Preparing your startup for due-diligence
As a startup founder, you’ve poured endless energy into building your company. But when the time arrives to court investors, one has to prepare yourself for the scrutiny of due diligence.
Prospective venture capital firms or angel investors will dissect your financial and legal documents to ascertain if you startup is not carrying undue risk.
Employing a meticulous checklist will smoothen the process and bolster your chances of success. Here, we dissect the critical components of due diligence and furnish startups with an indispensable checklist.
All early stage investments inherently carry risk; that’s the nature of the business. Depending on their stage, startups carry founders’ risk, technical risk, market risk, scalability risk etc. But the objective of the due diligence is to assess whether:
- Whatever that has been shared with the investors in terms of financial statements, customer contracts, metrics etc. is correct
- All compliances are in place and no undue risk is evident
- Best practices in terms of employment contracts, IP protection are being followed
Due diligence can be divided into the following groups:
| Financial Statements |
A review of the startup’s financial records is a critical aspect of due diligence. Investors check financial statements, tax returns, bank statements, and any other financial documents that. It is critical to keep the financial records up to date and accurate. The key records to be examined includes: Last 3 years’ P & L statement and balance sheet Last 3 years’ cash flow statement Tax returns Bank statements for the last 6 months Details and breakup of accounts payable and receivable Loan agreements, if any |
| Legal and Secretarial documents |
Investors will also want to look over your legal documents- articles of incorporation, bylaws, operating agreements, shareholder agreements, and any other legal agreements. It is imperative that these documents are current, accurate, and legally binding. Any ongoing legal proceedings shall need to be transparently shared. Compliance with labor laws will also be checked. |
| IP related documents |
Patents, trademarks, brand names and logos, content rights, copyrights, and other intellectual property that your startup owns will be scrutinized by investors. You will need to show the necessary documentation to prove ownership. Many times the IP is still owned by the founders. In such a scenario, the investors will insist on the IP being transferred to the startup before they close the deal or transfer the funds. Any IP related disputes will need to be disclosed. |
| Customer contracts |
Investors will want to look into customer contracts to develop a view on the revenue streams and customer relationships. It is critical that the contractual obligations as per papers match with what you shared at the time of pitching. |
| Employee contracts |
Employee agreements are an important part of due diligence. Investors will review your employment contracts, including non-compete and non-disclosure agreements, as well as any other relevant contracts. It is critical to ensure that these agreements are legally binding and that you are in accordance with any applicable employment laws. Even the founders should have employment contacts with the startup. |
What happens if the due diligence is not as per expectations of the investor?
It depends on the extent of deviations in the due diligence. If they are not significant then the investor may negotiate additional rights and/or valuation of the startup. If the deviations are significant, then the investor may drop the deal.