Statistically, about 20% of startups fail in the first year, 50% within five years, and 65% within 10 years. Key reasons include no market need, legal challenges, and flawed business models.
That’s why, before investing in startups, investors conduct due diligence. They want to make sure a company will be able to grow and generate a return on investment.
In the article, we explain why and when startup due diligence is conducted, describe best practices, challenges, and solutions, and provide a comprehensive checklist for each due diligence stage.
Why and when is the due diligence carried out?
Startup due diligence is a thorough investigation of the startup’s financial, legal, and operational aspects to assess its viability, risks, and potential before investing. It’s conducted by a potential investor, which is almost always a venture capital (VC) or angel investor.
Angel investors are early-stage investors who provide financial support to startups using their personal funds. They also may offer mentorship and guidance. On the other hand, venture capital firms invest in companies showing exceptional growth potential, offer technical or managerial expertise, and source capital from well-off investors and investment banks.
Here’s why potential investors need to conduct startup due diligence:
- Risk mitigation. 44% of startups fail because they run out of capital. This is just one of numerous reasons and an investor’s task is to identify all potential risks associated with an investment in a startup.
- Claims validation. Onepagetrip, a travel startup, was very ambitious about its project but had to close because it got so involved in developing a product, that it forgot about developing a comprehensive business plan. The thing is, startups often make ambitious claims about their products or growth potential, and investors need to validate these claims.
- Team evaluation. After analyzing the failure of 110+ startups, it was found that 14% of them explained the reasons for a failure by not having the right team. And even though there were other top reasons like no market need (35%) or running out of cash (38%), it’s believed that with the right team, most of these problems would be solved, or even not exist.
Investors should initiate due diligence as early as possible before any contracts are signed. In fact, informal due diligence begins the moment an investor engages with a startup, asking questions and defining the company in broad terms.
What are investors looking for in a startup due diligence?
Investors conduct due diligence to assess various aspects of a startup before starting the investment process. Key considerations are:
- Market potential, including the size of the target market, growth trends, and the startup’s potential to capture market share.
- Business model, including the sustainability and scalability of the startup’s business model.
- Competitive environment, including competitors, unique selling propositions, and the startup’s differentiation strategies.
- Financial health, including financial statements, projections, and revenue models.
- Operational efficiency, including operational processes, supply chain management, and technology infrastructure.
- Team, including the qualifications and experience of the founder and management team.
- Regulatory compliance, including relevant laws and regulations in the startup industry.
- Social and environmental impact, including the startup’s commitment to social responsibility, sustainability practices, and environmental impact.
Due diligence for startups: a checklist
Use the due diligence checklist below to assess the startup’s financial, legal, operational, and commercial aspects to ensure informed decision-making.
1. Business overview
Investors evaluate the basic elements of a startup to gain a comprehensive understanding of its core objectives.
- Mission and vision statements
- Target market analysis
- Business plan
Investors assess the financial health of a startup to assess its stability and growth potential.
- Historical financial statements (income statements, balance sheets, cash flow statements)
- Revenue streams and pricing strategies
- Loan agreements and outstanding debt
- Capital management, including accounts receivable, accounts payable, inventory, and cash
- Tax audits, tax returns, methods of accounting
- Financial projections and forecasts
Investors consider the legal and regulatory aspects of a startup, ensuring compliance and mitigating potential legal challenges that could impact the investment.
- Bylaws and articles of incorporation
- Intellectual property registrations (patents, trademarks, copyrights)
- Regulatory compliance documentation
- Vendor and supplier contracts
- Any ongoing or previous legal proceedings
- Non-disclosure agreements and employment contracts
- Environmental and sustainability concerns
Investors assess the startup’s core business operations, its efficiency and scalability.
- Supply chain documentation on suppliers, vendors, distribution channels, and inventory
- Technology infrastructure, systems, software applications, data management practices
- Key performance indicators (KPIs)
- Health and safety practices
Investors analyze the startup’s market position, customer relationships, and growth prospects.
- Market trends and growth drivers
- Key competitors, their strengths and weaknesses, market share, and positioning.
