Company due diligence for startups

Any startup that is looking to raise funding from a 3rd party is going to be subject to some level of scrutiny. The prospective investor needs to be able to dig into the company and evaluate the investment opportunity. With each additional funding round the degree of scrutiny increases. From an investor’s standpoint, this makes perfect sense and is 100% reasonable – the investor has every right, in many instances an obligation, to vet each opportunity in detail.

After all, an investment in a startup is inherently risky and an investor would only be increasing that risk by neglecting a full and comprehensive investigation. Furthermore, since there is a significant level of asymmetric information in play during the early stages, which raises the likelihood that the motives and goals of the two parties are not completely aligned, the need for independent due diligence and verification is important.

This critical step is what enables the interested parties (buyers or investors) take that leap of faith. It is through due diligence that they can inspect for any unknown issues, which should have been brought to their notice earlier and evaluate the growth prospects of the company. These important inputs help to decide whether the investment or acquisition will be worthwhile or not.

What is due diligence?

Due diligence is a formal legal investigation that assists to confirm that a business investment or acquisition will be beneficial to the investor or buyer. Every financial decision comes with risk, and it's important for anyone investing a large sum of money to fully understand the specific risks that come with their decision.

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Generally speaking, due diligence involves inspecting the investment or acquisition target's intellectual property, business operations, and financial track record. A prospective buyer may also consider how well an acquisition fits with its overall strategic plan.

Here’s a list of information a startup should be ready:

1. Corporate Documents:

1. Bylaws and operating agreements

2. Articles of Incorporation

3. All documents furnished to shareholders and directors

4. Shareholder agreements

5. Certificates from all countries and jurisdictions where the company does business

6. Times of Board of Directors and Shareholder meetings

2. Previous Securities Issuance:

1. Complete Stockholder contact information

2. Copies of stock certificates, option agreements and warrants

3. All outstanding preferred stock, including covenants

4. Employee stock benefit programs; stock purchases, stock options or others

5. Number of excellent shares, dates of issuance, and per cent ownership

6. All unique options, warrants or convertible securities

3. Financial Information:

1. Income statements, balance sheets, cash flow statements

2. Audited financial statements since inception

3. Accounting methods and practices

4. Records of all changes in the equity position

5. A three-year budget and financial projections

6. Accounts receivable ageing and accounts payable ageing

7. The company prepared monthly or quarterly statements

8. A complete and current business plan

9. Extraordinary income or expense details

10. Explanation of any material write-downs or write-offs

11. Revenue and gross margins by goods or service

12. Accountant report on the company’s financial condition

13. Product or service pricing plans and policies

14. A summary of all lousy debt experiences

15. Details of any outstanding contingent liabilities

4. Tax Status:

1. Detail of any tax audits

2. Income tax returns of the last 3 years

5. Contracts and Agreements:

1. Joint venture and partnership agreements

2. List of Bank and non-bank lenders

3. Purchase agreements

4. License agreements

5. Insurance contracts and agreements

6. Liens, equipment leases, leases or any other leading loans

7. Any supplementary agreements or agreements relevant to the business of the company

8. Contracts with suppliers, vendors and customers

6. Governmental Regulations:

1. Detail of any requests made by any local, state companies

2. Copies of all permits and licenses

3. Copies of reports made to government agencies

7. Litigation:

1. Description of any potential dispute including potential damages

2. Settlement documentation

3. Description of any current litigation including possible damages

8. Products and Services:

1. Inventory review including turnover, obsolescence and valuation policies

2. Backlog review by product line including Analysis of annual issues

3. List of all essential suppliers 

4. Detail of goods offering including a business share by product line

9. Marketing:

1. List of major clients

2. List of competitors and information about the market share

3. Current brochures and marketing materials

4. Analysis of pricing strategy

5. Sales protuberances by goods line

6. Any pertinent marketing studies conducted by outer parties

7. Sales commission structure

10. Management and Personnel:

1. Detail of any labour disputes

2. Management organizational plan and bios of superior personnel

3. Management influence plans including pension, benefit, profit sharing, deferred compensation, retirement and some non-cash compensation

