What is due diligence and how do I prepare my startup for it?
Due diligence is a crucial step for any startup seeking funding. It’s a deep dive into the company’s financial and legal history to assess risks and opportunities.
For startups, due diligence is especially important because they often lack a track record of success or established systems and processes. Investors want to ensure that they are putting their resources into a company with a solid foundation and poised for growth.
Going through due diligence provides an opportunity for founders to showcase their business acumen and build trust with potential investors. It can also help startups identify areas where they need to improve their operations or legal compliance.
Like it or not, due diligence is an essential step in building a successful startup. Preparing for and going through the due diligence process is not the fun and exciting part of running a startup. Many founders find it tedious.
If you need support to prepare for an upcoming due diligence, connect with us here. Our Ready to Raise product is designed to get you prepared for due diligence. Ready to Raise is included in all our General Counsel plans.
Key Areas to Focus on During Due Diligence
When preparing for due diligence, focus on several key areas to ensure that your startup is well-positioned for success. Here are some of the most critical areas to consider:
- Corporate Governance. Investors will review your corporate documents such as the certificate of incorporation, bylaws, board consents and foreign qualifications to ensure that the corporation is duly formed and in good standing.
- Funding. Investors will review all your past funding rounds including Simple Agreement for Future Equity (SAFEs), convertible notes, stock purchase agreements, ancillary funding documents and the cap table. This will give them an understanding of the equity stakes, rights and preferences of current shareholders.
- Equity. Investors will review your equity compensation plan and grants to understand how the startup has been incentivizing its service providers.
- Human Capital. Investors will review your standard offer letter, independent contractor agreement, advisor agreement and tech assignment agreement to understand the terms under which the service providers are working for the startup.
- Intellectual Property. Investors will review your patents, trademarks, copyrights and licenses to understand how the company is creating, protecting and utilizing its intellectual property.
- Agreements. Investors will review your material agreements with suppliers, vendors and clients to understand how it creates value and monetizes it.
- Financials. Investors will review your financial statements, including income statements, balance sheets, cash flow statements, and forward-looking projections and business plans. They will look for evidence of profitability and growth potential, as well as any red flags such as excessive debt or irregularities in accounting practices.
- Regulatory. Investors will review your documents related to any threatened or pending litigation, orders or injunctions, as well as any relevant permits to assess the current regulatory risk.
Focusing on these key areas during due diligence preparation can help ensure that investors or partners see your startup in the best possible light.
Sometimes a checklist can help you get prepared. So, we’ve created the following due diligence checklists:
Documents and Information Requested During Due Diligence
During the due diligence process, investors and partners may request various documents and information. Some of the most commonly requested documents include:
- Financial Statements. Investors will review your financial statements in detail, which may include not only current financials but also historical data and projections for future growth.
- Legal Documents. Investors will want to ensure that your startup is in good legal standing and may request copies of contracts, incorporation documents, patents or trademarks, employment agreements, and other legal paperwork.
- Customer Data. Understanding your customer base is critical for investors who want to assess the market potential of your startup. Be prepared to provide information on customer demographics, purchasing behavior and retention rates.
- Marketing Materials. Investors will want to see how you are positioning your startup in the marketplace, including examples of marketing campaigns, sales collateral or social media content.
- Operational Data. Providing detailed information on how your startup operates can help investors identify areas where they can add value. Be prepared to provide details on everything from manufacturing processes to supply chain logistics.
Being well-prepared with these documents and information can help streamline the due diligence process and build trust with potential investors or partners. It’s important to keep all relevant documentation organized and updated so that you can quickly respond to any requests that arise.
Organizing and Preparing Documents and Information for Due Diligence
After you’ve prepared for a due diligence, the startups that set themselves apart from the pack are well-organized and responsive. Preparing for due diligence involves organizing and presenting relevant documents and information in a clear, concise and easily accessible manner. Here are some tips on how to prepare your documents and information for due diligence:
- Investor Checklist. You already have your checklist that you used to prepare for due diligence. But once you enter the due diligence process, every investor has their own version. As a startup founder, your job is to organize the information in their preferred method and give them exactly the information they are requesting (no less and no more). In most cases, if you’ve prepared well using one of our checklists, you will just have some minor tidying up to ensure that you are organizing and presenting the material in a manner requested by the investor.
- Create a Data Room. One of the most effective ways to organize your documents is by creating a data room, an online repository where you can store all of the relevant information that investors or partners may need to review during due diligence.
A data room should be organized into different folders based on the type of document or information. One way to structure the data room is to create a folder for each of the sections on the investor’s checklist. This makes it easy for investors to find what they need without having to sift through irrelevant documents.
- Keep Documents Up-to-Date. It’s important to keep all of your documents updated and accurate. This means ensuring that only the final executed copy of the agreement is in the data room (not an unsigned draft). It means regularly updating financial statements, legal agreements, customer data, marketing materials, etc., as changes occur. Outdated or inaccurate information can cause delays during due diligence and may even lead to investors losing confidence in your startup.
