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How and Why Due Diligence Is Important?

Tyke Editorial Team by Tyke Editorial Team
August 29, 2022
Reading Time: 8 mins read
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How and Why Due Diligence Is Important
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Conducting a due diligence process for a potential merger or acquisition can be daunting, especially if you’re not familiar with the terminology or the process itself. Not conducting proper due diligence can lead to making costly mistakes – such as overpaying for a company, or investing in a company with hidden liabilities.

By using an investment due diligence checklist and following the recommended steps, you’ll be able to inspect all aspects of the target company and make an informed decision about whether to go ahead with the deal.

What is due diligence checklist?

Due diligence is a process completed by potential buyers or investors, where the interested party does research into your company before moving forward with a transaction. It assures the buyer or investor that your company would be a safe investment and worthy of acquisition. As such, how you handle any hurdles presented during this process can go a long way toward showing your professionalism, preparedness, and capable leadership.

Unfortunately, any fumbles or missteps — such as being unable to find important documents, sending outdated information, or otherwise displaying a lack of preparedness — can reflect poorly on your company.

 due-diligence-checklist

This is the process through which investors confirm that your company is indeed the promising investment you told them. You can identify how to invest in Indian startups by following this process.

Your pitch presented a high-level view of your business and its potential. You may have identified some risks, but you didn’t get into the details of your operation. The details, both good and bad, are what due diligence is all about.

Before investors hand over their money, they want to see evidence supporting your claims: contracts confirming customer commitments, testing results that back your performance claims, market research, and so on.

How do you prepare for due diligence?

You won’t satisfy your potential investors with a vague overview of your business operations. You need to dig through every document supporting your claims, policies, and practices. Due diligence takes valuable time away from you concentrating on your business, and that’s what makes it so painful for many founders.

The best way to prepare for due diligence is to get organized, which will make you stand out to investors. Due diligence can seem never-ending for founders. And producing concerning documents often results in investors asking for more information.

Let’s say an investor finds that a specific contract exposes the company to unreasonable risk, the investor will demand answers. In the best-case scenario, you’ll need to provide an explanation explaining how you’ve protected against the risk. We suggest reading out the risks and rewards of investing in a startup However, the investor may require you to negotiate an amended contract that lowers the risk to your business which is a time-intensive exercise.

If a single contract can delay closing your funding round, imagine the potential issues that can arise when investors closely examine your entire business.

So, while due diligence is time-consuming and can be frustrating, with preparation, this process can help accelerate your business toward success.

1. Start before you begin fundraising

Due diligence is inevitable in fundraising. But it is better to start before you have a deal on the table. Instead, save yourself a lot of hassle and start gathering documents and data before you ever pitch your first investor.

Due diligence is largely a document- and data-gathering exercise. You provide evidence for the claims you made during the pitch, the operational nuances of your business, and the risk mitigation you’ve taken. Use a due diligence checklist to make sure you’re collecting the right information.

Not only will this help you quickly respond to due diligence requests, but also, the better you know your business, the stronger your pitch will be.

2. Prepare to address material risks

Investors are often sold on the potential of your product or service. The due diligence process allows investors to evaluate risks that could prevent that potential from becoming a reality.

Material risks are those that could cause your business to fail. Know your risks and be prepared to discuss them before you begin due diligence. Have a document prepared to outline how your business will mitigate or overcome material risks. Don’t sit back and hope your investors won’t question any material risks. These will likely be their biggest concerns through due diligence.

Don’t rely on your memory or plan to respond to investor requests as they come. Lean on a due diligence checklist instead.

Insights due diligence

Each type of transaction will require different documents for the due diligence phase. You will encounter different requests for information when you are trying to secure funding than you will if you’re preparing to sell your business. Because “due diligence” is such a broad term and may vary based on the parties involved, it’s best to maintain a highly organized system to keep track of almost every important document your business generates.

Insights due diligence

While you will probably never need every single document on this list all at once, likely, you will eventually need each of them at some point during various transactions your business will encounter in the future.

Angel investors and venture capitalists have unique approaches to picking investments. As different as those visions might be, they’re all generally looking for the same types of documents from your business through the process. Use this due diligence checklist to prepare:

References

Investors are interested in your business, but they’re also interested in you and your team. They may ask for both customer and personal references to vet your product, service, and people.

