Once founders are raising their first round of investment from professional investors, they will undergo a more or less extensive due diligence by their future shareholders. Generally speaking, due diligence is a process of checking, analyzing, and evaluating the legal, economic, technical, and financial foundations, and risks of the target company. The due diligence report serves as a decision basis for the investors and secures them from making costly mistakes. Depending on the stage of your company and the complexity of your product and business model, the due diligence can be more or less complex. It is highly important to know how to manage a due diligence process for a deal’s success.
In early-stage companies or startups with simple business models, due diligence is a straight forward process. There are only a few contracts and the company has an only little operating history. At this stage, it might not even justify the name due diligence and is often referred to as red flag due diligence. That means it is not a detailed check and analysis of each and every aspect but a high-level search for red flags, which might turn out to be show-stoppers. However, if your company has a technically complex or legally challenging business, due diligence can still be time-consuming and costly.
In later-stage companies, a financial due diligence process due diligence is normally a long process covering all the different aspects in extenso and delivering detailed due diligence reports.
Due diligences are often performed (at least partly) by external partners like lawyers, tax accountants, auditors, or technical experts. Whether or not investors hire external partners will depend on a number of factors. The bigger the financing round and the investment funds involved, the more complex the due diligence processes. This is not only due to the thoroughness of the investors but might also be required by their fund regulations. A satisfactory outcome of the due diligence usually is a closing condition stated in the term sheet. The main purpose of the due diligence is to detect any severe risk or liability ofthe company has. The results play an important role for defining warranties and guarantees in the final investment agreements.
The best way to prepare for a due diligence process is to understand the different parts and elements of commercial due diligence of this process and the intention of your potential investors.
The Four Martial Arts of Due Diligence
Technical Due Diligence
The overall robustness and functioning of the product are of course a key asset of the company. As stated above, it often requires an external expert to review the technology. Different aspects are touched during a technical due diligence. First, is for sure the technical asset itself and its degree of innovation. The IP should (ideally) provide a strong competitive edge, which cannot easily be copied by better funded competitors. Second, is the robustness and scalability during phases of rapid growth. Investors want to be sure that your product is ready to handle a massive load once your sales and marketing gains traction. The overall quality in terms of architecture, the actual code, etc. will also be reviewed. Last but not least, the product roadmap will be challenged whether it is doable but yet challenging and if it fits your overall strategy.
Legal Due Diligence
This part is mostly conducted by an external lawyer. In early-stage companies, this is more a red flag due diligence that screens for material risk than extensive due diligence that looks at every contract. However, a legal due diligent checklist is formed and all the material contracts (e. g. convertible notes) of your company will be checked whether or not they comply with current laws and regulations, and significant business risks will be addressed.
Commercial Due Diligence
This is the most important part of managing due diligence, as it is the basis for the investment decision. While the other parts are mostly performed to confirm the investment decision, this one is to find out if there is big economic potential that justifies an investment. Commercial due diligence more or less starts right away when you start to talk to investors.
Once investors understand your product their first view will go in the market. Which market(s) are you serving and how are these markets structured? It’s not only a question of size and growth, but also on how the market is structured and how it is functioning? How many companies/customers are out there? Which size do they have? How can they be segmented? What is the sales approach with these customers? Each and every pitch deck investors see contains at least one slide claiming a huge market. The relevant question though is, which part of the market can you really address and how many customers can you win with your planned sales approach? Make sure to educate your investors on the structure of that market and how players interact. In addition, make sure that you can derive your market top down and bottom up, and that the numbers of potential clients are consistent with your business plan. This starts with a thorough research and to the extent possible with precise numbers regarding your market(s). Your investors will do that on their own also, but the more information you provide, the faster the due diligence will be completed.
How does the competitive landscape looks like? Investors want to make sure not to invest into a crowded space. They might even do if you can prove that you have a strong differentiator for your product or business. In any case you need to provide detailed information about your most relevant competitors to defend your competitive edge. Investors will for surely research your competition. Providing comprehensive and well-structured information can however set the tone for your discussion and guide potential investors in their research drawing the right conclusions.
At the core of the commercial, due diligence investors need to understand your business metrics both on an overall company level and on a unit economics level. The revenue and cost components for each item shipped to your customer determine the profitability of your business and should yield a nice profit in the long-term (at least). So, you need to have the numbers on hand and they need to be consistent with your business planning and your pricing schedule.