- Use Secure File-Sharing Tools. When sharing sensitive documents with potential investors or partners, it’s important to use secure file-sharing tools. These tools provide encryption and other security features that help protect your confidential information from unauthorized access. Examples of secure file-sharing tools include Dropbox Business, Google Drive Enterprise, Box Enterprise, etc. These tools also allow you to control access to specific files or folders so that only authorized individuals can view them.
By following these tips when organizing and preparing your documents and information for due diligence, you can help ensure a smooth and efficient process that builds confidence with potential investors or partners.
The Role of Legal Counsel During Due Diligence
Legal counsel plays a vital role in the due diligence process for startups. Their primary responsibility is to ensure that all legal aspects of the startup are in order, and that it complies with all relevant laws and regulations.
During due diligence, company counsel works with investor counsel to review existing legal documents and agreements, including contracts, intellectual property filings, employment agreements, and any other relevant legal paperwork. They are also responsible for identifying any potential legal risks or liabilities that could affect the success of the startup.
In addition to reviewing existing documentation, legal counsel may draft new agreements or modify existing ones to better protect the interests of the startup and its stakeholders.
Having experienced legal counsel on board during due diligence can provide investors or partners with additional confidence in the integrity and potential success of the startup. It can also ensure that all legal requirements are met, and any potential risks are identified and addressed before they become major issues.
If you need legal support during due diligence, feel free to contact us here.
Addressing Potential Red Flags During Due Diligence
No matter how much you prepare, during due diligence, investors will likely raise some issues or red flags that may give them pause. These can include everything from inconsistencies in financial statements to legal compliance issues or operational weaknesses. While it may be tempting to downplay or ignore these red flags, addressing them head-on is often the best approach. Here are some steps you can take to address potential red flags during due diligence:
- Be Transparent. The worst thing you can do when faced with a potential red flag is to try to hide it or downplay its significance. This will only erode the trust between you and your potential investors or partners. Instead, be transparent about the issue and provide as much information as possible. Explain what steps you have taken to address the issue and your plans for mitigating any risks going forward.
- Provide Context. Sometimes, a potential red flag may arise due to circumstances outside of your control. For example, if your financials show a dip in revenue over the past quarter, it may be because of external factors such as changes in market conditions or unexpected expenses. Providing context around why a particular issue has arisen can help put it into perspective and demonstrate that you have a clear understanding of the situation.
- Offer Solutions. When presenting potential red flags, be sure to offer solutions for how you plan to address them. This could involve implementing new processes or systems, hiring additional staff with specialized expertise or renegotiating contracts with suppliers. By showing that you have a concrete plan for addressing any issues that arise during due diligence, you can build confidence with potential investors or partners, and demonstrate your commitment to building a successful startup.
Addressing potential red flags during due diligence requires transparency, context and offering solutions. Taking these steps can demonstrate a startup’s commitment toward building a successful business while building trust with investors and partners alike.
Efficiently Managing the Due Diligence Process
Due diligence can be a complex and time-consuming process, but the skills required to ace due diligence are the same skills required to manage any project effectively. Startups can manage it efficiently by taking the following steps:
- Assign a Point Person. Choose a single person to lead the due diligence process. This person should be the head of finance or operations, and should make due diligence their primary job during the process. It’s a good idea to delegate their usual day-to-day responsibilities to another team member until due diligence is finished so they can focus on the task at hand. The point person will coordinate with all stakeholders involved, including legal counsel, financial advisors and other team members. They should also organize relevant documents and information in a centralized location, such as a data room (discussed earlier). By having one person in charge of managing due diligence, startups can avoid confusion or delays caused by multiple parties working independently.
- Set Clear Expectations. It is essential to set clear expectations with potential investors before beginning the due diligence process. This includes discussing timelines, required documents and information, and any specific areas of focus for due diligence. By setting clear expectations upfront, startups can avoid surprises or misunderstandings later in the process. It also helps ensure that everyone is aligned on what needs to be done and by when.
- Be Responsive. During due diligence, startups should respond quickly and thoroughly to any requests for information or documentation. This not only helps move the process along but also demonstrates their commitment to transparency and accountability. If there are any anticipated delays in providing requested materials, communicate this proactively with investors or partners so that they understand what is happening and why. Being responsive throughout the due diligence process helps build trust and confidence with potential investors or partners.
- Anticipate Potential Issues. While it’s impossible to predict every issue that may arise during due diligence, startups should take steps to anticipate potential problems. This includes conducting an internal audit of all relevant documents and information before beginning the due diligence process. Identifying potential issues early on can help startups proactively address them and avoid surprises later in the process. It also demonstrates a commitment to transparency and accountability.
- Stay Organized. Finally, staying organized throughout the due diligence process is essential for managing it efficiently. This includes keeping all relevant documents and information updated, using secure file-sharing tools and maintaining clear communication with all stakeholders involved in the process.
Startups can efficiently manage the due diligence process by following these tips. This process represents the first time that you and the investor work together on a project. By following these steps, your startup can create a positive first impression regarding how the team operates.