diligence process. Hiding this only makes you and your business appear less trustworthy. At worse, it can be considered fraud.

Don’t hide from the weaknesses or the strengths of your business. Talk up the strengths, but ensure that you understand and explain the weaknesses and challenges ahead, offering solutions to those problems so investors can see you have everything in hand.

Your Due Diligence Checklist

Checklists are a great way to ensure that you include everything that’s important. Think about the due diligence process as going on a journey. If you’re going on a long trip, you would want to make sure that you take everything you are going to need. Checklists allow you to do just that.

Here are the items you should have on your checklist. Each of these should be prepared as part of your due diligence package so you can quickly hand this information over to potential investors without wasting any time:

1) Due Diligence – Organization

? 1.01 Certificate of Incorporation (or equivalent) and all amendments and restatements

? 1.02 By-laws (or equivalent), as currently in effect

? 1.03 List of all business names used by or registered for use by the Company

? 1.04 List of any and all subsidiaries and affiliates of the Company and jurisdiction of formation

? 1.05 List of all jurisdictions in which the Company owns or leases (either as lessor or lessee) assets or has done so since incorporation

? 1.06 List of all jurisdictions in which the Company is qualified as a foreign entity, has applied for such qualification or has substantial contacts

? 1.07 Minutes, including minutes of meetings of the board of directors, board committees or the shareholders (or any equivalents); written consents of any of the foregoing in lieu of a meeting; and all materials distributed to the board, board committees and the shareholders (or any equivalents) at any meeting

? 1.08 List of any business acquisitions or dispositions made by the Company

? 1.09 List of all persons who have been or who currently are officers or directors (or equivalent)

2) Due Diligence – Capitalization and Securityholders

? 2.01 List of Company securities authorized and outstanding that indicates the holders, amounts and classes or series of such securities and copies of securities transfer books and stock ledgers

? 2.02 Agreements to issue and/or register securities

? 2.03 Agreements relating to voting of securities, preemptive rights, restrictions on transfers, rights of first refusal and any other grants of rights in respect of the Company’s securities

? 2.04 All warrants, options or other agreements relating to rights to acquire securities of the Company or requiring the issuance and/or registration of such securities 

? 2.05 All plans and grant or award documents for any stock option, stock bonus, stock purchase or other equity-based compensatory programs for employees, consultants, advisors and/or directors (or equivalent)

? 2.06 Any agreements with “finders” or which purport to obligate the Company to compensate any person or entity in connection with a financing transaction

? 2.07 Private placement memoranda, investment letters, questionnaires and other documents relating to any offering of securities of the Company 

? 2.08 Copies, front and back, of all stock certificates and stock powers

? 2.09 List of any copies of closing binders of each and every prior equity financing (including debt convertible into equity) 

3) Due Diligence – Financial Statements and Audits  

? 3.01 Financial statements for the last three years

? 3.02 Schedule of liabilities (contingent or otherwise) not reflected in the most recent financial statements

? 3.03 List of any change in accountants and/or auditors since incorporation

? 3.04 Copies of audit letters from counsel to auditors since incorporation

4) Due Diligence – Taxes

? 4.01 List of all domestic and foreign jurisdictions in which the Company remits sales, use, income, franchise, property or other taxes

? 4.02 Tax returns (federal, state and local) of the Company since incorporation

? 4.03 Reports filed and material correspondence with any and all tax authorities, including the IRS since incorporation

5) Due Diligence – Employees, Salaries and Labor Disputes

? 5.01 All collective bargaining agreements, employment agreements, offer letters, consulting agreements, severance agreements, non-compete or non-solicit agreements, change-in-control agreements and intellectual property transfer agreements, non-disclosure or confidentiality agreements to which the Company is a party and list of any of the foregoing agreements currently contemplated or about to be entered into by the Company

? 5.02 Summary of labor disputes, requests for arbitration, organizational proceedings, grievance proceedings and similar matters and history of recent union negotiations

? 5.03 List of all employees indicating each employee’s division, title, function, industry experience and earnings and whether each such person is an officer and/or director (or equivalent) of the Company

? 5.04 List of all employees terminated since incorporation and the reason for such termination, and indicate whether each such employee has signed a release (and provide a copy of signed release)

? 5.05 Termination procedures, policies and a sample termination letter

6) Due Diligence – Employment Policies and Employee Benefits

? 6.01 All personnel manuals, employee handbooks and documents relating to employment policies and procedures

? 6.02 Any affirmative action plan(s)

? 6.03 Policies and practices regarding compensation for all employees not earning a straight salary (i.e., bonuses, commissions, overtime, premium pay, shift differentials, etc.)

