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startup fundraising - due diligence by next road ventures
01 December 2021·9 min read

Attracting the right investors and landing investment is a long and engaging process for founders. On the other hand, every investor before signing an investment agreement wants to get to know all the business advantages and drawbacks. No wonder - no one wants to settle for a blind bargain, right? One of the crucial steps in the successful investment process is due diligence - usually followed by negotiations on the final shape of the investment agreement.  Let’s discover now what due diligence is and how you can prepare your startup to go successfully through it and get funded.

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What is startup due diligence?

Startup due diligence is a part of the investment process that helps investors, usually business angels or VC funds, to reduce risks involved in the transaction by verifying information provided in the startup pitch deck, assessing business and market potential, financial statements and forecasts, legal documents and all sorts of risks. So long story short, the aim of startup due diligence is to ensure investors that the company and the founding team are worth investment.

Every investor has their own methods of completing due diligence of a startup. Business angels usually perform a basic startup screening, while VC funds engage various experts, usually lawyers, accountants and technology advisors leaving no stone unturned. So keep in mind that during closing an investment round with a VC fund you should expect a thorough screening. That’s why the complete transparency in the startup pitch deck and provided documents along the whole investment process is so important - as any noticed discrepancies may become a potential deal-breaker. The good news for startups is that the VC market has been evolving and due to the high velocity of deals at startup’s early stages, more and more VC funds switched into just basic company assessment.

Key elements of startup due diligence required by investors

There are some crucial segments of the company that need to be analyzed before signing the final agreement with an investor. Here is the list of areas that startup due diligence investigates - make sure you have them well-covered to go through this process as smoothly as possible.

Usually, early-stage startup due diligence focuses on team, company’s reputation, its corporate documents, shareholder structure (cap table), basic legal screen, IP and technology stack check, analyzing business potential as well as financial statements and projections. Let’s take a look at areas of your business investors will likely double-check.

Startup team due diligence

Investment is like marriage so both startup founders and management should show alignment regarding the long-term vision and business fundamentals setting the scene for further growth. For investors, it is crucial to get to know people behind the business they are going to invest in and cooperate with.  Alongside founders’ background and previous business experience, investors will be looking for proven teams’ commitment, complementary knowledge and expertise as well ability to adjust to changing market conditions and global scaling. 

Startup financial due diligence

Startup financial screening is a core step in the due diligence process as it gives investors an overall insight into the financial performance of the company, its unit economics, KPIs, balance sheet, cash flow and profit and loss statement. Investors usually appoint the external advisor to check if all provided financial data have confirmation in startup books and bank accounts as well as look for additional insight into startup operations and red flags regarding company liabilities, possible irregularities and threats. 

Startup tax due diligence 

Tax audit enables investors to identify startup tax liabilities and discover potential irregularities e.g. through verification of the compliance of the declared revenues and costs for tax purposes with the values ​​resulting from the accounting records. For early-stage startups the aim is to check if the company pays taxes and its accounting records are managed professionally, mitigating potential tax risks. 

Startup legal due diligence

A legal startup audit is usually run by external lawyers with the aim to resolve all legal issues. The scope is quite wide even for early-stage startups as the legal screening includes company’s documents, shareholder structure, board meetings records, registration issues, GDPR compliance, material agreements, HR issues, assets, licenses, litigation etc. Messing up with legal compliance sooner or later ends up with a complex and costly process with lawyers so no wonder investors strongly focus on that part. So before due diligence, make sure that all legal documentation is easily accessible for the auditors.

Technical and intellectual property (IP) due diligence

During technical and intellectual property due diligence investors check the technical aspects of a product (e.g. technology stack, infrastructure, security) and the underlying intellectual property in order to confirm your technology advancement, its development potential and risks. IP check keeps investors confident that your startup owns the full rights to the developing technology, websites, designs, brand name, registered trademark and patents. 

Also, technology assessment will help to evaluate the rate of reliability and scope of opportunities that may arise in the future along with the ability to adjust to constantly developing cyber-security demands.

How to prepare your startup for due diligence?

Archive, archive, and once again archive. Some documents may seem irrelevant to you but all of them together show your startup’s history and value. The best way to avoid any issues in the future and keep the house in order is to catalog all company documents.

Once the due diligence process starts, you will be provided with a checklist of all the documents, agreements, licenses and regulations. It’s best to store and update due diligence folders in a cloud or shared VDR (virtual data room) so you and researchers can always have access to them. So if you keep your company documents in order, the due diligence process will go smoothly and allow you to save time and stress. Otherwise, it might distract you from focusing on business activities as the need to build the list from scratch will become a priority - it can be a real operational burden. 

How long does the due diligence take?

It’s hard to predict the exact timing of due diligence, the analysis may take from several days to even a couple of months. It depends mostly on the size of the company, length of its operations (new vs few years), type of product (e.g. deep tech), above mentioned accuracy in keeping the company’s documentation, and the scope of raised issues, irregularities and risks that need to be addressed. In general, startup due diligence shouldn’t last longer than 1- 2 months, for pre-seed companies it can be even a week or two.

What is the next step after due diligence?

After scrupulous review, advisors deliver a due diligence report that includes conclusions and potential risks. Usually, such a report describes only red flags, meaning that in other unmentioned fields everything works properly. Any critical threats result in further analysis and recommendation to make sure that they won’t negatively affect business and future cooperation with an investor. Then both parts of a deal move to preliminary talks and negotiations to finally agree on the shape of the investment agreement.

How can your startup benefit from due diligence?

Even though due diligence is carried in investors’ favor in order to limit their risks, startups may also benefit from this process. This thorough assessment performed by experts determines startups’ strengths and weaknesses, so the company will know the areas it should work on that were not discovered before. Due diligence confronts startup’s assumptions and may point at unexpected irregularities concerning business plan, product development, or financial forecasts. 

Of course, uncovering unexpected but crucial slips is not met by startup founders with enthusiasm. But look at this from a different perspective - thanks to the knowledge shared by investors and their advisors, you will be able not only to detect your startup deficiencies but also the way of addressing them will be handed to you on the silver platter. So even if the prospective investor will withdraw from the deal, the due diligence report is not a waste of your time as it will help you to grow stronger. 

Moreover, due diligence requires a lot of engagement from the investors’ side, so if they are willing to get involved and spend their precious time, it means that they are already committed to your business and see its potential. On the bright side, successful due diligence will assure that the company is trustworthy and, simply, have a great potential to grow meaning investment! So don’t stress out. Due Diligence may not be the easiest process but it's necessary in order to tie a knot with investors and finalize the investment.

For more assistance in writing your Investor Pitch Deck and pitching your startup to investors see the following articles: 

For even more insights on how to create a perfect investor pitch deck click here to download Perfect Pitch - The Ultimate Startup Guide, an ebook prepared by a team of experts and investors addressing the question of how to make your startup fundraising process successful.  

Related Posts:

Startup Fundraising: How To Create The Perfect Product Slide In The Investment Pitch Deck (by Katarzyna Groszkowska, Editor, Vestbee)

Startup Fundraising: How To Create The Perfect Market Slide In Your Startup Pitch Deck (by Katarzyna Groszkowska, Editor, Vestbee)

Startup Fundraising: How to Create a Perfect Solution Slide in Your Pitch Deck?
(by Katarzyna Groszkowska, Editor, Vestbee)

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