3 Tips to Survive Startup Due Diligence Process

Successfully closing an investment round is the goal of nearly every entrepreneur. Having access to both capital and expert business mentors gives a startup the fuel it needs to scale rapidly. When seeking investment, most entrepreneurs focus on building a solid pitch that inspires confidence from investors and promises hockey-stick growth. While the pitch is crucial to earning interest from investors, most entrepreneurs lack understanding of the due diligence process that follows a successful pitch. Many deals fall apart because due diligence fails even though the founders delivered a great pitch. Read below for three tips to ensure your startup will pass due diligence, and close the investment deal.

1. Be Organized with Respect to Financial Information

In the early days of a startup, generating and maintaining financial information is likely not a top priority. Financial records of many ventures are usually in poor shape. Entries may be missing, coded incorrectly, or scattered across multiple different locations. While not ideal, this situation is likely manageable for a bootstrapped startup as long as all obligations are being met.

Poor financial records will not satisfy an investor performing the due diligence process.During due diligence, a team of accountants and finance experts will comb through your financials looking for uncommunicated risks and verifying the claims you made in the pitch. Any unexpected information found could delay, or kill, your deal.
The best advice is to have all financial information prepared and independently scrutinized before seeking investment. Standard financial statements should be audited by a third-party accounting firm. Revenue models and forecasts should be updated to ensure accuracy and appear reasonable. Your financial documents should be prepared for presentation to an investor with short notice. Above all, be confident in the accuracy and completeness of the information. All founders should hold an understanding of past and present financial statements, and be prepared to explain any anomalies. Organizing this information makes your investors feel encouraged about the venture and the team running it.

2. Ensure your Legal House is in Order

Just as it is crucial to keep financial information organized, it is also essential for a startup to maintain proper legal documentation. Early phase startups likely do not have proper oversight of their internal and external legal documents. Furthermore ,these documents were likely not drafted or reviewed by a lawyer, which could be a risk if key clauses were omitted or used mistakenly. Such unreviewed documents could cause issues during the due diligence process. Investors will be unlikely to fund a company that appears to have a serious liability that could lead to a lawsuit.

To prevent issues from arising during due diligence, startups should gather, review, and organize all legal documents belonging to the company. Start by first reviewing the foundational documents of the company, such as the articles of incorporation and unanimous shareholder agreements. Make note of any clauses that deviate from standard agreements and be prepared to explain to investors. If these documents are incomplete or missing, hire a lawyer who can properly draft these documents to a level of rigour appropriate for external investment. Also, review the corporate minute book and verify all required director and shareholder meeting minutes are present and properly documented. After reviewing these documents, begin looking at all other corporate documents, making note of deviations from standard practice and adding or updating these where necessary. This includes employee agreements, sales contracts, partnership agreements, privacy policies, and terms of service.

Clearly, this exercise can amount to a significant and intimidating amount of work, particularly for a small inexperienced startup team. The best course of action is to either form an internal audit team, or hire an external auditor to execute the work. This may cost the startup productivity or cash, but will provide an excellent payoff when the due diligence process is executed without issue.

3. Be Cautious of Minority Shareholders

As a venture and its balance sheet grows larger, it tends to accumulate a collection of minority shareholders. These shareholders come from a variety of sources. Some may be friends or family members kind enough to “donate” cash to the venture early to support the entrepreneurial dreams of their loved ones. Some may be spouses or children of founders, who were given shares for tax optimization when dividends are issued. Other shareholders may stand entirely separate from the founders. These could be universities or incubators who received shares in exchange for providing intellectual property or business consultation. Regardless of the source or disposition, founders must be aware of all minority shareholders and not treat them passively. You will need their support when investors are looking to make a serious investment.

The best way to manage minority shareholders is to maintain a positive relationship with them. The founders should provide a reasonable amount of communication with all shareholders, with the amount of details proportional to their percentage of share ownership. While monthly or quarterly emails are sufficient for sharing information about the company’s progress, an annual face-to-face meeting is ideal. During this meeting, founders can discuss the desires and concerns about the venture that the shareholders have. Founders should answer their questions and respond to their feedback respectively. Founders can also use these meetings to investigate options to buy back shares, which eliminates future concerns about minority shareholders. Keeping minority shareholders informed and involved in corporate decision-making will prevent issues from arising during investor due-diligence.

Conclusion

Surviving the due diligence process is a stressful time for a startup. This is coincidentally when all the minor issues come out of the woodwork and expose themselves to investors. At best, they delay the deal and annoy the founders as they work to resolve issues at the last minute. At worst, these issues could be enough to frighten an investor and steer them towards one of the other hundred quality deals on their desk.

The best course of action is to take proactive steps to avoid or minimize issues before the due diligence process commences. Find and review the legal and financial information about the company regularly, at least once a year.. Make it easy for investors to understand the health of the company, and have appropriate answers to any risks that are apparent. In addition, rekindle the relationship between your founding team and any minority shareholders in the company. Discuss the deal with them, and listen to their concerns. Determine if they will be an ally or threat to the investment, and take appropriate action.

Following these recommendations will smooth the due diligence process, reduce stress for the founders and demonstrate strong leadership and business savvy to potential investors. Furthermore, a simpler due diligence process reduces work that lawyers and accountants must perform to conclude the deal. Overall costs associated with the deal are reduced and it can be completed faster. A cheaper, faster, less risky investment deal is a great way to launch the new relationship between your startup and your investors, and provides a great foundation to jointly build a successful venture.

Leave a Reply