Before giving money to a company, VCs do a thorough background check to verify that the information provided by the company is correct.
This requires going through the company's operational, financial, legal, taxation, & compliance documents. Founders can prepare for this due diligence (also called DD) and ensure there are no hiccups at the last moment.
This checklist will help you prepare for the due diligence process.
Giving an excellent pitch for an innovative product is not enough to get a cheque. No prospective investor will ever invest in your company without doing proper due diligence. So, having all documents and necessary information ready will give you an edge in the fundraising process.
Fundraising due diligence involves verification of the facts and figures of your startup by investors, such as traction, taxation, compliance, etc. To commence the due diligence process, investors ask for documents like shareholder agreements, board of directors meeting reports, tax statements, licence agreements, etc.
Would you buy a car without test driving it? For most of us, the answer would be no. We want to make sure that we invest our money in the right product.
Similarly, during the fundraising process, as the investors give term sheets, it is subjected to due diligence. If you pass the due diligence test, you get the money in your bank account. Otherwise, the deal stalls.
For startups, the challenges are that due diligence can be time-consuming and if you’re not due diligence ready, it may delay their fundraising. If you start from scratch collecting the doc, you lose momentum. Tracking/searching for docs can take weeks. In the worst case, it can kill the deal.
But you can fast track it by being DD ready. Keep docs ready. Keep your house clean. Be ready on your part.
Most entrepreneurs don’t like the DD (due diligence), because it involves a lot of bureaucracy and red tape. But for us, it also helped us clean up our own work. As an entrepreneur, we don't pay attention to a number of things we may consider a low priority. But the DD helped us bring everything together, make it squeaky clean - and I think it’s a good exercise.
-Bala Parthasarathy, CEO and Co-Founder, MoneyTap
Though you can't control the VC end, you don’t want to search around to find documents and information at the last minute. It will delay the process.
For investors, rigorous due diligence ensures that they are not taking more than the intended risk. The main objective is to see if the startup has maintained the hygiene and validate the founder's claims during the pitch.
In this post, we’ll discuss the due diligence process and will also provide a checklist that you can use for a fruitful fundraising process.
The depth, the documents required, and subsequently, the time it takes to complete the due diligence varies by different stages of startups and also by the industry in which they operate.
Early-stage companies (pre-revenue startups) have very few transactions–so there is not much to verify in due diligence. The capital invested by investors is small. Most angel investors don't have the resources for in-depth due diligence. The investment decisions are mainly based on the founders and business potential.
Only the basic docs may be required at this stage:
At this stage, financial reports are relatively less important as compared to large deal/later stages.
Series A and onwards, as the company starts possessing transactions, the due diligence takes time. So you’ll be required to prepare for due diligence mainly from series A.
The investment capital becomes larger from series A and is mainly raised from institutional investors. Institutional investors (VC firms) don't invest without proper due diligence. As the stake is higher, the institutional investors are more structured and follow a rigorous due diligence process before making any investment.
At the growth stages–from series B onwards–you can hire lawyers and financial advisors to prepare and help you clean your house before going for fundraising. It can save weeks–and many times, help in closing the deal.
From the VC end, professionals like accountants, lawyers, and financial advisors, do diligence in their respective areas. The more the investment amount, the more rigorous the DD would be.
Pro Tip: After the pitch presentation, tell them that all the data is in place and you are ready for DD. It shows you are an expert and knows how VC space works. It builds a good impression. Even if they don't invest–and they may refer to someone else who is more suitable.
Every venture capitalist has its own due diligence process but they all revolve around the following key areas:
In this checklist, not everything may be relevant to you. Just be prepared for those that are. Being ready gives the impression that you are very organised.
Let us see what different things investors look for in due diligence are.
Financial due diligence covers the review of financial reports, income sources, accounting standards, cash flows, balance sheets, projections, etc. With financial due diligence, investors are verifying that the financial information for past periods is accurate. They are also confirming whether the company's financial projections are reasonable enough or not and supported by relevant evidence.
The financial checklist revolves around the following questions and verification processes:
A taxation DD is done to make sure that you have complied with all the taxation requirements. Taxation due diligence helps identify underreported tax liabilities and see if all the tax liabilities are adequately represented in the books.
The taxation checklist revolves around the following questions and verification processes:
Common mistakes to avoid: Use of spreadsheets for maintaining books, use of personal account for transactions, missing profit and loss statements, unrealistic financial model
Technical due diligence is very much dependent on who conducts it. There are no standards for it. It takes from a few hours to 2 weeks to complete technical due diligence. With technical due diligence, investors want to confirm that the product does what you have claimed, is stable and won't create issues as it scales.
The technical checklist revolves around the following questions and verification processes:
Common mistakes to avoid: wrong or no architecture for the business context, lack of engineering best practices like version controlling, devOps best practices, containerisation, test automation or clean code, not taking data security seriously and not relying on micro services and trying to build everything.
Investors want to verify the legal aspects of your company’s transactions, be it court filings or property documents. It involves verifying different legal documents to see current and potential lawsuits against the company.
Is there any conflict or ongoing lawsuits on the startup? Is there any loophole in the company which can potentially cause lawsuits? Investors evaluate the startup to understand the compliance with contemporary rules and regulations depending on the industry.
The legal checklist revolves around the following questions and verification processes:
Intellectual property falls under the category of intangible assets. With IP due diligence, investors can confirm the value of your company’s IP assets. They can ascertain if your company is valued at its potential or whether some assets are overvalued. Major IP assets include trademarks, copyrights, patents and trade secrets. It's better to take the help of an intellectual property attorney to assess your IP and be well prepared for IP due diligence.
The operational due diligence involves assessing the day-to-day operations of your business like sales, top management team, HR activities, and employee satisfaction. These factors show the level of operations of your business and how sustainable it is. Investors will be more encouraged to invest in businesses with a positive operations history.
The operational checklist revolves around the following questions and verification processes:
The due diligence process shows your credibility and that of your business. Though the due diligence happens subtly throughout the fundraising process, the formal DD starts after signing the term sheet–and happens before every fundraising round.
Some VCs may ask for a few docs while taking the applications during the initial stage. Keep in mind that these are not detailed evaluations and just to make sure you have those documents. It is done mostly for screening purposes. So, if you don't fit into their investment philosophy, they can filter you out.
For example, if the VC only invests in the fintech and HR tech domain, others will be filtered out. In such cases, there would be another detailed DD after signing the term sheet.
If your record is clean, you can expect a more favourable relationship with your investors going forward.