? 6.04 Policies for fringe benefits, perquisites, holidays, vacation and severance pay

? 6.05 Incentive, bonus, deferred compensation, profit-sharing and nonqualified pension plans

? 6.06 Employee health and welfare plans, whether insured or self-insured, including most recent Summary Plan Description for each

? 6.07 All Form 5500 Series Annual Financial Reports and summary annual reports (including all supporting schedules and audit reports) for each employee-benefit plan described in 6.06 above and 6.08 below

? 6.08 Each tax-qualified retirement plan and any related trusts or insurance contracts (as amended to date) and most recent Summary Plan Description for each

? 6.09 Most recent IRS Determination Letter for each tax-qualified benefit plan

7) Due Diligence – Financial Commitments

? 7.01 All indentures, loan and note agreements (whether demand, term, installment or other) and line of credit arrangements, whether bank loans, industrial revenue bonds, mortgages or other and whether secured or unsecured, and all documents evidencing other material financing arrangements, including sale and leaseback arrangements, installment purchases, letters of credit, capital and leveraged leases and receivables securitizations

? 7.02 Summaries of compliance with the instruments described in 7.01 above (including indication of whether defaults are presently anticipated for future periods) and all communications with lenders

? 7.03 Guarantees for the benefit of or by the Company

? 7.04 List of loans to or from securityholders, employees, officers, directors (or equivalent) or any of their immediate family members

? 7.05 Contractual obligations relating to termination of employment

? 7.06 List of all outstanding indebtedness of the Company detailing amount and effective interest rates of such indebtedness

? 7.07 Schedule of all liens and encumbrances to which the property and assets of the Company are subject

8) Consents

? 8.01 List of all material consents required to be obtained by or on behalf of the Company to complete the proposed transaction, specifying the name of the entity or individual from whom consent is required and the agreements under which required and the reason why such consent is required

9) Due Diligence – Permits and Licenses; Compliance

? 9.01 All material permits and licenses (including, without limitation, environmental permits and licenses) needed by the Company

? 9.02 Description of any regulatory and compliance issues the Company has faced, currently faces, or anticipates to face (including, without limitation, FDA, HIPAA)

? 9.03 Information related to potential regulatory or product liability claims or actions that the Company may face

? 9.04 If applicable, written policies and guidelines regarding protection of personal health information and related privacy policies

10) Due Diligence – Insurance

? 10.01 All insurance contracts (including director-and-officer liability (or equivalent), automobile, general liability, environmental liability, key person (whether or not owned by the Company) and products liability; list of and summaries of insurance claims, disputes with insurance companies or denials of insurance coverage which are currently pending or have occurred since incorporation; and list of insurance claims paid against occurrence policies

? 10.02 Workers’ compensation documentation

? 10.03 Vendor liability endorsements

? 10.04 List of any time the Company has ever been declined for a policy or of any time an insurance company has declined to provide a key person policy requested by or on behalf of the Company (whether the policy was to be owned by the Company or not.

11) Due Diligence – Litigation

? 11.01 List of and status of pending and threatened claims, litigation, administrative or other proceedings and governmental investigations involving the Company or, to the extent that they relate to performance of corporate duties (whether for the Company or any third party), any of the directors (or equivalent) or officers or relating to any product manufactured or distributed by the Company and list of counsel presently and previously handling such matters

? 11.02 List of outstanding judgments or decrees against the Company and, to the extent that they relate to performance of corporate duties, any of the directors (or equivalent) or officers 

? 11.03 List of all consent decrees, settlement agreements, injunctions and similar matters involving the Company and, to the extent that they relate to performance of corporate duties (whether for the Company or any third party), any of the directors (or equivalent) or officers

? 11.04 List of all pending and threatened claims, litigation, administrative or other proceedings and governmental investigations involving any Key Person (defined to mean any founder, officer or director or key employee of the Company) during the last five years

? 11.05 List of any and all bankruptcies and license revocations or suspensions or censures or prohibitions on involvement in the sale or trading of securities or commodities in which any Key Person has been involved if in effect during the last five years

12) Due Diligence – Intellectual Property

? 12.01 Patents, trademarks, service marks, copyrights, trade names, trade secrets and other intangible assets owned or used by the Company (including domestic or foreign applications, registrations, licenses and assignments)

