The Importance of Due Diligence in Fundraising: Tips for Startup Founders
What would an ideal startup owing diligence checklist look like? We have it covered for you in this article.
To successfully obtain finance, entrepreneurs must do thorough investor due diligence. By knowing what to expect from investors during due diligence, you can better handle any obstacles. Startup investments carry a high degree of risk. Pre-investor due diligence aids investors in spotting possible dangers and warning signs. Studies show that approximately 10–15% of submitted investment ideas make it through the first evaluation process. The agreements beyond the first scrutiny round are subject to a thorough due diligence analysis.
Due Diligence and Fundraising
Founders must put in much time and effort to attract the proper investors and proceed with startup fundraising. However, before signing an investment agreement, any prudent investor would investigate the company’s strengths and weaknesses. This makes sense, as nobody wants to accept a shady deal.
Due diligence is critical to any successful investment process, generally followed by contract discussions. Now that we know the importance of due diligence let’s learn what it is and how to prepare your business.
What is Due Diligence?
Investor due diligence covers various investment opportunities, from seed money to private equity to venture capital. The investment’s kind, size, and purpose will determine how in-depth and detailed the due diligence process has to be. When considering businesses, “due diligence” refers to the investigation that angels and venture capitalists do before determining whether or not to invest.
Therefore, the success of a startup fundraising depends on thorough due diligence procedures. Investors, typically angel investors or VC funds, conduct due diligence as part of the funding process to verify information stipulated in the startup’s pitch deck and assess business and market prospects, financial records and projections, legal documents, and various risks.
Example For Due Diligence
Suppose a company is considering acquiring another company. Before finalizing the acquisition, they engage in due diligence. This involves reviewing the target company’s financial statements, contracts, legal agreements, intellectual property, operational processes, and potential liabilities. It also includes conducting background checks on key personnel.
By thoroughly examining all aspects of the target company, the acquiring company can decide whether to proceed with the acquisition and on what terms. This process helps identify potential risks and opportunities, ensuring a successful and well-informed business decision.
How does Due Diligence work?
When considering investing in a startup, conducting due diligence through various methods is important. Venture capital firms thoroughly investigate potential investments, whereas business angels tend to undertake just a cursory check. Securing a funding round with a venture capital fund means passing a rigorous screening process.
That’s why startups must be completely forthright in their pitch deck and any other documentation they submit during fundraising. The encouraging aspect for businesses is the way the VC sector has been changing, and that, in response to the rapid pace of acquisitions in the early phases of a company’s development, many VC funds have simplified their focus to include just basic business evaluation.
Benefits Of Startup Due Diligence
Although investors do due diligence to reduce their risk, the business itself might gain significantly from the process. The startup will benefit greatly from the unbiased and in-depth review of its current state that due diligence provides. The following are some benefits of due diligence.
- There need to be more business strategies or more optimistic projections of burn rate and cash flow for businesses in their early stages. Performing enough research may help you spot problems like these and others, such as hidden dangers or misaligned products.
- Discovering a serious fault in your company that needs fixing is never pleasant, but it may have huge long-term benefits. Due to their extensive backgrounds, most investors can identify areas where your firm could improve and offer suggestions for enhancing the situation.
- The notion of doing due diligence may daunt startups. You should know that this is very typical and often crucial to any venture capital transaction. You should approach the process with the mindset that the investor wants to help you and your firm succeed rather than seeing them as competitors to get dirt on you.
- Due diligence should be easy and pleasant if you honestly present your firm during the investment pitch. Many meetings and conversations with investors are likely required. Still, your startup’s development trajectory might enter a promising new phase if all goes well.
- In addition, remember that doing due diligence is an expensive and time-consuming procedure for the investor. If they’re willing to invest time and money to learn about your startup, they likely hold your business in high regard.
Types Of Due Diligence In Fundraising
Investor due diligence does not follow a predefined “template”. The extent of due diligence is often determined by the nature of the investment. The types of due diligence like commercial, legal, financial, operational, organizational, and tax can differ depending on the investment, but they are all part of a standard due diligence process.
- Commercial Due Diligence – This sort of due diligence looks at the bigger picture of the sector in which the firm operates. By keeping tabs on the world, businesses may learn what factors and events could impact their long-term strategy.
- Operational Due Diligence – The term Operational due diligence refers to investigating a company’s operations, both in the past and present. An investor may learn more about the company’s operational potential, obstacles, and possible capital expenditure needs using this kind of investigation.
- Financial Due Diligence – Performing financial due diligence entails investigating a potential investment to see whether it will provide a positive return. In other words, it’s the method used to weigh the pros and cons of a proposed investment. The first step is to calculate the target company’s true worth. It also entails looking at its cash flow, profitability, and present financial status.
- Legal Due Diligence – This kind of due diligence entails researching the firm’s paperwork. The primary goal of legal due Diligence is to uncover any legal risks associated with an investment proposal. Due Diligence aims to verify that the firm is operating within the bounds of the law and that any prospective investors are aware of any restrictions on their investment.
- Organization or Business Due Diligence – Due Diligence in an organization is investigating its formal structure and any related problems. Such an investigation would focus on organizational hierarchy and lines of authority. It also entails figuring out how much power each individual has inside the business and how decisions are made.
Key Factors To Consider For Due Diligence
Before finalizing the agreement with an investor, examining many key due diligence factors is important. Ensure you have all of these bases covered to sail through the startup due diligence process with fewer bumps.
Size of the company and structure
An investor’s primary concern in business investment is the company’s financial and legal standing. The investor is interested in learning more about the company’s organizational structure, key decision-makers, and owners.