4. Employee Confidentiality Agreements

5. Employee reimbursement plans including pension, options, profit sharing, deferred compensation and retirement

6. Number of employees, turnover, absentee queries and hiring projections

7. List of Company’s Directors

8. Listing of any consulting Agreements

9. A credit history statement on all principals, managers, and directors

10. Employee HR, benefits, and insurance manuals

11. Resume verifying on all principals, managers, and directors

12. The research report on all principals, managers, and directors

11. Property and Equipment:

1. All List of real property owned by the company

2. An appraisal of all facilities and fixed assets

3. Detail of any easements or other encumbrances

4. Company space expansion plans

5. Copies of titles, contracts, and deeds of trust

6. Leases and sub-leases

7. Patents, trademarks and other intangible assets

12. Research & Development:

1. Commercial Analysis of R&D efforts

2. Detail all research and development in progress

3. Documentation policies including examples

13. Other Company Information:

1. Existing articles comparing to the company and its industry

2. Copies of all past and proposed company press releases

3. Company newsletters and any investor relations material

Due diligence for investment 

The process involves asking and answering a series of questions to evaluate the business and legal aspects of the opportunity. Once the process is complete, the investor will use the outcomes of the process to finalize the internal approval process and complete the investment. If the investor acts as a lead investor in a syndicate, then they may also share the outcome of their due diligence with other investors.

There are three stages of due diligence:

1. Screening due diligence

2. Business due diligence

3. Legal due diligence

Stage 1: Screening due diligence

Investor review and evaluate hundreds of business opportunities over the life of the fund and use predetermined criteria to identify which opportunities to focus on as possible investments. This allows them to quickly flag the ones that fit and indicate that they will spend more time and money evaluating.
Typically, for every 100 opportunities reviewed, ten will receive a detailed review (Stage 2 and Stage 3 of due diligence) and the fund may invest in one of them. Most opportunities do not make it through screening for two reasons:

1. The opportunity does not fit the fund’s mandate or criteria (e.g., the business’ stage, geographic region, size of the deal, industry sector).

2. Some funds will only review opportunities that have come via a referral from a trusted source.

Stage 2: Business due diligence

Once the opportunity is determined to “fit” the fund’s investment criteria, the deal is assigned to a junior and senior member of the team who will investigate further to determine the viability of the deal. Each firm may have a specific process, but it tends to involve reviewing the management team, market potential, the product or service (and the need it meets) and the business model.

Stage 3: Legal due diligence

Once the fund has reached the stage of moving toward a favourable decision, their lawyer will complete a legal review. Make sure that your lawyer is prepared to answer their questions. The advisors you choose can reflect favorably on you, including your lawyers, so do your research to find the right ones. Ask for references to determine which lawyer investor respects and use themselves. If the investor is highly experienced in this area (or has in-house legal counsel), they may take on part of the review to reduce the overall deal expenses.

Check-list

1. Founders and Management: Investors do extensive background checks on your company’s founders, management and other key personnel.

2. Legal Matters: This will include every scrap of organizational paperwork involved with your company, such as state sales tax license, partnership agreements, articles of incorporation, etc.

3. Financials: The investor will take a look at your financial history, profit and loss, budgets and projections. You’ll also need to show any business plans and contracts with suppliers and customers.

4. Employees: You’ll be expected to show contracts or employment agreements with all of your employees to ensure you have the protection of all intellectual property rights.

5. Technical: The investor may want to review the technical information on your product, such as technologies used, and how you address security and scalability issues.

6. Clients: Investor may talk to selected clients to understand how well your business is performing and how well it can expect to perform in the future. They also will review all client contracts to determine if they support your projections.

Due diligence is a very detailed and highly crucial process. The output that is obtained has a high level of significance because it helps the investor make a well-informed decision regarding whether the company is worth investing or not. Therefore, the process has to be in an extremely thorough and detailed manner to arrive at the best.

How can Lawtendo help?

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