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How to prepare for investor due diligence

Posted by Neha De

June 14, 2022

You have managed to impress an investor with your perfect pitch as well as signed a term sheet (a nonbinding agreement that details the basic terms and conditions of an investment) with them. Now, before you get the funds into your account, it is time for the investor to do their due diligence. 

Due diligence –

According to Investopedia, “Due diligence is an investigation, audit, or review performed to confirm facts or details of a matter under consideration. In the financial world, due diligence requires an examination of financial records before entering into a proposed transaction with another party.” It is “a systematic way to analyze and mitigate risk from a business or investment decision.”

Investor due diligence typically comprises checking and verifying evidence that supports claims made by founders, such as contracts substantiating customer commitments, market research, results of tests conducted to back performance claims and the like.

Types of due diligence

When an investor decides to do their due diligence, they go through three basic stages of investigation: 

1. Screening –

An investor goes through a large number of investment proposals in order to identify businesses that may be a good fit for their fund’s criteria or mandate.

2. Business –

After a potentially viable small business or startup is shortlisted for investment, they investigate and probe to ascertain whether it will be a profitable investment for them. This incorporates looking at the business model, products or/and services being offered as well as their market fit, and the management team.

3. Legal –

If a firm manages to get past the above two stages, the investor’s lawyer steps in to ensure everything is in order according to the law. They may even check with the startup’s lawyer/legal team to verify the facts.

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How you can prepare for investor due diligence

An investor will most likely not be satisfied with a perfunctory overview of the operations of a company. They will dig through every possible area before parting with their money, so be prepared to have documents supporting your claims, practices and policies. 

Due diligence takes plenty of time and effort, which can be challenging for a lot of founders, because it takes them away from focusing on their business. The best way to tackle due diligence is to be organized and benefit both the investor and the startup owner during the due diligence process. 

Serial entrepreneur Alejandro Cremades writes in an article in Forbes, “The days of the due diligence period have consistently been some of the most tortuous in founders lives. Most would rather give birth, have to run into a burning building to save a kitten, or have all of their teeth pulled. At least the pain would be over much faster. Few want to revisit those days. Much less share with the world how it really felt. It can be traumatic.”

That said, even though due diligence can be time-consuming and stressful, with proper preparation, this process can actually help accelerate a company toward success. 

Step 1: Start preparing before starting the process of fundraising

When it comes to fundraising, it is best not to wait until there is a deal on the table, simply because due diligence is unavoidable. Therefore, gathering data and documents before the pitch to the first ever investor can come in handy. 

Due diligence is essentially a process of data- and document-gathering. Founders provide corroborative documents for the claims they make during the pitch, the operational nitty-gritties of their company along with the risk mitigation steps they have taken. A due diligence checklist can come in useful while collecting the right documents and information.

A due diligence checklist will not only help founders quickly respond to due diligence queries, it will also make the pitch stronger. These are some essential elements of a due diligence checklist: 

• Business plans and financials –

In the due diligence process, founders should provide data that supports the overview of their company’s historical performance, runway, forecast and other performance metrics presented in the pitch. This includes a formal business plan, forecasts such as purchase, sales, profit margins, marketing spend and customer growth, among others, balance sheets (from beginning to present), income statements (from beginning to present) and tax returns (from beginning to present). 

• Corporate documents and records –

This includes everything related to the legal and organizational structures of an organization company, such as organizational documents (articles of incorporation, bylaws, articles of organization, operating agreements and so on), minutes of meetings of shareholders, board of director meeting minutes and the like, organizational chart of the company and documents for any affiliate businesses.

• Intellectual property –

If a business’s products are protectable under intellectual property (IP) laws, expect investors to focus here. If a founder has protected their IP, the investors will like to make sure that they have done it correctly. They will expect to see all existing and/or applied for trademarks, patents, copyrights and domain names. If they have not applied to protect their assets, a legal explanation detailing the decision not to file for IP protection.

In addition, any IP assignments made to the founder/their company from another inventor or company and associated recordation documentation should also be provided.

• Market research –

To prove the company’s potential in the existing market, investors look for data that back the claims. To make the process smoother, provide data and research related to industry trends, customer acquisition cost, customer retention rate, total addressable market, price, cost and margin (PCM) analysis, trial results if any, focus groups, surveys, interviews and any other research pertinent to the company and product/service offerings.

• Shareholder agreements and related information –

What investors are the most interested in what return on their investment will be. Therefore, they will want to know exactly how much equity they will own in a company in exchange for their money and how that ownership interest weighs up against other investors. Documents to show here include a list of shareholders/owners and their individual ownership interest percentage, all existing stock and options and their value at the time of issuance, any agreements associated with voting rights of owners/shareholders, any agreements associated with stock, options, grants and other issuances, vesting schedules associated with any issuances of stock or options, and any regulatory or legal documents associated with shares and shareholders.

• Material agreements –

Any agreement that could significantly impact the firm should be included in material agreements. These will vary from organization to organization depending on the nature of business. Some basic examples are standard terms of service or use between the company and its customers, property agreements (real estate leases as well as personal property), insurance policies, any mortgages, loans, encumbrances or liens against the firm, any loans given by the company, consulting agreements, licenses of any company IP to third parties or of third-party IP by the company, any NDAs, purchase agreements, terms of use and the like, any agreements with directors and other officers, any agreements that lie outside the ordinary course of business that could have a material impact on the company and so on.

• Risks and potential legal disputes –

If a company is currently involved in a legal battle or foresees any future legal disputes, the investors will need to know about them. In this situation, documents to be provided may include any documents or correspondence associated with any existing or potential lawsuit, investigation or proceeding.

• Equity grants to employees –

Often early employees — or even consultants or customers — are offered equity in the early days of a business. This may impact an investor’s ownership interest in the business, and they should be made aware of the equity already promised to others.

• Employee benefits –

When a business scales, the staff members inevitably become its biggest cost and liability. Any procedure, policy, agreement or benefit related to them goes in this section. This may include a list of all workers along with details such as title, contact information, salary, commissions, bonus potential, exempt or non-exempt status; standard offer letter and/or any employee contracts; any agreements between the organization and any director and/or worker; any documentation corresponding to employee benefits  such as insurance, 401(k), medical, stock option and so on; severance plans; and company handbook and any other company policy.

• References –

While most investors are interested in the company they are thinking of investing in, there may be those who are also interested in the founder(s) and their team. These investors may ask for both personal as well as customer references to evaluate a product, service and people. 

Step 2: Establish organizational infrastructure

Most due diligence components require multiple documents (for instance, company records, shareholder agreements, customer contracts, etc), and providing these documents through a single channel can streamline the process.

Step 3: Prepare to handle material risks

Material risks are those that could cause a company to fail. For example, if a founder has pitched a new social media platform, the biggest risk to their business is likely the complete market dominance of Facebook. If this new social media platform is a worthy investment, how has Facebook not already built something similar? 

Knowing the risks and being prepared to discuss them before starting the due diligence process is important. A due diligence checklist can play an important part here, too.

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Neha De
Neha De

Neha De is a writer and editor with more than 13 years of experience. She has worked on a variety of genres and platforms, including books, magazine articles, blog posts and website copy. She is passionate about producing clear and concise content that is engaging and informative. In her spare time, Neha enjoys dancing, running and spending time with her family.

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