Due Diligence for Startups

Due diligence is a critical process for startups, particularly when seeking investment, entering partnerships, or engaging insignificant transactions. It involves a comprehensive evaluation of a company's operations, financials, legal obligations, and potential risks. For startups, this process is essential for identifying hidden liabilities, validating business models, and ensuring that the company is prepared for growth and investment. Whether conducted by investors, potential partners, or the startup itself, due diligence provides transparency and builds confidence, helping startups avoid future challenges and achieve long-term success. Startups should always aim to be due diligence-ready. In this article, we provided tips on how to smoothly sail through the due diligence process either at the request of your investors or in preparation for them.

‍Due Diligence Process

Due diligence is the review done by an investor to confirm the status of a startup before investment to ensure alignment with its investment thesis and risk appetite. The review is performed to discover the assets (revenue, staff strength, cash flow) and liabilities of the business in light of planned investment. This process typically starts once the term sheet is agreed upon between the startup and the investor. Investors leave no stone unturned in the search for potential liabilities. However, to complete the due diligence process promptly, they focus on some key areas:

1. Investors Will Demand Information About Your Employees and The Management

Information regarding your employees and consultants which includes their names, titles, salaries, benefits, etc. would be required. Your team is crucial to a successful collaboration and investors will typically want to work with persons who they believe to be the right fit in terms of vision and personality. Even if the valuation, financials, and product are just right, the investor might pull out of the deal if they identify red flags in the team. More often than not, investors (mostly angel investors) are particular about teams with diverse skills, ranging from product development to technology to sales to marketing.

2. Financials Should be Readily Available

Most times, it is believed that a startup’s past financial performance is the best indicator for future performance. Most investors will want to see your historical financial records (whether audited or otherwise).Be prepared to send over your statement of financial position, comprehensive income, cash flow and other financial statements. The financial information will also assist with the determination of your valuation.

 3. The Equity And Ownership Structure Of Your Startup Will Be Carefully Scrutinized During The Due Diligence Process

There is no doubt that some startups have a complicated ownership structure, because multiple co-founders, angels, and early-stage investors may all have invested in prior friends and family rounds of investment. Therefore, an intending investor must have access to all equity and corporate information. The investors will also assess previous deals your startup has entered into with other individuals and/or companies that binds your startup or exposes your startup to financial liability.

4. Investors Will Want To Confirm That Your Startup Owns Its Intellectual Property

A list of your startup’s trademarks, patents, copyrights and domain names including documentation of filing or registration with the appropriate governmental entities is always required during the due diligence process. These documents will evidence that you have the right to the intellectual property of the product you have developed or are developing. Now, suppose you haven’t filed for patents or registered trademarks of your relevant proprietary products or builds, you may wish to commence the applicable registrations before approaching an investor.

5. Material contracts are very information requirements for the due diligence process.

Investors vary in their risk appetite. Some may be willing to invest in businesses despite the risk involved if the potential return is considerable, while others may be warier and invest in businesses with lower risks. However, both types of investors will assess a startup on how potential risks can be dealt with. One of the ways to access the risk is to see all of the material contracts between the startup and third parties which could have clauses that bind the startup adversely, expose the startup to financial liabilities or encumber the assets of the startup. Some contracts (insurance contracts) also serve to mitigate the business’ risk in multiple ways. The investors are sure to ask for your material contracts which could include but are not limited to SAFEs, Share Purchase Agreement, Loan Agreement, and Debenture Agreements.

Conclusion

It is imperative to draw up a due diligence checklist anticipating what an investor will want to know – most will provide this when the time comes but a checklist early on ensures that these documents are prepared ahead of time and are kept up-to-date.

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