Due diligence is the opportunity investors have to gather the information they need about startups to make an informed decision before investing and minimizing their liabilities. Due diligence involves a thorough investigation of a business entity by investors to guide their investments and ensure they invest in a reliable and safe product.
In Due Diligence, investors verify information provided by the business and assess various segments of the industry to establish its genuineness and performance and expose as many risks as possible before making an investment decision. Due diligence may also extend to identifying the social or environmental impact of the business.
Not only will the due diligence process lead an investor to either pursue or drop a deal, but it will also lay the foundation for structuring the deal if they decide to move forward. Therefore, during the due diligence process, a startup must be very transparent with the actual state of affairs of the company. Investors do not rely only on information that founders or the management team provide; they dig deeper to verify the information or expose discrepancies.
Investors typically begin due diligence 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 is a list of all the documents they’ll require from the startup and what information and access the founders should provide.
Some areas that investors assess when conducting due diligence include;
- Background checks: Investors usually scrutinize the founders and management team. For some investors, verifying the team behind the entity is as crucial as verifying product and financial information. As such, they check the founders’ background and previous business experience, the team’s commitment and expertise, and the ability to adjust to changing market conditions and global scaling.
- Financials: An important area that investors examine is a company’s financials. This may include financial statements, KPIs, balance sheets, profit and loss statements, assets, business plans and forecast financial information (including budgets and cash flow forecasts), debts, cash flows, and other relevant financial documents to determine the actual financial state of the entity and the possible implications/outcomes if an investment is made. The financial due diligence also covers the forecast financial performance of the entity.
- Legal: To identify legal risks and propose solutions, investors assess a company’s legal obligations and liabilities and any binding agreements the company has entered into.
Some of the verticals that may be assessed include the company’s incorporation documents, requisite approvals or licenses if applicable, shareholder structure, board meeting records, data processing compliance, material agreements, litigation and other relevant documents.
- Tax Compliance: Investors assess a company’s compliance with the relevant tax laws by examining tax returns, audits, and other relevant tax documents. This ensures that the business pays tax and that professionals handle its tax compliance.
- Intellectual Property (IP) and Technology Check: Investors undertake an IP Due Diligence to ensure that the product they invest in has the appropriate intellectual property protection. This is to determine the quantity and quality of the intellectual property owned by the startup to ascertain its value. It involves assessing patents, copyrights, brands, and trademarks. Investors will generally request a list of all the IP rights of the startup.
To prepare your startup for the due diligence process;
- Store and update company documents, agreements, and licenses in a shared VDR (Virtual Data Room) so that you and investors can always access them. This shortens the time as well as eases the process.
- Due diligence is not only beneficial to investors. It also provides a startup with an objective assessment of its strengths and weaknesses. Due diligence can draw the attention of the founders to unexpected risks, improper documentation, or other irregularities they might have been unaware of previously. On the other hand, successful due diligence increases the credibility of a startup and often guarantees investment.