Corporate records and documents

This includes anything related to the legal and organizational structures of your company, including:

  • Organizational documents (articles of incorporation, articles of organization, bylaws, operating agreement, etc.)
  • Shareholder meeting minutes, board of director meeting minutes, etc.
  • Company organizational chart
  • Same documentation for any affiliate companies

Business plans and financials

In your pitch, you presented an overview of your past performance, forecast, runway, and other performance metrics. In due diligence, you must provide the data that supports these presentations:

  • Formal business plan
  • Forecasts: Sales, purchasing, margin, customer growth, marketing spend, etc.
  • Balance sheets (from founding to present)
  • Income statements (from founding to present)
  • Tax returns (from founding to present)

Market research

To position yourself in the market, you pitched your potential in the existing market. Be prepared to show how you came to your conclusions with research, data, and surveys to back your positions:

  • Industry trends
  • Total addressable market (TAM)
  • Customer acquisition cost
  • Retention rate
  • Price, cost, and margin analysis
  • Prospective customer research
  • Trial results
  • Competitive landscape
  • Focus groups, interviews, surveys, etc.
  • Other research

Intellectual Property

If your products are protectable under intellectual property (IP) laws, expect your investors to spend significant time here. If you have protected your IP, they’ll take plenty of time to make sure you did it correctly. They’ll expect to see:

  • All existing and/or applied patents, trademarks, copyrights, and domain names
  • If you haven’t applied for protectable assets, an explanation (preferably a formal legal opinion) describing the decision not to file for IP protection
  • Any IP assignments that were made to you from another company or inventor and associated recordation documents

Shareholder information and agreements

Investors are not just interested in your business, they are also interested in a return on their investment. They need to know exactly how much of your business they’ll own in exchange for their investment and how that ownership interest compares with your other owners:

  • List of owners and percentage ownership interest
  • All existing stock and options and their value at issuance
  • Any agreements related to stock, options, grants, and other issuances
  • Vesting schedules related to any issuances of stock or options
  • Agreements related to voting rights of shareholders
  • Any regulatory or legal documentation related to shares and shareholders

Material agreements

Material agreements will vary from company to company based on the nature of your business. Any agreement that could significantly impact the business as you presented it to the investors in your pitch should be included in material agreements. Common examples include:

  • Standard terms of service or use between your business and customers
  • Any agreements or understandings between your company and others with obligations exceeding $25,000
  • Property leases (real estate and personal property)
  • Loans, mortgages, liens, or encumbrances against your company loans provided by your company
  • Insurance policies
  • Licenses of third-party intellectual property by your company
  • Any standard form used by the company in the ordinary course of business (NDAs, purchase agreements, terms of use, etc.)
  • Any agreements outside the ordinary course of business that could have a material impact on the business
  • Consulting agreements
  • Agreements with officers and directors

Risks and potential litigation

If your business is currently in a legal dispute or you have reason to believe you might become involved in any, you’ll need to list that. Here are some examples of what you may need to provide:

  • Correspondence and documents related to any existing or threatened lawsuit, proceeding, or investigation
  • Correspondence and documents related to any existing or potential regulatory investigations or compliance concerns
  • Due diligence item: Employee relations and benefits
  • If your business scales, employees will inevitably become your biggest cost and liability. Any policy, procedure, benefit, or agreement related to employees goes here. This might include:
  • List of company employees including title, salary, bonus potential, commissions, exempt or non-exempt status, and contact information
  • A standard offer letter and/or any employee contracts
  • Agreements between the company and any employee and/or director
  • List any documentation related to any employee benefit (401(k), insurance, medical, stock option, etc.)
    Severance plans
  • Company handbook and any other company policy

Equity grants

It’s not uncommon to offer equity to early employees, or even customers or consultants, in your early days. These grants impact your investors’ ownership interest, and they will need to see the equity you’ve already promised others.

Conclusion

Due diligence isn’t just about handing over a stack of paperwork. Your due diligence preparation shouldn’t end once you’ve gathered all of the above documents. To maximize your chances of everything going smoothly, organize each document into a system that makes sense to you and any potential buyers or investors.

Keep in mind, that some interested parties may want to glance through your documents just to make sure you have them, while others prefer to break out a magnifying glass and examine every detail. Read through each document carefully to check for errors, outdated information, and other problems that might have escaped your attention.

As long as you’ve done a good job managing important financial documents, your company should have no problem with the due diligence phase in your startup journey.

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Tyke Editorial Team

Tyke Editorial Team

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