How do investors perform due diligence in startups? The term “due diligence” is used in the startup world to describe an audit of a company.
Potential investors undertake this process to uncover any business liabilities or shortcomings. The context is a proposed business transaction, such as an investment or a merger.
Due diligence is a method for venture capital (VC) firms to assess and verify startups to reduce risks and doubts before investing in them.
A startup’s management team must be completely transparent during the due diligence process. That’s because any anomalies that come up could undermine the deal.
This means being transparent about pending lawsuits, patent issues, dissatisfied employees, or business missteps.
That’s how you build confidence with potential investors and ensure the VC fundraising process or exit goes more smoothly.
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Here is the content that we will cover in this post. Let’s get started.
- 1. Does due diligence for startups have legal consequences?
- 2. When is it necessary to conduct due diligence?
- 3. What will investors look for when conducting due diligence?
- 4. The employees and founders
- 5. The startup’s financials
- 6. The product
- 7. Information about your customers and vendors
- 8. The market
- 9. Minutes and corporate documents
- 10. Equity structure
- 11. Capitalization table
- 12. Revenue streams
- 13. Information on outstanding lawsuits
- 14. Benefits of due diligence for startups
- 15. Conclusion
Take into account that investors will not solely rely on the information provided by your startup.
They will do independent external assessments, which may include interviewing past and present personnel and partners.
They’ll also contact customers for feedback on your product and brand experiences.
Due diligence may be time-consuming, which is why founders are well-prepared and able to devote sufficient time and resources.
That’s how they’ll ensure that the process runs smoothly. An unsuccessful due diligence process can dramatically lower a startup’s value.
Does due diligence for startups have legal consequences?
You might wonder what’s preventing a startup from lying during the due diligence process. And even in the pitch and pitch deck beforehand.
Why can’t they send over a forged set of books or sales numbers to close the deal? Is the investor going to find out?
The answer is always yes, the investor will find out eventually. Some startups attempt to “fake it until they make it,” but this is a poor strategy.
If you misrepresent your startup throughout this process, you could face serious legal consequences.
Investors can construct contracts that include warranties and legal redress in the event of misrepresentation.
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These rules allow for a lawsuit if the information you submit during the startup’s due diligence proves incorrect.
Additionally, criminal consequences are inevitable when selling shares without being entirely forthcoming if the misrepresentations are significant.
As a result, founders must take due diligence seriously.
Hire independent attorneys and accountants if necessary to ensure that you give the correct information to a potential investor.
It is critical to provide accurate, verifiable data to preserve the founders’ assets and the company’s.
Understand how investors perform due diligence in startups so you have a better chance of achieving your objectives.
When is it necessary to conduct due diligence?
The procedure begins once the startup and the investor have agreed on a term sheet.
The investor or buyer will then deliver a list of due diligence requests. This will tell you of the documents they’ll require, as well as the information and access you’ll need to offer.
Due diligence is a time-consuming process and could take weeks if you have all of the necessary documentation.
However, it could take months if you need to compile essential documents or explain significant inconsistencies in the data you gave.
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What will investors look for when conducting due diligence?
Investors attempt to be as comprehensive as possible in their research for potential liabilities.
In order to complete the due diligence process as quickly as possible, they’ll have to concentrate their efforts on a few critical aspects of the startup.
Generally, there are ten important areas that investors evaluate the most:
1. The employees and founders
Investors will almost certainly want to learn more about the startup’s founding team. Investment firms frequently invest in groups rather than individuals.
They’ll want to conduct their due diligence on the team to ensure it has the right talent to execute and create high-quality goods.
Investors look for a team with various abilities, including product development, sales, and marketing.
An investor may want to chat with specific team members before issuing a check to gain their perspective on the startup.
Investors may withdraw from a deal if they notice red flags in the startup’s history that they don’t like. Even if the financials, valuation, and product are all perfect.
2. The startup’s financials
Your startup’s historical financial success, rather than your projections, is the best sign of future performance for investors.
They’ll want to dig through your financial statements, examine any debt you’ve accumulated. And double-check your agreements with current partners and investors.
You might jeopardize the funding if you have a history of failed deals, excessive burn rate, or irresponsible debt.
Take the time to create a checklist of the essential factors investors look for when they perform due diligence in startups.
Take into account that you’ll have to furnish detailed financial information during the due diligence process.
The following is a list of documents that most investors will wish to see:
- All financial statements have acquired approval
- Extracts from the register of annual tax statements
- Annual balance sheets and the most recent balance sheets available
- Profit and loss statements
- Your annual budget, which includes a detailed summary of all of your salaries and expenses
Preparing this documentation for early-stage startups can be difficult. Especially if they haven’t hired a Chief Financial Officer (CFO) or are outsourcing the position.
It’s a good idea to get a head start and prepare the documentation before the due diligence process begins.
If possible, it’s a good idea to start preparing the paperwork as soon as you think about raising funds.
3. The product
Pricing, market position, and scale of operations are common ways for traditional enterprises to achieve a competitive advantage.
On the other hand, startups are valuable due to their ability to disrupt conventional industries through innovation.
Because of this focus on innovation, investors are interested in the startup ecosystem because of the product and how groundbreaking it may be.
Expect interested investors to dig deep into your product’s functionality, manufacturing or development process, and distribution strategy.
Investors will also expect to see complete code evaluations of startups that have a software product or rely on a tech platform.