The business model of venture capital investors is built on buying and selling, and already at the time of the investment VCs think about potential exit routes. The more mature your company is, the more relevant the question might be. However, it is an important question right from the beginning and you should think about that and provide an answer. You can help investors make better deal decisions by performing cash flow, providing relevant market and customer benchmarks along with commercial due diligence exit opportunities.
Financial Due Diligence
Closely related to the commercial, part investors will conduct financial due diligence. Generally, this is more focused on the accounting and controlling part and checks your start-up’s book-keeping. Especially in early-stage start-ups, financial due diligence is heavily focused on your financial planning as there are not much historic data to be reviewed. Therefore, it’s very important to have a solid financial model in place (learn more about how to build a solid financial model here). During the financial due diligence process, investors will challenge all your planning assumptions and benchmark them to other cases to make sure they are realistic. Investors want to find out if your model is robust and if the amount of money you are raising is sufficient to reach your goals.
In later stage companies, a financial due diligence is more complex as it also analyses a lot of historic data as well as previous tax and audit reports. Analysis will be done regarding your clients, suppliers, balance sheet accounts and accounting policies, invoicing and payment history, write-offs and cash status among others. The more history the company has, the more important it is to understand whether the historic accounting data is consistent with the numbers from the business plan and that they underpin the planning going forward. Additionally, the financial due diligence should also assess the company’s overall quality in terms of accounting and controlling standards and the ability to monitor operative and financials KPIs.
Setting Up a Data Room
If you are lucky (or simply very good), several venture capital investors are interested in exploring the opportunity. As a consequence, many parties can be involved in how to manage a due diligence process. due diligence. Instead of sending the relevant information upon request to all the interested parties separately, you should summarise them in a data room and make it accessible to your prospects.
At a later stage, when lawyers and other external parties are involved having a data room will become even more important. Handling all the different requests on-demand via email will steal too much of your time and you can´t track who got which information.
Many early-stage start-ups use google drive, Dropbox or other filesharing offerings. Those tools will do the job in that phase. The more information in the data room, the more relevant in becomes to manage the accessibility by different investors and their partners. This is where professional data room providers come into play. Below you can find some companies and their offering as well as some useful links for further research. Professional data rooms offer a lot of useful features. You can manage who gets access to which information, inform users whenever you upload or change the information, or archive the data room at the end of the due diligence process.
Selected data room providers:
Some sites for further research:
What to Include in Your Data Room
What needs to be included in your data room is of course different for each start-up and depends on the maturity of the business and the concrete area the company is operating in. However, there are some obligatory parts in each due diligence. Generally speaking, all relevant documents regarding your commercial, technical, legal, regulatory, or financial operations should be in the data room.
That’s why I put together a due diligence checklist that should make sure you get everything together before the process gets going.
Due Diligence Checklist
A lot of those points won’t apply to most early stage start-ups. Many later stage companies might have even more complex information. Overall, I think the list covers a lot and makes clear which information venture capital investors are looking for. There will always be additional requests for specific information for the individual case. But if you work through the checklist you should be well prepared.
Top Ten Due Diligence Best Practices
Managing due diligence processes can be very lengthy, very time-consuming, and very costly. However, good preparation can really make a difference, and start-ups are well advised to also see it as a chance to clear things up, correct what was wrong, and strengthen their organization going forward. Much due diligence reveals critical aspects that need to be fixed before going forward. Not only from an investor’s perspective but also for the founders. Below are my top ten tips on how to prepare and manage a due diligence process.
- Clearness and Transparency are Key
Keep things orderly by organising a clean folder/sub-folder structure including numbering and naming of documents to enable quick orientation for the user. Information and documents interrelated with one another should be in the same folder or reachable via hyperlink. Include all relevant documents as soon as possible; no salami tactics.
- Create Overviews and Summaries
Whenever there are more than three documents (e.g. contracts with customers or suppliers), create overview tables or documents.
- Create a Table of Contents and Keep it Updated
In any case create a table of contents for your data room that lets the users find quickly what they are looking for. Keep the numbering and the links updated.
- Update Your Data Room Continuously
As always, the easiest way to prepare and manage a due diligence process is to set up a data room immediately after founding the company and keep it updated while you build your organization. Simply use it as your own filing system to keep your business documents orderly. Continue to do so also after the due diligence ends, (after the match is before the match).
- Manage Access Carefully and Don’t Forget to Close Access For External Parties
Over time (hopefully), a lot of investors or their lawyers will request access to the data room. Manage the credentials carefully and don’t forget to end their access rights once the due diligence is over. It can be very insightful to track who has been active in the data room and which documents were clicked most. Professional data room providers will enable you to do so.
