The impact of fundraising due diligence on valuation

In the world of venture capital (VC), the phrase “due diligence” is used to describe the process through which an investor evaluates a possible investment. Investing in start-ups is inherently risky. Selecting prospective winners, identifying major risks, and working out a strategy to mitigate those risks with management are all part of the diligence process. When considering whether or not to invest in a new or developing business, due diligence is an essential first step.

To determine the feasibility of investing in a startup, venture capitalists examine the company’s financials, legal papers, market and competitive environment, operational KPIs, and management team. But what about the impact of fundraising due diligence on valuation? Is there a negative impact of fundraising due diligence on valuation? Let’s find out!

Due diligence and valuation

A venture capital firm or similar investor will not put money into your business unless they have completed a thorough due diligence procedure. To assess the commercial and legal potential of the opportunity, a set of questions must be asked and answered. When it’s done, the investor will utilize the results to get the necessary approvals from inside and make the investment. The results of the VC’s diligence may also be shared with the other investors in the syndicate if the VC is acting as the lead investor.

What is due diligence?

The term “due diligence” refers to the research or careful consideration that any reasonable company or individual would be expected to do ahead of entering into a contract or arrangement with another party.

It may be required by law, but in most cases, it’s used to describe inquiries that are conducted voluntarily. In many fields, diligence is most often shown by an acquirer investigating a target firm or its assets before deciding whether or not to complete an acquisition. According to proponents of the concept of “due diligence,” such an investigation improves the quality and quantity of data available to decision-makers, and it guarantees that this data is systematically considered in the context of the decision’s potential outcomes.

Purpose of Fundraising Due Diligence

Performing due diligence is a method for lowering one’s risk exposure. Before a party gives their consent to a transaction, the procedure makes certain that they are fully informed of all of the facets of the deal. For instance, a broker-dealer would provide the contents of the report on diligence to a client so that the investor may make an educated decision and refrain from holding the broker-dealer liable for any losses.

Types of Due Diligence in Fundraising

The type of diligence in fundraising depends on the nature of the business and the requirements of the investor. However, the most common types of due diligence are discussed as the following.

• Intellectual Property and Technical Due Diligence – It is an examination of a product’s or service’s intellectual property and its technical characteristics. For IT firms, this is a subject of crucial importance. Experts in the area of technology will investigate the possibility of this action to determine its feasibility.
• Due Diligence in Taxes and Finances – During this process, analysts look at the company’s past financial records, either as a whole or for individual projects, as well as our projections of future performance and financing needs.
• Due Diligence in Human Resources – Human resources (HR) due diligence includes familiarity with local employment agreements, labor laws, labor relations, regulatory frameworks, work environment, and industry standards. Financial costs and benefits might be associated with an organization’s human resources.

Timeline and process of conducting fundraising due diligence

During the venture capital (VC) due diligence process, a firm is thoroughly researched and analyzed before any investment is made. The procedure usually includes looking at the company’s books, contracts, industry, and performance indicators. Some of the most important phases of a venture capital diligence process include:

• Checking the Numbers – A thorough evaluation of the startup’s financial accounts, cash flow estimates, and revenue sources is an essential part of doing financial diligence. The goal is to spot any warning signs or prospective financial issues that might derail the transaction.
• Respecting Requirements of the Law Regarding Due Diligence – The process of doing legal diligence includes investigating the startup’s incorporation papers, shareholder agreements, employee contracts, and Intellectual Property. The purpose is to locate possible legal issues that might detract from the investment.
• Analysis of the Market and the Competition – Conducting market and competitor diligence includes investigating the startup’s target market, existing competitors, and future growth prospects. The aim is to evaluate the breadth and depth of the market opportunity presented by the new company.
• Checking the Operational Background – Analyzing the startup’s operational KPIs including client acquisition costs, attrition rates, and rate of conversion is part of operational due diligence. The goal is to spot any problems or threats associated with daily operations that might ruin the investment.
• Management Checks and Balances – When investigating a new company, it’s important to do your homework and learn as much as possible about the people running it. The management team’s capacity to carry out the company’s strategic strategy and realize its goals will be evaluated.

Impact of fundraising Due diligence on valuation

The risks and rewards of an investment might be better understood once adequate diligence has been performed. Because of this, they can make well-informed selections and choose assets that fit with their investing aims.

Positive Impact of Fundraising Due Diligence on Valuation

Simply put, doing due diligence is an essential part of the venture capital industry’s evaluation process. It aids investors in making an informed selection by highlighting the startup’s strengths and weaknesses. A robust diligence procedure may improve the likelihood of profitable investment and reduce associated risks. The following are the positive impacts that fundraising diligence has on business valuation.

