The Importance of Due Diligence in Startup Investments

Those investors who choose to put their money into startup companies are seen as taking a bigger risk than those who invest in publicly listed companies. However, with that risk, there is also the opportunity to achieve far healthier returns.

This is a major reason why certain types of investors find investing in private startup companies so appealing. But, appealing or not, it is only sensible for startup investors to be aware of how important it is to carry out due diligence on any startup they are looking to invest in.

Here’s a good look at what due diligence is and other factors that both startups and investors need to be aware of.

What is Due Diligence?

An investigative process. It is something that investors carry out to gain a better understanding of the target company they are looking to invest in.

It is also a very important step in the M&A (Merger & Acquisitions) process where the investor gathers evidence to enable them to assess the future performance of that target company.

Due diligence in the startup world relates to the audit process that potential investors carry out before deciding whether to invest in the startup or not. The intention of this process is for investors to check that everything the startup states matches up with the data available. It is also used to uncover any ‘red flags’ that a startup may have omitted from their investment pitch.

There is no single process for due diligence because the intensity of activity often depends upon the amount of investment involved. To give an example, startups going for pre-seed funding are likely to go through a less thorough analysis than one heading into series A funding.

This means that the due diligence process can be as straightforward as a conversation at the end of a pitch or, as will be seen below, a much more rigorous approach that involves investors carrying out financial, legal, operational, and personnel due diligence exercises.

When Does the Due Diligence Process Occur?

It tends to happen once you have carried out your pitch presentation to either an angel investor or VC (Venture Capitalist) firm. If the investor(s) you have presented to are interested in your proposition the next step would be for them to proceed with due diligence on your company.

There are obvious reasons for this approach. After all, it is highly unlikely that any individual would purchase a property without having a survey carried out to check for any issues. Startup investors view their investment decisions in the same way. It helps them to gain assurances about your company before they commit to funding.

The next section is aimed at startup founders but potential investors need to understand this too.

Founders Should not Consider Fudging the Books

Founders should always follow ethical business practices. This means it can never be considered wise to misrepresent your business or to fudge the books.

As a founder, it goes without saying that you are keen to secure investment that will allow you to grow the company. However, integrity and honesty are a must.

Any startup that attempts to falsify documents can be sure that the investor concerned will eventually discover this. When they do, the startup concerned will suffer serious legal complications.

Founders need to understand that many investors will include specific contract terms relating to misinterpretation. Any startup that is found to have purposely misguided stakeholders is open to being sued and as a worst case being charged under criminal law.

This should highlight just how seriously the due diligence process needs to be taken. Founders need to adhere to best business practices and make a commitment to be as transparent and accurate as possible when providing investors with the required information.

With these factors in mind, let’s take a look at…

The 4 Main Due Diligence Areas That Will be Concentrated on

As touched on, the startup due diligence process can vary and is dependent upon the specific case. However, for more comprehensive research and clarification investors will look at 4 main areas. These are:

Financial due diligence

This is the process used to evaluate a startup company’s financial performance and health. During financial due diligence, financial statements and other financial documents are compiled for review. Examples here are cash flow and income statements, balance sheets, tax returns, and other documents related to the startup's finances.

This financial review is important to potential investors as it helps them understand how financially sound the target company is. It also gives an insight into whether the startup has (or will have) sufficient resources to carry out its operations while meeting its stated milestones. 

Financial due diligence can be used to establish whether the startup in question is a good investment opportunity or otherwise.

Legal due diligence

The legal due diligence review process is carried out to ensure that the target business is legally compliant with all applicable regulations and laws. It involves research of the company’s legal structure, ownership documents, licenses, permits, corporate governance documentation, IP (Intellectual Property) rights, records of litigation, and employee contracts.

An element of this research will look into any potential legal obligations or liabilities that could arise from carrying out the business in a particular industry sector or jurisdiction. Startup investors should also review all agreements or contracts that are in place to make sure their rights will be protected.

In essence, the reason behind the legal review element of due diligence is to establish whether there are any legal issues that could affect the successful investment (or acquisition) of the target company.

Operational due diligence

As the term suggests, this strand of startup due diligence for investors involves examining how the target company operates its business. Factors here will include assessing the company organization, how it is managed, and how it is run on a day-to-day basis.

Through this review, investors will also look into the company’s processes and systems to understand just how effective and efficient they are. Completing operational due diligence can also give investors insight as to whether a startup has true potential for future growth.

Personnel due diligence

The final area of the startup due diligence process for investors should be a personnel review. This is important because it will help establish whether the startup has the right management team in place to carry out set goals, objectives, and their ability to reach projected milestones.

Such a review will look at employee contracts, their qualifications, experience, and the skill sets of each team member. Interviews with personnel can also help establish how dynamic the team is, how well they work together for the good of the company, and whether the working environment is a healthy one.

Why is Detailed Due Diligence Essential?

There is no secret that the more informed you are, the better placed you will be to make an informed decision on whether or not to invest in the target startup company. Carrying out research in the above 4 areas of due diligence will certainly arm you with the information required to make that decision.

The due diligence process is essential when evaluating a potential investment. Why? Because it allows investors the opportunity to identify any potential risks that may be associated with the target company.

It also gives investors a more detailed, in-depth understanding of the startup. This understanding will be seen in such areas as the company’s competitive advantages, their weaknesses, and it can help to highlight opportunities for improvement. 

Understanding any potential risks and the startup's potential ahead of time it is giving you investor-advantage. This advantage can then be used to decide whether the target company you are looking at is a worthwhile investment or not.

How Long Does the Due Diligence Process Take?

As can be imagined, the length of time taken to go through the due diligence process is dependent upon several factors. Each investor will have their own approach and this includes the amount of time they are willing to spend on it.

To begin with, the stage the startup is at and the complexity of its operation will affect the duration. As an example, a startup that has a complex business model or one that has gone through several funding rounds will take more time and attention than a startup at an earlier stage in its lifecycle.

This means that investors should see the due diligence process taking anywhere between several weeks to a few months.

Use a Startup/Investor Platform That is Second to None!

Serious startup investors should seek professional assistance and insight when going through the due diligence process on a potential investment.

As South East Asia’s most active investor matching platform, the highly knowledgeable team at WOWS Global is perfectly placed to give that.

Our mission is to assist both startups and investors to realize the potential of mutual funding initiatives. This is spurred on by our secure, online Virtual Data Room that allows ease of access and storage of all relevant data.

Concerning investor services, the comprehensive solutions that WOWS offer investors are second to none. We allow investors to achieve such things as portfolio diversification, access to exclusive cap table holdings in fast-growing private companies, and bespoke investment solutions that give customized offerings based on industry, sector, and asset class.

Any investor who would like to be considered for an exclusive invitation to join the WOWS Investor Network with its access to hundreds of vetted and growing Asian start-ups should click here. Alternatively, please feel free to contact WOWS to find out exactly what we can offer you:

contact@wowsglobal.com