? 12.02 Opinions relating to patents (including right to use, patentability, blocking patents, infringement and validity) and opinions relating to trademarks (including registrability, infringement and validity) and opinions relating to other intellectual property

? 12.03 List of all software programs owned by the Company that are (a) used internally by the Company in its business operations or (b) made available by the Company for use by customers

? 12.04 List of all software programs owned by third parties that are (a) used internally by the Company in its business operations (other than non-custom, mass-marketed software products licensed under a “shrink wrap” agreement) or (b) made available by the Company for use by customers, indicating in each case the owner of and nature of the Company’s right to use such intellectual property

? 12.05 License agreements relating to intellectual property under which the Company is licensor or licensee (including “shrink wrap” software products to the extent related to the products developed by the Company) and list of any obligations to pay or rights to receive royalties

? 12.06 Documentation alleging infringement of third-party intellectual property by the Company or relating to alleged or actual third-party infringement of the Company’s intellectual property

? 12.07 Secrecy, confidentiality, nondisclosure and assignment of inventions agreements with employees, consultants or independent contractors and list of any employees, consultants or independent contractors not covered by such agreements

? 12.08 Written policies and guidelines distributed to employees regarding protection of proprietary items, technical data, marketing data or confidential information used by the Company in its business operations

? 12.09 Documentation relating to third-party development and testing of the Company’s products, services and proprietary products and information

? 12.10 List of any open source or community source code incorporated into any of the Company’s software products or products under development

? 12.11 List of all liens and encumbrances upon the Company’s intellectual property

13) Due Diligence – Property, Plant and Equipment

? 13.01 List of all real property currently and formerly owned by the Company

? 13.02 List of all real property currently and formerly leased to or by the Company 

? 13.03 All leases and subleases regarding real property and material amounts of personal property leased to or by the Company

? 13.04 All material agreements encumbering real or personal property of the Company, including, without limitation, mortgages, deeds of trust and security agreements

? 13.05 All material equipment leases involving the Company, including capitalized or financing leases

14) Due Diligence – Environmental Matters

? 14.01 All notices of violation or enforcement activity relating to any domestic or foreign environmental laws received since incorporation or otherwise unresolved at present

? 14.02 All “potentially responsible party” notices, Section 104(e) (i.e., 42 U.S.C. §9604(e)) requests or other documents relating to possible liability under CERCLA, on-site or off-site

15) Due Diligence – Other Contracts

? 15.01 All contracts, agreements or arrangements restricting the nature or geographic scope of the Company’s business

? 15.02 All contracts, agreements or arrangements between the Company and any officer, director (or equivalent), securityholder or any of their immediate family members

? 15.03 All contracts, agreements or arrangements between the Company and management or key personnel

? 15.04 All secrecy, confidentiality and nondisclosure agreements between the Company and employees or third parties and list of any employees not covered by such agreements

? 15.05 All indemnification contracts, agreements or arrangements for officers and directors (or equivalent)

? 15.06 All contracts, agreements or arrangements between the Company and any of its subsidiaries or affiliates

? 15.07 All commission, brokerage and agency contracts, agreements or arrangements to which the Company is a party

? 15.08 All joint venture, partnership, corporate alliance, collaboration and similar contracts, agreements or arrangements to which the Company is a party

? 15.09 All executed closing documents relating to any merger, acquisition or disposition by the Company (whether consummated or not) 

? 15.10 All marketing contracts, agreements or arrangements, including sales agent, representative, dealer, distributor, consignment, consultant, pricing and advertising agreements, to which the Company is a party

? 15.11 All material supply, requirements, purchase or sales contracts, agreements or arrangements to which the Company is a party

? 15.12 All material licensing and royalty contracts, agreements or arrangements to which the Company is a party

? 15.13 All government contracts, agreements or arrangements to which the Company is a party

? 15.14 All contracts, agreements or arrangements relating to the Company’s securities to which the Company is a party, including, without limitation, subordination agreements, standstill agreements, stock option plans, forms of stock option agreements and agreements pursuant to which the Company has agreed to issue or to register securities 

? 15.15 All contracts relating to the operation of the Company’s website

? 15.16 All other contracts, agreements or arrangements that provide for the aggregate payment or receipt by the Company of $10,000 or more

? 15.17 All other material contracts, agreements or arrangements

16) Due Diligence – Miscellaneous

? 16.01 All other documents and information that are significant with respect to any portion of the Company’s business or that should be considered and reviewed by prospective investors in the Company

As you can see, there is much to think about when creating a due diligence package. It’s better to be over-prepared than under-prepared, so make sure that you have as much reliable, documented information about you and your business as possible, ready to be concisely presented to investors.

