Ten tips for startup founders on investor due diligence

Startup funding is a remarkable farrago of falsehood and myth, but, before you head to investors with your pitch, you’ll need to prepare for the due diligence process.

Due diligence is an audit process a potential investor undertakes before committing to investing in your venture. The aim of due diligence is to check that everything you’ve told them matches up with the data. Investors also use due diligence to uncover any red flags a startup may have left out of their investment pitch. There’s no hard and fast process, the intensity of the activity often depends on the amount of investment involved. For example, pre-seed projects will likely go through a less rigorous analysis than a company heading into series A funding.

Due diligence occurs after you’ve presented to an investor and they’re interested in your proposition and seriously considering investment. Think of it this way: you wouldn’t buy a property without first carrying out a survey to check for potential issues. investors view the due diligence process in the same way, its how they gain assurance in your startup credentials.

Note that it’s never wise to oversell or misrepresent your venture’s growth, capabilities, or performance. While all startups are keen to grow and gain investment, honesty and integrity are paramount. If you falsify any statements, investors will find out – think Theranos! All of this is to say that due diligence is a process that should be taken seriously. Don’t try to pull the wool over your investors’ eyes. Approach the process with a commitment to accuracy and transparency.

My experience working with startups is that preparing for due diligence is an opportunity to verify the growth plan, taking a bird’s eye view across the business and see areas that are optimised and those that need improvement. It’s a bit like having a medical, checking the ‘vital signs’ and everything is in good working order.

So, let’s look a little more at what the due diligence process involves.

The time required for a due diligence project varies, depending upon the size of the investment and complexity of your business. The aim is to run the process alongside the investment contract negotiations, putting it at the centre of a potential transaction and on the critical path to completion. It’s an agile process, designed to ensure key issues are identified on a timely basis to inform discussions.

The process starts with an information request or due diligence questionnaire, outlining the information the investor requires to facilitate their decision to turn their interest into a tangible investment commitment. This usually follows an agreement ‘subject to due diligence’ which is documented as a ‘Heads of Terms’ signed by both parties which sets down the principal terms on which the investment will be made.

The output of the due diligence review will highlight issues and risks to be considered before the investment is concluded – for example, legal disputes, high employee turnover, customer churn – or on the upside, confirm sales growth projections, validate new product development and the calibre of the leadership team.

Having completed a well-scoped due diligence review, prospective investors or acquirers will benefit significantly, becoming more informed about their proposed target:

  • It can help deliver a stronger deal and smoother transaction, enabling an active dialogue which improves the relationship between the two sides and facilitates the mechanics and detail of the deal.
  • For the investor, it allows them to decide if the target investment is the right fit and value to their portfolio, giving them otherwise unknown insights.
  • It will reduce risk post-transaction, by highlighting current and potential future issues in the business which could come to light later down the line, and have an adverse impact.
  • Provides expert third party insight into the target company – for example, technical due diligence could highlight issues with technical debt or scalability challenges which may not have been apparent.
  • Provides clarity on the underlying financial model of the business, thus giving some comfort on the future performance and return on investment.

You can clearly see why investors value a due diligence review on a potential target business. However, if you are considering taking investment, then it is worth undertaking due diligence on yourself to see if you are ‘investor ready’. This means collecting all the information which a potential investor will want to see. It may highlight any issues that you can tackle prior to investment and will allow you to present your business in the most favourable way possible, ensuring you get the best valuation for your business and investment terms.

Ahead of commencing the process, I recommend entering a Confidentiality Agreement before handing over any sensitive data you’ll disclose. You’ll want to ensure the party is obliged to keep this information confidential. In return they may require an Exclusivity Agreement to give them a period where you are only talking to them.

With that in mind, here are ten things to prepare for your diligence assessment.

1. Financial information and business plan Your business plan and financial records and projections are the most common data points investors ask for.  For your potential backer, the aim of reviewing this information is to make sure that your pitch deck matches up with the business plan and forward view on detailed numbers. They’ll also want to ensure you’re not struggling with cashflow is the timing of investment ask in advance of runway challenges.

2. Intellectual Property Rights Your IP rights are a key differentiator, what gives you sustainable competitive advantage and uniqueness in the market? Often cited as ‘the moat’ of your startup, defensible IP is compelling to an investor as they improve your exit value.

