Due Diligence for Startups and Checklist

Due diligence is an essential process for startup founders, angel investors, venture capital firms, and individual investors. This process must be treated as a two-way street if those involved are to get the best possible out of any funding deal.

Below we will take a look at what due diligence means to all parties and why it must be addressed with due care and attention.

What is due diligence?

Due diligence comes in many forms and is an investigation, audit, or review that is carried out to confirm either facts or details of a matter under consideration. In the world of finance, due diligence requires an examination of financial records and is undertaken before entering into any proposed transaction with another party.

Concerning the startup world, due diligence is the audit process that any potential investor should undertake before committing to any investment in your business. In basic terms, the aim of investor due diligence is to check and confirm that everything your company has stated matches the detail they subsequently discover.

The investor due diligence process is also used to uncover any red flags that a startup may have omitted from its investment pitch.

There is no hard and fast due diligence process

The level of due diligence carried out can be of varying levels. In truth, the depth of investigational activity will often depend upon what investment amount is involved.

An example here is that a startup founder who is looking for pre-seed funding is far more likely to go through a less rigorous analysis than a more established startup that is heading into a Series A funding round.

The due diligence process can be as straightforward as a face-to-face conversation once your pitch has ended. At the other end of the scale, the process can involve lawyers, accountants, and the associated amount of paperwork this approach involves.

At the more in-depth end of due diligence, investors are likely to look into much greater detail relating to your financial numbers and perhaps your personal history which can involve the running of background checks on you and your investee company.

When Does The Due Diligence Process Begin?

The process tends to begin once a founder has presented their investment pitch to either an Angel Investor or a VC (Venture Capital) firm. If these investors have an interest in your business proposition it is only natural that they will want some initial assurances and that will happen by them carrying out due diligence on your company.

Founders should view this as being a sensible and professional route for investors to take. After all, if you were buying a property you would first have surveys carried out to ensure that no potential sale-stopping issues came to light.

Angel Investors and VCs quite rightly view startup investments in the same light and the due diligence process is their way of gaining independent insight and assurances about your company. 

The other thing founders will be clear on is that investors are taking a financial risk by giving your startup the necessary funding. Of course, with this risk comes the possibility of reward because investors are in the business of making a profit.

Before parting with funding, investors need to be confident that your startup has the potential to give them a healthy ROI (Return On Investment). This is where their due diligence comes in.

Do Not Be Tempted To Fudge The Books!

Founders should NEVER be tempted to fudge their books or provide any misrepresentation of their business.

It is only natural that you will be eager to gain investment to grow your company. You will also want your venture to be seen in the best possible light.

However, treat honesty and integrity as your bywords. Founders who falsify documents can be sure that investors will eventually discover what has been done. When they do, the only thing you will have achieved is to land yourself in a major legal wrangle!

It is also worth remembering that the majority of investors will include specific contract terms that relate to misinterpretation in any agreement signed with you. If you are found to have misguided a stakeholder(s) there is a good chance you could be sued. In the worst-case scenario, you could even be charged under criminal law.

This must tell founders that the due diligence process has to be taken seriously. Be honest and upfront and do not try to dupe investors. By approaching this key element of raising funds through a commitment to accuracy and transparency you will be serving the best interests of your startup.

Founders Should Use Due Diligence To Their Benefit

Founders should not consider due diligence as a chore. Quite the opposite. It should be used to your advantage.

When preparing for the expected investor due diligence this is an excellent opportunity for you to carry out an internal audit. This will allow you to gather the relevant details and reassess them as well as reconfirm your growth plan expectations.

Doing so will give you a fresh look at where you are at, whether you are on track for your next milestone, and identify areas of your startup that need optimizing. All of this can be achieved before any potential investor involvement.

A Checklist - Be Prepared For What Investors Will Want

It is usual for investors to have a standardized due diligence checklist. They will use this to verify that all relevant data and details are as you have stated. Founders should be aware that such a checklist will differ from firm to firm and that different investors could well require different details.

On the face of it, this can complicate matters in terms of what you should be prepared to provide. However, an effective approach is to prepare the most common documents. Ones that all investors are likely to require.

To achieve this, turn the tables and prepare your own due diligence checklist. Doing so will give you a head start in having the bulk of documents and information ready as soon as a potential investor asks for it.

We will shortly get into an 8-part checklist that you can use to form an effective internal due diligence assessment checklist. But before that, a very important note:

Do This BEFORE Handing Over Any Documentation….

When you get to the advanced stage of due diligence negotiations with any potential investor or firm it is strongly recommended that you enter into a confidentiality agreement. This should be signed and agreed upon by both parties BEFORE you hand over any documentation. This agreement should then be stored in a secure cloud storage system.

As will be seen in the conclusion of this article, there is one very easy, secure, and cost-effective way to achieve this.

The reason for establishing a confidentiality agreement is that the data you will be disclosing and sharing with potential investors is of a sensitive nature. This means you need to be sure that any investor who is given such data is obliged to keep the information confidential.  

