Funding could mean the life or death of your startup. Sixteen percent of failed startups surveyed by Failory claim that lack of funds was their undoing. Yet, your ability to attract funds depends on the outcome of an investor’s “due diligence” on your business. Seasoned investors know how important this is, and so should you as a startup owner. With a good idea, you can hire android app developer, create a product, and make an appealing pitch. But you can only go so far if your claims fail in the face of scrutiny. This guide will prepare you for your next meeting with an investor—what to expect and how to prepare for due diligence.
What Is Due Diligence for Startups?
When you pitch your business to investors, they don’t accept your claims at face value. Due diligence is how they verify your claims about your startup in order to mitigate risks and uncertainties. According to Thomas Reuters, “due diligence is the process by which a buyer of or an investor in a company, asset or business investigates the reviewing legal, financial and commercial information relating to it […].”
In a typical due diligence process, legal and financial professionals will scrutinize the startup’s records to confirm that its claims are valid and tenable. Before the investor follows through on a promise to invest, his team ascertains the value of your company, your assets including intellectual property, your team, and some other aspects, which we discuss in detail later.
This investigation aims to ensure the investor makes a safe and prudent decision in investing in your company. This is the point where the investor sifts those interesting facts and figures quoted during a pitch to expose claims that are exaggerated, unrealistic, or false. After due diligence, the investor may choose to proceed with the investment or decline based on his findings. With evidence obtained from the exercise, the investor may decide to renegotiate the terms of a proposed investment or request further information before a final decision.
When Is Due Diligence Carried Out?
Once a term sheet—which outlines the terms and conditions of the investment—is agreed upon, due diligence formally begins. For instance, a venture capital (VC) investor will send the startup an initial list of information requests. What often follows is further correspondence between investor and startup teams, more information requests, and efforts to verify claims. This process takes anywhere from 2 weeks to 3 months, depending on how fast information is requested, provided, and analyzed.
However, an investor may run background checks on your startup before formal due diligence. This could be simple website checks or a casual chat with your team.
What Do Investors Ask The Startup For?
If you’re an investor, I bet you want to verify every aspect of the business, every claim, every number. While this is not practicable, investors try to be very thorough when they make information requests, usually covering critical areas of the business. These include details about your team, financials, assets, intellectual property, business model, litigations, and previous investments.
Investors will ask for information that ascertains the number and competencies of your workforce, starting from co-founders, executives, and other key team members. They want to see that your talent base can execute the organizational goals within a reasonable financial outlay.
Your financial records are the most scrutinized aspect of your business. Investors will demand to see your financial reports, income, and cash flow statements, balance sheets, budgets, audited accounts, tax records, and debts. These and other important financial documents are analyzed to ascertain your company’s financial health. Investors also seek out your business plans and financial projections, paying particular attention to the underlying assumptions.
During the due diligence period, you will have to provide details of your assets in the term sheet. In addition, the investor’s team will ask to see official copies of property and other assets acquired, owned, or disposed of by the company. Also, provide details of properties that could be sources of liability to the company, including leases, rents, and property service charges.
Investors in tech startups pay a great attention to your Intellectual Property (IP). They often demand proof that you have the rights to the technology and IP that your startup uses. These proofs include licenses, patents, trademarks, and copyrights. In addition to these documents, tech investors can request to know the status of pending IP applications, disputes, breaches, and any special arrangements.
After you’ve pitched a profitable business model to investors, they come around to ensure it is workable. Some crucial areas of your business plan that investors seek to verify are:
- Market size and market share
- Existing Customers
- Suppliers and Vendors
- Distribution channels
- Business Processes
- Strategic partnerships
Investors will seek to verify that you have healthy business relationships with stakeholders crucial to the business’s success.
The investor’s lawyers will demand details of any outstanding lawsuits, including potential outcomes. In some cases, you may provide details of past lawsuits and their outcomes.
Previous Investments and Equity Structure
Finally, the investor will ask for information about past investments in your startup and your obligation to past investors. Furthermore, the investor will review your capitalization table to ensure ownership value is not too diluted.
Beyond the requests for information, angel investors and VC funds may run background checks to confirm the information you present to them.
Startup due diligence is an integral part of an investment deal. Your team should not approach the process with fear, although it can be exhausting. Instead, you should be proactive, promptly responding to requests for information and providing clarifications and assurances along the way. While entrepreneurs may want to hide important information, this could have legal implications in the future. Investors feel confident to cut you a check when the process is transparent.