Why Is Due Diligence Important?

Due diligence is one of the most important parts of building and operating a startup. It is also all too frequently one of the most under appreciated parts of the process of creating, maintaining, and growing a company. 

As such it often becomes much harder and riskier and disruptive than it needs to be. 

It is true that it can be one of the hardest things for a founder and company to go through. It will almost certainly take longer, and be more work than you expect.

Yet, as a founder you also have much more control over this core part of doing business than most realize. At least if you learn about it, prepare for it, and plan ahead. 

So, what’s the big deal about due diligence? What should be expected? What can founding entrepreneurs do to master this element that can be so pivotal?

What Is Due Diligence In Startups?

Due diligence is often talked about, yet rarely fully appreciated until entrepreneurs are right in the midst of it. Right when they are feeling the pain of learning it the hard way. 

There are two main occasions when due diligence arises. During fundraising and exiting or M&A activity. Variations of this may also arise when seeking insurance, licensing, filing and complying with regulations, and in leasing.

Fundraising

The most common form of this will arise at each attempted round of startup fundraising. This is most intensive and thorough when raising equity capital. Increasingly intensive as rounds compound and larger amounts are raised from a wider variety of more sophisticated investors. 

Although there may be similar types of underwriting and investigation done when applying for various other types of financing. 

If you are not prepared for it, the first real due diligence experience can be a real shock to the system. 

Keep in mind that in fundraising, 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.

Exiting and M&A

If you are successful at passing due diligence through multiple rounds of fundraising, then you may gain the opportunity to go through it all again, on an even more in depth level to take your company public, or sell your business.

If you are successful at raising and growing you may even end up conducting your own due diligence on other companies that you seek to acquire or merge into yours.

Why Is Due Diligence So Important For Entrepreneurs?

What’s the big deal about due diligence?

It Will Make Or Break Your Company

Due diligence is the key to raising capital, merging companies, making strategic acquisitions, and finally exiting or taking your company public. You won’t be able to do any of these things without being able to get through due diligence. 

If due diligence is a struggle for you and your company, it will also make every attempt to raise money, grow, and get to the next level an unappealing chore. 

From the other side of the table, it will also be less likely investors and acquirers will follow through. Especially when they may have many other competing startups and companies vying for their dollars and partnerships. 

Even if you get through it, if it is a nightmare for the other party it can set off the relationship on the wrong foot. That can sour the future together before you even get started.

Revealing Your Secret Sauce

While this should certainly be a secondary concern to actually getting the funding you need, and growing your company, there are unscrupulous entities and bad actors who will use this process to learn the ins and outs of your business, and then use it for their own interests. 

That may be investing in the competition against you, directly competing against you, or disclosing sensitive information to others. 

Disrupting Versus Uniting Your Team

The due diligence experience can substantially impact your team. For better or worse. 

It can bring you together. Strength you, and help to boost your performance and unity. At least if you orchestrate it well. 

On the other hand, if you have not prepared well, have not prepared them, don’t empower them to do their best, and are fragmented in your stand on this round or exit, it will be a mess. It can drive a wedge, and create dissension in the ranks and leadership.

It Can Make Or Break You

This will be one of the hardest things you’ve ever experienced up until this point. Even more so than taking the leap of faith to try and bootstrap a new new business idea, or to go pitch hundreds of investors despite receiving just as many noes. 

There may be rare rounds when things do sail through. Just don’t expect it. 

If you are not mentally prepared for this leg of the journey it may break you. If you do not resolve to persist through it, and you quit, the end of your business will follow quickly behind.

Fortunately, there is a lot you can do to make it easier, more palatable, and efficient. Though you do have to be informed, be strategic, and take action in advance. 

Why Is Due Diligence So Important For Investors?

Potential investors must conduct thorough due diligence. Here are just some of the reasons for that. 

Understanding What They Are Really Investing In

You might have an amazing sales pitch that gets them excited and eager to throw down an appetizing term sheet, but then they need to really get to grips with the reality of what they are investing in. 

Is there really substance behind the pitch deck? What do you really have, and have achieved?

The Value

This is a financial transaction for investors. That means they both need to look a realistic financial forecast based upon some tangible proof of concept or sales data, as well as the tangible value of any assets. Whether those assets are intellectual property, or hard assets like real estate.