Your Due Diligence Checklist

This 8-point checklist should not be seen as the be-all-and-end-all of what is required during the due diligence process. However, it is a solid basis and will stand you in good stead when it comes to the essential data you will need to provide potential investors with.

1 - Financial information & current business plan

These 2 pieces of information are the data points most commonly asked for by investors. They will expect to see such things as your balance sheet, income details, cash flow fluctuations, your accounts ledger, and very importantly your accurate, up-to-date capitalization table. They will also require your detailed business plan.

From a financial point of view, they will also look at any debt you have. Showing a significant debt amount could well stop them from going ahead with any investment.

2 - IP rights

If you do not have any Intellectual Property (IP) rights these should be applied for before going into a pitch presentation meeting. Why? Because they are key economic differentiators and can go a long way to helping you achieve the funding amount you are looking for.

IP rights cover such things as patents, copyrights, trademarks, and design rights. Each of these individual rights can be extremely advantageous in its own way. The more relevant ones you have, the more favorably investors will look at giving funds.

Your IP rights are an integral part of this value proposition.

3 - Business & Legal structure documentation

It is quite likely that your startup will have relied on external investments to get up and running. There may also be multiple co-founders. Any person’s involvement in your startup should be registered and you should have in place documentation outlining your company’s ownership structure.

A well-managed cap table can go a long way to achieving this but electronically stored and hard-copy details should also be readily available. Most importantly these details need to be up-to-date.

As well as this legal structure detail, make sure to have your certificates of incorporation and certification available. While it may not be seen as a priority, founders should also produce and file minutes of any management and stakeholder meetings. When presenting to angel investors these are likely to be requested.

4 - Valid customer data and supply chain contracts

It is quite clear that during your pitch presentation you will highlight just how good your solution is for customers. That is natural and expected. It also goes that any potential investor will not simply take your word for it, they will want to check.

In that respect, they may want to reach out to customers to obtain verified feedback about your company and service or product. While potential investors are interested in this sort of feedback they will also be interested in your supply chain. They will want a comprehensive understanding of any vendors and suppliers you are working with.

5 - Revenue streams and sales numbers

This required detail goes without saying! Investors are in the numbers game. That means you should expect every potential investor to dive deep to gain an understanding of your revenue streams.

The bottom line here is that any potential investor will want to get a handle on how your company makes money. Just as importantly they will want to understand how you intend to increase your revenue streams and up your sales numbers.

This can be achieved by providing metrics such as:

• The average revenue per user.
• Cost per customer acquisition.
• Conversion rate.
• Churn rate.
• Pipeline coverage.

Do not worry too much if you are still at the proof-of-concept stage and your startup is not yet in the money-making phase. If that is the case, you need to focus on the potential of your service, product, and solution.

6 - Market analysis

This is again where factual data needs presenting and then backing up. Saying you have a completely unique, first-of-its-kind product or service that will completely change the sector you are in needs backing up with facts. It is accepted that you should be enthusiastic about your planned business but you should not state things that are not accurate.

The reason for this is that angel investors WILL carry out extensive research and reviews of your competition as well as the overall market you will be operating in. They will do this to accurately assess just how your product or service fits into that market niche.

7 - Background checks / Possible team interviews

Based on the human angle, potential investors place a big emphasis on whether to invest in a startup or not. As part of their due diligence they will look very closely at you, as the founder, and the team you have built.

It is quite likely that background checks will be carried out. On top of that, there is the possibility that any potential investor might want to speak with you and your team members on a one-to-one basis.

If they request this it is because they are trying to grasp individual personalities, the value that key team members can add, and their skills as well as business experience.

8 - Are any lawsuits pending?

This will not apply to all startups, however, if your company is involved in contesting any lawsuit, you must make potential investors aware of the facts. Transparency on such matters with investors is very important. Make all documentation pertaining to any pending or threatened legal issues known.

A Professional Way To Ensure You Are Due Diligence Ready

Being due diligence ready can make or break your fundraising efforts. This is where startup founders should seek expert advice and assistance. WOWS Global is ready to offer exactly that.

From state-of-the-art equity management tools including digital cap table management and ESOP management to secure virtual data rooms, document template resource banks, and custom fundraising advisory services – the WOWS Global ecosystem is a tried and tested solution for startups to achieve lightning-speed growth!

When it comes to detailed financial due diligence we will guide you through the process. Our personal assistance will ensure that your startup is ahead of the game before, during, and after your pitch presentation and during those all-important investor follow-on meetings.

Your access to investors will also be spurred on due to our exclusive WOWS advisory service that gives the ability to match like-minded investors and startups. This priority access to exclusive investment opportunities has proved to be a winning formula for a wide range of now-prospering startups.

To understand exactly what WOWS Global can do for your startup, please do not hesitate to contact us for an initial no-obligation discussion at:

support@wowsglobal.com