- Customer contracts and relationships, customer satisfaction and loyalty
- Product or service offerings
- Strategies for entering new markets or expanding to new locations
Due diligence best practices
To ensure the due diligence process is thorough and efficient, follow these best practices:
- Use a virtual data room (VDR). A VDR is a secure online repository for storing and sharing sensitive documents. This is, without doubt, the best solution a startup can use during due diligence as it ensures controlled access, confidentiality, easy organization of information, and seamless collaboration. Providers like iDeals, Intralinks, and Datasite are considered the best on the market. You can book a demo or use a free trial to assess their suitability for your needs.
- Organize pitch decks by investors. As each investor has unique interests and requirements, create separate folders for pitch decks tailored to each investor. This approach helps startups maintain clarity and effectively cater to individual investor preferences.
- Don’t hurry with sharing due diligence documents. Share documents with investors only when a term sheet is in place and a trusting relationship is established. It helps to prevent unnecessary risks and protect sensitive information from unauthorized access or misuse.
- Leverage the 5Ms concept. The 5Ms concept, created by Eugene Hill, a managing partner at SV Life Sciences, refers to five key areas that represent the fundamentals of building a startup. Investors prioritize these five areas during due diligence, focusing on the market (size, growth rate), management (the team’s experience), money (financial strategy, revenue streams), method (business models, growth strategy), and metrics (already tracked metrics and data to validate a product or service).
5 common mistakes startups make during investor due diligence
Let’s look at the common legal mistakes startups make during due diligence, as highlighted by Legal Nodes, a legal services provider.
1. Unissued founders’ shares
It often happens at the beginning of a startup journey that its founders only verbally discuss their agreements, not documenting them. This, later, often leads to conflicts and becomes a reason for the failure of about 65% of startups.
|To fix this, maintain an up-to-date Stock Ledger, develop a Founder’s Agreement, and ensure all meeting minutes are properly recorded. This establishes clarity in share ownership and prevents discrepancies between company documents and the capitalization table. Not having these documents in place can be a red flag for investors.
2. Unsigned options with employees and advisors
When investors begin due diligence, they always ask if the startup’s employees have been promised stock options. If they have, it’s crucial to have clear stock option plans and agreements. Not having these documents may raise concerns and make investors hesitate about the investment.
|To fix this, maintain an up-to-date Stock Ledger with option holders’ data. Also, sign stock option agreements before due diligence and regularly update the company’s valuation. This ensures transparency in share issuance, motivates the team, and provides clarity on the actual value of shares.
3. Vital intellectual property doesn’t belong to the company
In the due diligence process, investors want to confirm that the company legally owns its intellectual property. They want to avoid cases like TWG Tea, where the domain name was registered by one of the co-founders. When he left due to internal conflicts, the legal battle over ownership followed, lasting seven years.
|To fix this, register domains, trademarks, patents, and inventions in the company’s name. Transfer any personal holdings to the business through legal agreements.
4. Intellectual property created for the company is not protected
In due diligence, investors review agreements with all contractors and consultants as they want to ensure the intellectual property of all the components of the product, like codebase and designs, belong to the company. Neglecting to secure intellectual property rights through signed agreements can pose risks, putting investors’ stakes in jeopardy.
|To fix this, ensure all intellectual property is transferred to the company and all contributors sign the IP assignment agreement.
5. Tax reports not filed
Startup founders often forget to file tax reports, even with zero income, in their first year of operation. But later, during investor due diligence, this becomes a problem, as it may potentially result in fines and reputational damage. That’s why investors give special attention to tax-related documents.
|To fix this, seek tax and accounting advice early after registering the company, understand reporting obligations, and file necessary reports diligently.
- Startup due diligence, conducted by potential investors, involves a comprehensive review of the company’s financial, legal, and operational aspects.
- Investors evaluate various aspects, including market potential, business model, competitive environment, financial health, operational efficiency, team qualifications, regulatory compliance, and social and environmental impact.
- Due diligence best practices include using virtual data rooms, organizing pitch decks tailored to each investor, avoiding early sharing of due diligence documents, and leveraging the 5Ms concept covering the market, management, money, method, and metrics.
- The most common mistakes startups make include unissued founders’ shares, unsigned options with employees, intellectual property issues, lack of protection for created intellectual property, and negligence in filing tax reports.
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