Gross margin and revenue
The company’s existing sales and gross margins are the next area of focus for investors doing due diligence. The company may examine each product line’s real sales revenues and operational profitability. The purpose of breaking down a company’s sales is to identify typical earnings by commodity.
Market size and competition
Investors look at market and consumer data in great depth. Investors don’t only look at who they’re competing with now; they also consider who could be a future consumer. This aids them in making an exact assessment of a company’s potential customer base.
Market size is another critical consideration; how huge is this potential gain? How much return can you expect? Is the company capable of rapid expansion? This is because every sector has its own unique challenges and must adhere to its own specific set of rules.
Ownership and management
Investors care most about a company’s management team when doing corporate due diligence. This is because a company’s management team is responsible for running day-to-day operations and will continue to do so in the future.
During Management Due Diligence, key personnel with significant responsibilities are sought out. In addition to assessing their overall salary and related costs, this also involves evaluating their competency and potential.
Financial statement analysis is a significant portion of due diligence. During due diligence, an investor may often raise doubts about the validity of a company’s financial reports. As such, they could review the company’s monthly, quarterly, annual, and tax reports.
One of the most crucial tasks for every investor is estimating a company’s worth. A business valuation provides a financial evaluation of a company’s value. To arrive at a reasonable value for a business, it is necessary to examine the company’s performance over a number of years. This process includes industry, economic, and company-specific outlook projections.
Threats and risks
An investor must evaluate the dangers that may arise from an investing opportunity. This can be done by asking pertinent questions about the company’s history, present, and future. Investors may benefit from this evaluation since it will allow them to make educated choices and reduce exposure to potential dangers.
An investor may look to future revenue and profit projections to assess a company’s potential. He could also watch for potential business-affecting changes in the market. He may also be curious about recent developments in the company’s goods and services, collaborations, IP, etc. Such revisions can assist the investor in doing more research on the underlying investment offering.
How to Prepare For Due Diligence?
Make sure to archive everything. While individual records may appear unimportant, when taken as a whole, they reveal important information about your startup’s past and present. Having a centralized place to store all firm records is a must for staying on top of things and preventing chaos.
During due diligence, you will be presented with a comprehensive list of relevant legal records, contracts, permits, and statutes. If you and your researchers need constant access to your due diligence files, saving them in a cloud storage service or a shared virtual data room (VDR) is ideal. Due diligence may be less time-consuming and stressful if firm documentation is readily available and well-organized. The alternative is to construct the list from the start, which may be a significant operational load and a potential distraction from other important company activities.
What Does An Investor Look For in Due Diligence?
Investors will need more effort to conduct a comprehensive investigation in their quest for risks. However, to finish the task of due diligence quickly, they will need to zero down on a select few key areas of the business. There are six primary areas that investors often look at closely:
- Product and service – Pricing, market dominance, and economies of scale are common competitive advantages for conventional enterprises. Suppose venture capitalists are considering investing in your company. In that case, they will investigate every aspect of your business, from product design to manufacturing to distribution.
- Market – Investors won’t merely examine your firm in their due diligence procedure. They will also be concerned with your overall market position and the market health you want to join. They will wish to provide credible estimates of the size of the market and the share you may expect to achieve.
- Team – VCs prefer to partner with people they think are a good match for them personally and professionally because the human aspect is a critical component of a successful partnership.
- Financials – Instead of relying on your projections and predictions, investors should look at how well your firm has done financially. They will look closely at your financial accounts, pay special attention to your debt, and review your agreements with current investors and partners.
- Equity structure – During due diligence, the company’s dealings with its past investors will be closely examined. Investors will put a disproportionate amount of weight on obligations, the equity structure, and any other contractual conditions that exist.
- Risks – Investors’ willingness to take risks varies greatly. Some people may be ready to put money into dangerous projects if the payoff is high. Some people are more risk-averse and would only put money into guaranteed winners. Both sorts of investors, however, place a premium on businesses that have developed a thorough strategy for mitigating risk.
When Do Issues Happen In Venture Capital Due Diligence?
To attract venture capital, your business plan must be strong. Some issues can be addressed by startups themselves, like maintaining detailed records, while others may require external solutions. Sadly, most obstacles that discourage venture capitalists are of the latter kind. Here is a rundown of the most typical reasons venture capitalists decline to fund a startup:
- IP Security – This is a wide area, yet it is very important when considering new technological companies. Does the firm have IP protection, and if so, what does it protect? Also, certain goods and services aren’t patentable because of how they work. Therefore, new marketplaces sometimes function on a “first come, first served” basis.
- Evaluations from Outside Stakeholders – A common practice among venture capitalists is building extensive professional networks across many fields. They will consult their contacts when an investment opportunity arises where they need more expertise.
- Team Unity – For young entrepreneurs, operating a firm may be fast-paced and full of opportunities. Due diligence bureaucracy, on the other hand, may appear tedious. Investors will know they’re investing in the appropriate individuals if a manager can guide their team through this. Cutting corners sends the opposite message.
Be Prepared For Due Diligence With Eqvista!
An investor may do thorough due diligence to learn about the opportunities and threats of a proposed investment. An accurate appraisal of your business will provide you with essential metrics and forecasts. That’s why you need to think about using Eqvista’s professional valuation services.
Eqvista’s suite of tools and resources empowers individuals and businesses to navigate the due diligence process effectively, enabling them to identify potential risks, evaluate opportunities, and make informed choices that lead to success. We can ease the burden of your due diligence by providing you with valuation services performed by seasoned specialists. Do you have any concerns? Get in touch with us immediately!