Neil Patel

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How does due diligence work for startups?

Due diligence is one of the least talked about parts of doing a startup. This, in turn, means it is one of the areas in which founders are least prepared physically, in the form of documentation, and mentally.

Yet, it is also one of the most critical phases of fundraising and M&A for achieving any type of exit. Unless you can skate through the startup due diligence process, your venture isn’t going to go far.

It can be a beast. Though being informed and prepared is 80% of the battle here. The more accurate your expectations, and ready you and your company are in advance, the less stressful it will be, the more profitable these transactions will be, the quicker you’ll get through it, and the greater the potential of your company.

So, how does it all work? What should you expect from the startup due diligence phase? How can you excel in it?

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    What Is Due Diligence In Startups?

    Due diligence is essentially an audit of a startup. Most commonly encountered during startup fundraising, and when selling your company.

    This is where acquirers, investors, or other auditors take a deep dive inside a company to truly evaluate it. Including determining the real value and assets, liabilities, and risks.

    This is typically far more intensive and lengthy than most founders anticipate. Which can really mess with your plans, expectations for putting money in the bank, and the ultimate terms of your deal. Or, for that matter, completely derail any prospective deal you thought you had.

    When Does Due Diligence Come Into Play?

    Due diligence generally comes into play during the following situations for startups:

    • Licensing and regulatory approvals
    • Filing for an IPO
    • Mergers
    • Selling your company
    • Financing your company
    • Equity fundraising

    This may also be applicable to securing big government contracts. As well as selling to or partnering with large corporations.

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    Due Diligence In Startup Fundraising

    The first point at which most startup entrepreneurs will encounter due diligence is most often when they go out to raise capital.

    It’s kind of like what a lender may do in the form of investigations and verifications for a loan, only on steroids.

    No matter how attractive your pitch, is or how interested you get investors, they are going to want and need to conduct thorough due diligence on your company before they can complete that investment.

    This is not just to ensure they are getting a good deal, and are making a sound investment, but because they often have legal and financial obligations to other investors as well. Such as the case with angel groups and VCs. If they don’t do their homework, then they are going to be on the firing line when things go wrong.

    So, don’t count on money hitting the bank until you’ve passed this step in the fundraising process.

    Due Diligence When Selling Your Company

    This is very similar to startup due diligence in fundraising. For all the same reasons.

    Obviously, regulators and the SEC, and various stock exchanges have their own rules. Though what’s involved and can be negotiated may vary more widely when it comes to M&A and selling your company. Especially depending on the size of your company, the complexity, which assets are being focused on as the source of value (think acquihires versus asset sales), and the dollar amounts involved.

    Before you can expect to close on the sale of your business, or even set the final terms in stone, you will have to endure this same process.

    Keep in mind that in fundraising or selling your company, storytelling is everything. In this regard, for a winning pitch deck to help you here, 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.

    Steps In The Fundraising Process

    As fundraising is most often the first encounter most entrepreneurs will have with this type of startup due diligence, let’s dive into where it fits into the process.

    Networking & Relationship Building

    Even before the pitch and showing off your deck, fundraising begins with networking and building relationships.

    You have to get to know investors, or at least know those that can introduce you to the right investors. In this process, you can also have conversations about and learn what they look for in due diligence, and the issues or good experiences they’ve had with other startups they’ve invested in before.

    The more you build trust and credibility with them in advance and tell them how you are doing things in your startup, the easier due diligence can be. Especially in the case of early rounds with angel investors.

    Pitching

    Then the time comes to get out there and actively pitch your startup. To send out messages, present your pitch deck, and wow them with your verbal pitch.

    Though if you have already managed to attract inbound interest in investing in your startup, you may have the upper hand in negotiating the due diligence phase.

    The pitch is all about the sale. It is getting them interested in all the highlights and potential. Of course, then you have to back it all up. That’s where startup due diligence comes in. It’s where you prove everything you’ve proclaimed, and really have the back end of your business buttoned up too.

    Term Sheets

    If investors are interested, the next step is for them to provide you with a term sheet.

    This is essentially like a letter of interest. An offer. It lays out the general proposed terms of the investment. Including what they expect to get in return.

    Depending on the sophistication of the investor, and how developed their systems are, it may well detail the items to be included in due diligence as well.

    Negotiations

    At this point, you’ll begin initial negotiations. Hopefully, with some strong representation and guidance.

    This includes negotiating what will and won’t be included in startup due diligence. As well as what the findings can impact, and to what level.

