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Reality shows like Money Tigers and Shark Tanks have democratized the visibility and access to investment opportunities for startups. But while the requirements from investors have become more diverse and varied, startup due diligence behind the scenes still has more implications. For example, technical due diligence (TDD) may be the highest deciding factor when investors are conducting due diligence for startups offering app-based solutions. This is a rigorous process that can not be done on stage. It may require back and forth with a dev team that provides comprehensive software development service.
Before seeking investment for your startup, it’s essential to understand the key aspects of due diligence. In this article, we’ll provide you with some of the necessary information and tools to make informed decisions in the constantly-changing world of startup funding.
What Is Due Diligence for Startups?
Beyond the startup’s pitch and marketing efforts, investors conduct in-depth assessments before signing on the dotted line and offering their financial, strategic, and operational resources. Just like a bank will not loan you without a proper risk assessment of your credit standing, an investor will not release funds without an appropriate evaluation of your financial viability and potential returns. They will go beyond the information provided to them and do an independent review. That’s due diligence.
Aside from creditworthiness, an investor will typically engage legal professionals to assess the compliance of the products or services with regulations and intellectual property rights before investing. The ability of founders and the team to execute the business plan, drive innovation, and adapt to market changes are also key considerations. In addition, feedback from customers, third parties, and shareholders can not be overlooked as well.
When Is Due Diligence Carried Out?
Due diligence happens before a binding agreement. It’s often conducted immediately after the startup and investors sign a non-binding document known as a term sheet. With that, both parties clearly understand the proposed investment terms and recognize areas of alignment. Startups can then proceed to cross their t’s and dot their i’s wherever needed before a contract is initiated.
What Do Investors Ask the Startup For?
1. Financial Statements: To scrutinize the financial value of a startup, investors will request a profit and loss Statement (P&L), cash flow report, book of accounts, and other related documents. For a startup in the pre-revenue stage, the focus of the financials may shift towards highlighting financial projections, anticipated expenses, funding requirements, and the feasibility of the business model.
2. Intellectual Property: In an age where many businesses depend on open-source tools to build their products, investors often require evidence of strong intellectual property protection and proprietary innovations that differentiate the company from competitors. These typically include proof of patents, copyrights, trademarks, and brand of the company’s products or services.
3. Startup Governance and Staff: During the due diligence, investors will inquire about the documentation of the past and present employee count, their contract terms, expertise, and overall contributions to the company’s growth and success. In short, the document or any other means of communication usually includes details regarding the comprehensive organizational setup and profiles of the management and other crucial staff members.
4. Regulatory Compliance: Startups’ regulatory obligations can not go unscrutinized before an investor decides to invest in the company. From industry-specific regulations to general business compliance requirements, investors want to ensure that the startup understands its obligations and has taken the necessary steps to fulfill them. FinTech startups, for example, must demonstrate robust internal control procedures for regulatory compliance regarding anti-money laundering (AML) and know-your-customer (KYC) regulations, customer data and privacy.
5. Cap Table: Investors usually require a concise, accurate, and up-to-date cap table. This document must include equity structure, showing the past and present ownership and funding details such as the number of authorized shares, diluted shares, securities issued, and the ownership percentages of each shareholder.
6. Market Position: Investors don’t limit their due diligence to the business alone. They also evaluate the market viability and your position in it. In addition, independent checks and direct inquiries go into measuring competitive forces, market dynamics, potential growth opportunities, and market trends.
7. Customer Information and Supplier Agreements: In startup due diligence, it’s necessary to gather information about agreements that establish the rights of third parties to the companies’ assets. These agreements can include security contracts, employment or distributor contracts, mortgages, and other similar arrangements.
8. Overview of Existing and Potential Revenue Figures: This type of due diligence goes without saying. The bottom line is a big deal to investors. They want to see evidence of strong financial performance and sustainable profitability. When measuring potential revenue figures, investors consider KPIs such as customer lifetime value (CLTV), churn rate, average revenue per user (ARPU), customer acquisition cost (CAC), and repeat purchase rate.
9. Risks and Mitigation Strategies: Investors value startups with strong policies and internal controls to cope with possible risks. This may include the Directors and officers insurance policy used to provide financial protection to the company’s directors and officers in case of legal claims or liabilities. Besides, startups dealing with sensitive customer information, financial transactions, or proprietary data must show proof of comprehensive cybersecurity measures.
10. Environmental, Social, and Governance (ESG) Performance: With a market size of USD 715 billion during the peak of COVID-19, the global drive for impact investing is attracting significant attention from investors worldwide. During startup due diligence, funders may assess investments based on the environmental and social outcomes that the startup delivers and its internal governance procedures. ESG makes business sense today, where stakeholders, including policymakers and regulators, increasingly value sustainable and responsible practices.
Startup due diligence can be a dread, especially for new founders seeking funds without strong personal networks. A prior understanding of investors’ expectations and how to meet or exceed them is crucial to ease this rigorous step. We hope the common requirements mentioned here put you on the right track for securing investment and successfully navigating the due diligence process.