In the video below I discuss in detail how to navigate the due diligence process which you may find interesting.

FULL TRANSCRIPTION OF THE VIDEO:

Hello, everyone. This is Alejandro Cremades, and today we’re going to be talking about how to navigate the due diligence process. If you’re looking to raise money, or if you’re looking to get your company acquired, you’re always going to have to go through the due diligence process once they have proposed to you the terms either in a term sheet, if you’re looking for financing, or in a letter of intent if you’re looking to get your company acquired. So, with that being said, let’s get into it.

In terms of graduating through the ranks when it comes to the due diligence, at a pre-seed level, they’re going to want to do some due diligence on you, maybe speak with people that have worked with you, and things like that.

At a pre-seed level, it’s all about you. When you mature to a seed level, then they’re going to want to see pitch decks, any roadmap that you have, and again, it’s all about the future and the possibility that you are presenting to them. 

When you go to a Series A level, at this point, you already have some type of revenue, and there’s validation on your product/market fit. Here, they’re going to want to take a look at the technology, also the distribution that you have, maybe speak with some of your customers, maybe with some of your other investors, and perhaps with some of your employees.

When you continue to graduate, and you go to a Series B and beyond, it’s going to be more of the same. But again, those are going to be areas where they’re going to be focusing as a whole, which are going to be all about the team, they’re going to be all about your technology, and they’re going to be all about your business.

In terms of how to make the due diligence a little bit easier, you never want to be the bottleneck. Essentially, what you want to do is, even before you think they’re going to be getting a term sheet, what you want to do is have all the due diligence already done upfront. Make sure that you have a folder on Dropbox or maybe on Google Drive, where you put all the documents that are required.

And, by the way, below is a link to an article that I published where you can go through all the different checks on what’s going to go into that folder. But to give you an idea, these are the documents that you will put on the due diligence folder.

First, it’s going to be documents with regard to the organization, 2) The capitalization and security holders’ documents, 3) Financial statements and audits, 4) Taxes, 5) Employee salaries and labor disputes, 6) Employment policies, 7) Financial commitments, 8) Consents, 9) Permits and licenses, 10) Insurance, 11) Litigation, 12) Intellectual property, 13) Property plan and equipment, 14) Environmental matters, 15) Other contracts, as well as 16) Miscellaneous.

Then, also setting up expectations is critical. When you’re going through the due diligence process, you want to know how long do they typically conduct the due diligence process and what is their exact process because maybe every single investor or any single institution, or perhaps company that you’re speaking with, they have a different type of process, different individuals that are involved, and you want to get clear as to what’s going to be the timing and the timeline of that due diligence in order to really happen.

Remember that this is a team effort. You’re going to need at least one or two individuals of your team, and ideally, you are supervising it if you’re the CEO and the founder, essentially looking at all the different documents and everything that is said. 

There’s going to be a lot of back-and-forth during this process, and again, it’s going to be a team effort, but one individual is going to have to take the lead for everyone else and be that point of contact. Otherwise, it’s going to be all over the place, and it can create confusion as there is a line of communication with the other party that is requesting more information to validate some of those claims that have been made and that need to be validated on due diligence.

Due diligence is stressful, and you’re going to need to have a plan to deal with it. In many instances, it can take days. It can be like being in rooms, in board rooms, or whatever that is, in conference rooms with all of the investors or with the parties that represent the company that is looking to acquire you, so it can get really stressful.

For that reason, you need to exercise, you need to take care of yourself, and that’s going to be a really big one so that you also, when you get super stressed out, just get out of that room, turn off your computer, and go do something else so that you don’t do anything stupid.

With that being said, hopefully, you like this video. Make sure that you click Like. Make sure that you also leave a comment and also subscribe so that you don’t miss out on any of the new videos that we’re rolling out every week. 

Then, also, take a look at the fundraising training, which is the training where we help founders from A to Z with everything related to fundraising. There, we have live Q&As, templates, agreements, a community of hundreds of founders all over the world helping each other, and I think you really would like it. Thank you so much for watching.