They will need to know how well your code is written and how scalable your platform is.
Investors will also need to know if you are the only owner of the rights to your product or service.
Your patents and intellectual property holdings will go under investigation. Most institutional investors will see intellectual property lawsuits or disagreements as a warning indicator.
No one likes to get involved in an intellectual property dispute since they are nearly always protracted, complicated, and expensive.
If you have any IP difficulties, it’s better to disclose them throughout the due diligence process. And make all patent and legal documents readily available.
You need to be clear about the stage of development of your product too. Over-selling what you have has become a legal issue for more startups.
4. Information about your customers and vendors
Due diligence may entail an investor sitting down and interviewing each of your consumers to see if they enjoy your product or service.
The investor will most likely want to learn more about your main clients and suppliers.
If there are people who make up a significant portion of your startup, they’ll want to know.
Conversely, if your sector relies on certain vendors, an investor will want to see that you have strong relationships with them. It’s how investors perform due diligence in startups.
5. The market
Investors will look at more than your startup during the due diligence process. They’ll be curious about the market’s feasibility and your overall position in it.
Investors will most likely inquire about the size of the market and how much of it you’ll be able to secure.
They’ll not only request this information, but they’ll also likely conduct more investigation on their own.
Investors may back out from the deal if they determine that there aren’t enough growth possibilities due to a smaller potential customer base. Or because your product isn’t the correct market fit.
6. Minutes and corporate documents
Any investor interested in investing in your startup will want to know that it has the proper legal framework and all registrations are up-to-date.
Expect to bring your , letters of good standing, and annual meeting minutes if you’re a corporation.
If your business is an LLC, you’ll undoubtedly need to provide its incorporation documents. Also provide proof that it’s in good standing with the appropriate federal agencies.
Your investors want to ensure that all of your corporate documents are in order to avoid fines and the possibility of someone piercing the corporate veil.
7. Equity structure
Ownership structures in startups are often complex. Equity may be held by early-stage investors, multiple co-founders, friends and family, and angel investors.
Furthermore, any agreements formed with them may include stipulations that will influence how the startup is seen at this funding stage.
For this reason, as part of the due diligence process, all transactions between the startup and previous investors will be investigated closely.
Debt, share structure, and other contractual conditions will all be scrutinized by investors. Including employee stock options.
8. Capitalization table
An investor will look over your capitalization table to make sure it isn’t already too diluted.
If you’ve previously taken on significant investments, be prepared to describe them in further detail. And ensure the investor that their investment would not be diluted in the same way.
9. Revenue streams
Expect investors to dig deeper into your primary revenue streams as part of the due diligence process.
They’ll want to know things like your churn rate and cost per acquisition if you sell a subscription service.
Investors want to ensure that the income streams will keep growing in the future. The unit economics need to work.
It’s perfectly fine if your startup is still in the proof-of-concept stage.
After that, an investor will consider your possible revenue streams and how they might appear, as well as how your startup can grow.
That’s how investors perform due diligence in startups.
10. Information on outstanding lawsuits
If your startup is involved in any litigation, you will certainly be required to present evidence regarding them, as well as their future repercussions.
Before investing in your startup, an investor will need to analyze these factors.
Would you like more information about how to navigate the due diligence process conducted by potential investors? Check out this video I have created with helpful information.
Benefits of due diligence for startups
Due diligence will provide an objective and complete review of the startup’s current state, as well as a thorough explanation of its strengths and shortcomings.
Most investors have extensive expertise and knowledge of the process of launching and expanding a business.
They will be able to not only identify but also address your startup’s flaws.
Early-stage startups may lack adequate business planning or have overly ambitious burn-rate and cash-flow projections.
Due diligence can help you identify these concerns and find unanticipated risks or product misalignments that you may not have been aware of before.
Due diligence should not be a stressful or difficult procedure if you honestly portrayed your startup during the investment pitch.
If everything verifies, your startup’s expansion could be about to enter an exciting new chapter.
Due diligence is a procedure where you should view your potential investor as somebody who wants to help you grow your startup.
And not as someone who wants to cause damage to your startup.
It’s also vital to remember that due diligence is a time-consuming and expensive procedure for the investor.
They are already fairly dedicated to the deal and have a positive impression of you and your startup if they are prepared to commit this much money and effort to assess your startup.
Due diligence for startups isn’t difficult if you accurately represent your startup during the investment pitch.
You may be required to present a variety of documents and have some of your employees speak with the potential investor.
If your documentation is in order and your numbers are correct, you’re unlikely to lose the transaction once this process is complete.
It is usually preferable to under-promise and over-deliver rather than the other way around.
Let’s say you use modest estimates in your presentation. But an investor’s due diligence finds that your startup’s financial projections may be significantly higher.
If that’s the case, they are more inclined to invest in your startup.
If, on the other hand, you offer more than what’s possible and they realize there’s a slim chance of it happening, they’ll be less willing to invest.
Or they will want to renegotiate the terms.
Lastly, make sure you respond quickly to any inquiries posed by a potential investor.
Even if it’s only an acknowledgment with a timeframe for when you’ll deliver the material to them, it’s better than leaving them waiting.
Demonstrate to your investor that you’re serious about moving past due diligence and bringing them on board to help your startup thrive.
Understand how investors perform due diligence in startups and work out how to present all the information they’ll need.
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