• Uncovering Hidden Value – The due diligence procedure helps to increase openness between investors and new businesses. This contributes to the development of trust between the persons involved, which in turn serves to enhance the connection between them.
• Mitigating Risks – The diligence procedure contributes to the identification of any dangers and warning signs connected to the investment opportunity. This allows investors to make choices based on accurate information and reduces the risks associated with probable outcomes.
• Building Investor Confidence – Investors may get more insight into the startup’s prospects after investing by doing due diligence. This might take the form of anything from offering advice on how to run the business to exposing the firm to investors.
• Strengthening Negotiating Position – When investors do their diligence, they learn all they can about a business, including its financials, market prospects, and management team. This paves the way for fair negotiations and an appropriate appraisal of potential investments.

How due diligence can uncover hidden value in a company

Due diligence can help you discover various assets and their value in the company through the following aspects.

• Intellectual Property – If you’re a business owner looking to sell, doing IP diligence can help you get the most money for your company and prove that your IP investments were worthwhile. You may be certain that you are calculating an accurate value for the assets by factoring in both their tangible and intangible components.
• Growth Opportunities – It involves examining the firm or product’s earnings, financial risks, legal concerns, and possible deal breakers are all part of the diligence process. The goal is to identify areas of opportunity for expansion by comparing past data with forecasts for the future.
• Undervalued Assets – An examination of how value is currently being created internally and where enhancements may be made, including but not limited to order processing, production, management of supply chains, developing novel products, sourcing, and handling suppliers. It helps in understanding the value of such undervalued assets.
• Cost Savings – The evaluation of synergies and potential for cost savings is becoming more vital for businesses considering sophisticated acquisitions. Investors and lenders both benefit from having more information about the extent of anticipated savings or lack thereof, and this information may be gained via an impartial examination of the fundamental support and planned results.

Negative Impact of Fundraising Due Diligence on Valuation

The process of doing due diligence in valuation may be difficult for several reasons, and they may have a few negative impacts including the following:

• Uncovering Red Flags – Throughout the process of doing diligence, new businesses may be reluctant to provide sensitive information, which may make it difficult to evaluate the possibilities of both dangers and opportunities.
• Delays in Fundraising – Due diligence may be a time-consuming procedure, and investors may only have a limited amount of time to do it, especially if they are competing alongside other potential buyers for the same deal. This may in turn result in delayed fundraising.
• Increased Scrutiny – The due diligence process often includes subjective evaluations of the potential of the firm, which may lead to divergences of opinion between investors as well as possible biases. So there is n element of increased scrutiny involved here.
• Reputational Damage – Due diligence is a time-consuming procedure that often requires the involvement of many specialists in fields including law, finance, and market research. Competing interests among investors, such as varying time horizons and return expectations, may make diligence more difficult and may pose a threat to brand reputation.

Balancing the Positive and Negative Impact of Due Diligence

To guarantee that the due diligence process is understood and used by all departments and workers, it is necessary to strike a balance between the good and negative effects at the operational level. Organizations need to take a variety of operational steps to back up their third-party diligence process, ensuring that it is properly implemented and communicated to management and staff. In addition, businesses may improve their compliance by teaching third parties how to do diligence themselves. Maintaining your sense of judgment and impartiality is crucial to your success. Every choice made by an organization should have a clear explanation and supporting documentation.

Tips on how companies can minimize the negative impact of due diligence on valuation

It is an important, but also a time-consuming procedure, to carry out thorough diligence. The following are some useful hints on ways you can minimize the impact of due diligence on valuation.

• Be Proactive – The process of doing one’s due diligence might eat up a significant amount of time. The most efficient way to begin is to plan. When teams make use of the most modern technologies, they can begin the process in a matter of minutes.
• Hire Experienced Professionals – Due diligence can be streamlined via the use of experienced professionals like investment banks and consultancies. Transaction teams have previous experience performing diligence and are familiar with the measures that must be taken.
• Be Transparent and Open – During the diligence process, teams should immediately address any possible bottlenecks or hazards that come to light. Transparency can help both parties updated on the progress and the need for effective measures.
• Focus on the Long-Term – It must offer considerable value for the investor by pointing out where the target business’s flaws (also known as warning signs) are, as well as by pointing out certain possibilities that exist inside the target firm, so assisting investors in preparing themselves for long-term happiness.

Get expert help for your due diligence and valuation!

Although it might be difficult to complete, due diligence has several advantages that make it worthwhile, such as helping you avoid losses and make more informed choices before and after your transaction. Startups may benefit from more openness and financial backing if investors can make well-informed judgments based on comprehensive diligence.

To save time and money during diligence, using Eqvista’s premium business valuation tools is highly recommended. To help reduce the time and effort required for due diligence, our skilled professionals will walk you through the required paperwork and give reliable valuation reports. Contact us now to learn more about our services.