3. Business Documentation Potential investors will want to see a variety of company and legal documents – shareholders’ agreement, cap table, minutes of management meetings, employment and customer contracts, lease agreements etc.

4. Litigation The startup world can be pretty tough. If your company is in the unfortunate position of battling a legal dispute, ensure to be transparent with any incoming investors. Provide documentation on any legal issues, pending or threatened from customers, suppliers of ex-employees.

5. Meeting the team The human factor is for me the reason why I invest in startups. The product, market, and opportunity maybe compelling but if the team aren’t convincing in their ability to sell and execute, I step aside. As part of due diligence, you the founder and your key colleagues are going to be put under the microscope. As well as conducting background checks and even psychological assessments, potential investors may wish to speak your team one-on-one to assess personalities, values, and competancies.

There’s not as much you can do to prepare for this phase. The success of your business depends on your team, so it makes sense that investors place such an emphasis on the people element of a startup.

6. Customer data and revenue numbers In your pitch, you’re going to say that you’ve developed a product or solution that customers love. Potential backers will want to check this. They may ask to reach out to customers for verified feedback about your company.

Expect investors to want to hold a clear understanding of your revenue streams. Ultimately, they want to determine how your business model makes money and can scale in the future.

  • Pain point: What is the customer need?
  • Product: Does your product solve this pain point?
  • Satisfaction: How happy are the customers with you?
  • Competition: Why did they choose your product?
  • Stickiness: What would make the customers switch to you and then stay?

This step will include preparing metrics such as your churn rate, cost per customer acquisition, average revenue per user, conversion rate etc.

If you are pre-revenue and at proof-of-concept, don’t fear. Focus on the potential of your solution, creating realistic forecasts of what your revenue will look like once you’ve actioned a go to market strategy. But be wary of being overzealous about proposed figures, be confident but extreme predictions may damage credibility.

8. Market Analysis If you’ve proposed that your startup is a true innovator and offers an industry-first, with game-changing features that are like nothing else out there, you need to ensure this opinion is valid. As part of the due diligence process, investors will undertake a market sizing review, a competitor review, and how you fit into it. What is your moat and path to dominance ? What are the latest trends in your industry? Staying on the pulse is vital and will show your investors that you’re reliable and in-the-know.

9. Preparation and documentation Ahead of commencing the process, and providing access to the data room, there are some key documents you need to have in place, including a draft offer letter, a term sheet ‘subject to due diligence’, an exclusivity agreement and agreed timescales for the investment. Don’t be pushed into disclosing company confidential information until the investor provides these and evidences their firm intent.

Equally, if your data isn’t in good order, an investor may not build enough confidence to sign on the dotted line. For that reason, preparation is key. By following the above checklist, you’ll be able to tackle the content of the due diligence process. Having an organised, indexed, comprehensive data room is a pre-requisite, enabling sharing via the cloud.

Finally, at the end of the process, you will required to sign a Disclosure Letter which confirms you have disclosed all relevant information to the investor, so it’s back to being open and transparent.

10. You! Whilst a startup isn’t as much about the founder as many think, at this stage investors are investing in you. They’re looking for founders with a deep drive and personal motivation, paired with a growth mindset, which enables them to attract talented people around them when scaling the business. They’re looking for resilient founders who can go through the rough patches while staying humble. To balance this, they’re looking to exclude ‘spiky’ founders who think they know it all. There will be lots of contact with you throughout the evaluation process as you participate in most of the meetings, so they will observe you up close and personal.

In a way, you can’t really understand and appreciate the challenges of due diligence until you have experienced it yourself. It’s an exciting time raising funds, but in reality, it can quickly get tedious, confusing, and frustrating because of the level of details and time that it takes.

There are many startups out there, just like you, seeking funding. Often, the difference between investment success and failure is how you approach due diligence, it really has an impact on the investor decision not just in terms of the data, but also their experience of the process – it gives them a good insight into your business, your folks and you.

Put in the time and effort to ensure that your approach is open, honest, and transparent, make yourself available and accessible, and that documentation is accurate and matches what you’ve put in your pitch deck. Do this, and your startup will be on the way to an exciting new phase.

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