Due diligence in the context of startups refers to the audit/evaluation of the business that angel and Venture Capitalist investors conduct before determining whether to invest. Effective due diligence is, therefore, essential for startup fundraising. Due diligence is a concept everyone who has ever watched Shark Tank, Dragon's Den, or any other program where billionaire investors test startup entrepreneurs would be familiar with. Investors are introduced to several businesses throughout the programs, along with their financials and expected growth. The presentation is polished and assured, and suddenly it ends because the entrepreneur left out a crucial detail. A concealed debt, litigation with a former business partner, or some other ethical problem with the proposed product is frequently discovered by investors.
What is due diligence?
An informal introduction to due diligence can be seen in the banter between startup founders and investors on Shark Tank and similar programs. In truth, due diligence is a far more formal and regulated procedure in which investors thoroughly examine every facet of the company.
As used in the context of startups, due diligence refers to a series of inspections an investor might perform on a startup to verify that particular facts about the company are accurate or that the investment is a suitable strategic fit. The second objective of the due diligence process is to find potential red flags that should have been mentioned before the due diligence. An acquirer who is considering an acquisition may also conduct due diligence.
Who performs due diligence?
The type of due diligence required by a company, as well as who will perform it, will be determined by the stage of the business and the amount of the transaction.
For instance, a founder raising £100,000 in pre-seed funding for their startup will receive fewer checks from angel investors than a business raising £1M in Series A funding from a venture capital company or being acquired by a corporation for £100,000,000.
For early-stage investments, investors frequently conduct their due diligence, which typically includes speaking with the founder several times to understand their vision, methodology, and whether they possess the necessary skills to deal with unpredictability.
Lawyers and accountants will frequently perform due diligence for a significant transaction, ensuring that all paperwork and financial projections are accurate. Background investigations on the co-founders and key management team can also be part of due diligence and can be done by other parties.
Process of due diligence and checklist
When a startup engages with an investor, informal due diligence begins. A general definition of the company is given using the seemingly trivial questions that investors pose. The procedure can start once the term sheet has been approved by both the startup and the investor.
A venture capitalist request list, including several information requirements, will now be sent to the startup by the investor, who is usually always a VC investor.
The complexity of the company and its ecosystem, the speed at which papers may be retrieved, and the VC investor's ability to obtain and process information quickly all affect how long due diligence ultimately takes. Naturally, if there are any anomalies throughout this procedure, it will also slow down or stop altogether. The procedure should take no less than two to three weeks, but it could go on for up to two months.
Going through a due diligence process as part of the evaluation verifies that the organization under consideration is able to respond to inquiries and provide sufficient justification when needed. The due diligence checklist might, for instance, demand that the company's audited financial records, including its capitalization table balance sheet, financial statements, income statements, and business plan, be disclosed as well as the directors' identification proof and the company's audited financial records.
In order to ensure that the company's intellectual property rights and cash flows are adequately protected and that the company is not bearing an excessive amount of liability or capital expenditures in its agreements, due diligence checklists also include reviews of contracts (redacted when necessary), such as stock option or employment agreements.
To make sure the company's intellectual property is adequately safeguarded, the due diligence checklist can also include an examination of patents, trademarks, and copyrights. Startup due diligence frequently includes interviewing the management team concurrently with these operations to better understand the methods that produced these data.
When due diligence takes place and its outcome
In advance of a financial transaction, due diligence is performed. Due diligence may also be performed in connection with a regulatory investigation or following security failures like breaches. Startups should set themselves up for due diligence from the start by gathering the appropriate paperwork and organizing it in a way that makes it simple to retrieve it should the need arise.
A due diligence report that summarizes the process will be produced as a result of the process, enabling the investor or acquirer to decide whether to make an investment or pursue an M&A transaction. M&A transactions or investments will be given the all-clear to proceed in the form of a term sheet stating the parameters of the agreement, assuming the company has submitted all necessary papers and the due diligence has not revealed any red flags.
The investor is almost certainly interested in the product or service if the due diligence stage has already been achieved. The investor looks out for almost everything in the due diligence process, including but not limited to product/service, market, people, financials, equity structures and risks. Being honest with potential investors or acquirers about risks and any aspects of your company they might be concerned about is crucial for startups. Early discussion allows for establishing a course of action before these concerns are classified as red flags.