- Comply to Data Protection Laws
Keep an eye on the relevant data protection laws and if in doubt consult with your lawyer. Anonymise employee and other personal data at a minimum before submitting such information to your potential investors or their lawyers, or before granting them access to the data room.
- Inform Users About Changes in the Data Room
To build trust between all parties, let the users of the data room know whenever you are adding, changing, or deleting information from the data room. Keep in mind that once investors or lawyers start to work through your data room, changing information, especially adding significant documents towards the end of the process makes your partners feel uncomfortable and makes you suspicious. Be transparent of which information is still missing and will be added later on. You might even use placeholders from the early beginning to clarify that additional information will be provided at a later point in time.
- How to Cope With Critical Contracts
Every now and then there will be contracts founders are unsure about or from which they even know containing critical elements (e.g. software escrow agreements, exclusivity agreements, critical licenses). There is no use in hiding them from your partners or wait until they ask for them. This will damage the relationship. Instead, I would strongly recommend to proactively reach out to your investors and their lawyers (preferably bring your own lawyer as well), and explain the contract and the reasoning why you signed it. Do not add it to the data room without communication. Try to control the discussion and address the concerns of investors and especially their lawyers from the very beginning. If applicable proactively present mitigation measures (also if they might only be completed after closing).
- Manage External Parties Carefully
As soon as external parties, e.g. lawyers get involved, it might be a good idea to stay close to those parties and address their questions and concerns. The work of these parties will normally result in a due diligence report that will be submitted to the investors. It highlights all the detected risks and potential pitfalls of the investment. In order to prevent misinterpretations, mistrust caused by missing information, or other disruptive factors stay close to them and actively try your best to understand their thinking and concerns. It will unnecessarily extend the due diligence if you need to dispel worries that result from not having communicated on the matter early in the process. In addition, if they detect problematic issues, try to get them engaged in proposing a mitigation measure in their report right away. Commercial and financial Due diligence processes are not only good for detecting relevant risks but in some cases are regulatory requirements for the investors. A red flag from their lawyers might force them to halt the process until the issue can be resolved. In any case, prevent the lawyers of both sides to enter into endless disputes without you or the investor sitting on the table. Never forget that time is money in their business.
- Keep a Copy of the Data Room at the End of the Due Diligence Process
Title and business guarantees are standard deal terms in venture capital contracts. Whether or not certain issues and implications can be deemed as known to the investor at the time of investment is always debatable. As many (early-stage) investors are only conducting a red flag due diligence, they are not willing to be held liable for having thoroughly analysed the entirety of contracts and document from the data room. From a founder’s perspective this might feel unfair, since you as a founder made all the information accessible to the venture capital investors and their partners. This discussion is normally resolved through the concrete guarantee definition or liability limitations. However, founders as well as investors are well advised to keep a copy of the data room for their records. In some cases, a copy of the data room might even be attached to the contracts as a proof for what was known to the parties at the time of the investment.
Benefits of a Well-prepared Due Diligence Process
Due Diligence is always an exercise of trying to find the hidden risks and critical issues. As a founder you must not take that personally and be as transparent and open as you can. As an investor your expectations should be in-line with the maturity of the company.
Preparing for how to do due diligence on a private company provides a number of benefits that will help you get through more smoothly:
- Anticipate Risks or Even Fix Them Beforehand
Many things (if known early) can be fixed before the due diligence process starts. At a minimum, they can be addressed very early on. Communicating possible mitigation measures prevents the investors (or their lawyers) from red-flagging the issue.
A good preparation, a clean and clear setting, and good communication will earn you a lot of trust and a good foundation for a longer ride with your investors.
Well prepared due diligence processes will show your professional working style and will be seen a strong management.
- Limit Cost of the Due Diligence
Endless discussions are not only time-consuming and stressful for both sides. They will also increase the cost for the due diligence massively if they get out of control. In most of the cases, I have seen the due diligence costs are worn by the start-up to a certain extent. Limiting the due diligence cost should be in the interest of all parties.
- Ease contracting and closing of the transaction
Not worth mentioning a well-prepared and managed due diligence will shorten the time the transaction needs to close. It will ease the final contracting and prevent long discussions on guarantees and post-closing conditions.
Due diligence processes can range from quick and dirty to extremely detailed and painful procedures. They can cost you a lot of time and a pile of cash. A great strategy and working on how to manage a due diligence process can make a huge difference. Sure, even the best preparation won’t make critical issues magically disappear. But in any case, it helps to get to a result in a timely and cost-efficient manner, even if that means that you and your potential investors part ways without doing the deal.