    Other items included in these negotiations are likely to be pricing, board seats, types of shares, decision-making powers, and much more.

    Due Diligence

    Next comes this startup’s due diligence phase. Expect absolutely everything about your business and you as a founding team to be thoroughly investigated and verified.

    Including patents you claim you have filed, the completeness of your product, your sales and profits, contracts, and more.

    Expect teams to go through every document in your company’s history, to talk to your past business partners, vendors, customers, and more.

    Renegotiate

    After all of this, you can expect your investors will often want to renegotiate some of the terms and clauses in your funding agreement.

    Some use this phase to purposely find justification to get a better deal. Others just find issues that warrant them protecting themselves further.

    After this back and forth, you can hopefully save the deal, and complete the funding.

    Closing

    Once the final agreement is drafted with any revisions, then you can proceed to sign and get money transferred to the bank.

    What Are Investors (And Acquirers) Looking For During Due Diligence

    The main categories that investors are looking at in startup due diligence include:

    Product

    Investors need to verify the product exists, it is and does what you say, and that any IP is protected as you say it is.

    Market

    If your investors are not already domain experts in this space, then they will want to have further research done to evaluate it, and if it is viable and able to deliver on their wants, expectations, and your pitch.

    People

    They need to know who is involved, what their stake is, what control they have, and what their backgrounds are in terms of finances and good business dealings.

    Finances

    Investors typically want to look at all the financials of a company. They not only want to know what the balance sheet is, and how much capital you have, but the cash flow coming in, profits, and more. They need to know what liabilities and debt obligations there are, as well as the real value of any assets that can act as collateral if your startup fails.

    Equity Structure

    Who else is on your cap table? What pools of shares are there? What classes of shares are there?

    Risks

    In addition to financial obligations, investors need to assess all other risks, including IP conflicts, competition risks, economic risks, pending lawsuits, control of the company, and more.

    When you’re ready to know more about how to navigate the due diligence process when fundraising, check out this video I have created. You’re sure to find it helpful.

    What’s Normally Included In Startup Due Diligence?

    What are some of the items you can expect to be on your investor or acquirer’s startup due diligence checklist?

    • Product testing
    • Market research data
    • Pricing and profit margin info
    • Patents, trademarks, and other IP
    • Product and business roadmap
    • Banking and financial statements
    • Financial forecasts
    • Audits and tax documents
    • Cap table
    • Copy of investor agreements
    • Shareholder agreements
    • Supplier list and contact information
    • Partner and distribution channels contacts and contracts
    • Customer information
    • Employee contracts
    • Documentation of any assets and liabilities

    Where Most Entrepreneurs & Startups Fail In Due Diligence

    • Over-promising in pitches
    • Not budgeting time and resources for startup due diligence
    • Not having your documents and data ready
    • Poor accounting
    • Lack of organization
    • Not being mentally prepared for this part of the marathon

    How To Prepare To Ace Startup Due Diligence

    There are four main things that you can do to help this process go more easily.

    Keep Great Records

    It will go much easier if you are in the habit of maintaining great, clean, and well-organized records.

    You’ll be able to enter due diligence with confidence, and will be able to support a higher valuation and better terms.

    Budget Time & Resources In Advance

    Expect this to be a full-time job for one of the founders or executives for months. You need someone strong who can handle 18-hour days, midnight calls with lawyers, and dealing with countless requests.

    Be sure to budget for this, and for someone to handle their normal workload.

    Advice

    Do not enter this without great advisors. The more you can get, and the earlier you can get it, the better.

    VDR

    Start loading your virtual data room with all of this information well in advance of your campaign so that it is ready to go. You don’t want to burn great capital raising or acquisition opportunities because you were the drag on the process.

    Summary

    Startup due diligence is one of the most critical factors for a new venture. It will make or break your venture. This can happen before you can get off the ground, or even after you’ve been operating for a while, and thought you found an exit.

    It is a core part of any equity fundraising event or acquisition. As well as other key deals startups make.

    Entrepreneurs tend to focus on the sales pitch, but rarely give enough time and attention to preparing for this often grueling part of the process.

    Fortunately, there is a lot you can do to learn about it, get great help, and get in shape to walk through this part of the game a lot easier and faster.

    You may find interesting as well our free library of business templates. There you will find every single template you will need when building and scaling your business completely for free. See it here.

     

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    Neil Patel

    I hope you enjoy reading this blog post.

    If you want help with your fundraising or acquisition, just book a call

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