The Risks

What liabilities and risks is their investment going to be exposed to? It could be operation, legal, market forces, or other risks. They need to calculate for that when balancing their overall portfolio and potential for average returns across the startups that they are investing in. 

Legal & Financial Responsibility 

Investors typically also have legal and financial responsibilities to others too. VC firms and startup accelerators will have LP investors whom they are responsible to. They have to repay them. If things go wrong they can be sued if they didn’t conduct a reasonable amount of due diligence on the investment. 

Why Is Due Diligence So Important For Acquirers?

Due diligence can be even more important for acquirers. They are typically making larger investments, and are taking on all the risks. Compared to an investor who may just take up part of one funding round. 

In addition to the above items, there is one more key part of the due diligence when it comes to M&A transactions. 

Potential For Integration

If an acquirer plans to hold your company in their portfolio, or merge companies and products together, they need to know that they can integrate these different parts. 

Integration is the chief reason that most M&A deals end up failing to deliver. If it does fail, their investment can be wasted. It may even derail their own company. 

When evaluating integration they may look at factors like:

• Company culture
• The tech and software stack being used
• Which team members they can keep on
• The size of earnouts and length of vesting period founders are willing to commit to

You may be interested in watching the video below where I cover in detail how to navigate the due diligence process.

What Due Diligence Is Involved?

What exactly does due diligence involve?

Among the many parts of this process you can expect the following.

Vetting The Founders

Founders and other key players can make or break a company, and investment. This is not only about their abilities, but scruples and integrity. Even Mark Cuban has had to step in and take over startups due to rogue founders. 

They want to know that you aren’t putting their investment at risk. Are not going to be engaging in Twitter wars that will damage the company. Or won’t be lying to the press and misleading the public about the business. 

Reviewing The Organizational & Financial Structure

The quality of the founding team is very important. Though so is who the other executives, key team members, and investors and owners are.

Acquirers and investors want to understand what debt there is, how the ownership is split, who is on the cap table, and their rights in the next round, or other liquidity events.

Interviewing Customers

They will want to interview your real customers. They will want to get details on how happy they are, and how likely to stay as paying customers. They want to make sure the product does what you claim. 

Verifying IP

Investors and acquirers need to verify patents, trademarks, and other intellectual property. That you have really filed and own it, and how much it may be worth. 

Verifying Financial Statements & Forecasts

Expect them to go through every dollar and document. They will likely also create their own forecasts and potential outcomes. Often these may be even more bullish than yours. Though poor accounting can certainly detract from your valuation.

Valuation

Investors and buyers may use a variety of methods and approaches to value your business. This will depend on their preferences, the stage of business, and what they intend to do with it. As well as how they will fund it, and how the transaction is being structured.

Legal Issues

Careful attention needs to be applied to pending lawsuits, litigation, or settlements. 

Risks & Assets

They will need to review contracts with customers, retention versus churn rates, employee contracts, and more. As well as evaluating the value of individual assets and their liabilities. 

How To Ace Due Diligence

How can you do better at acing the due diligence process to preserve and add value, keep these parties motivated, and make it go faster, and less painfully?

Be Transparent 

Your pitch and deck is a sales tool. Though be honest upfront in your pitch, and it won’t fall apart in due diligence. 

Have Your Team United

Before you enter any of these processes your whole team should be united on the goal. This includes your workers, cofounders, shareholders, and board members. 

Be Organized & Keep Clean Records

Don’t wait until its due diligence time to try and pull everything together and catch up on your taxes or other accounting and paperwork. Take the time to create systems and processes in advance. Prepare a data room for your due diligence in advance of pitching. 

Negotiate

You can negotiate what will be involved in due diligence, and what will be excluded. As well as how information will be throttled throughout the process.

Be Prepared Mentally & Financially

Be prepared for how long this is going to take, how hard it will be, the extra labor, meetings, hours, and stress. Brace yourself for the emotional roller coaster, negotiation tactics and renegotiation, and plan for the costs on your business for all of this. 

This will allow you to stay strong, stay the course, and still get a great deal in the end. 

Summary

Due diligence is extremely pivotal for startups. It is one of the most influential parts of building a business. All the way from fundraising through your exit.

There is a lot involved. Yet, founders also have a lot of control over the process and how well it goes.

Invest in learning about it, preparing for it, and it will be far more profitable and palatable when the time comes.