The Angel Investor's Guide to Conducting Startup Due Diligence

Today's topic is in response to the regulatory turbulence that fintech companies have been facing around the world over the past few weeks. From the accounts seizure in Nigeria to the investigations in India and the sanctions violation fine in the United Kingdom, it's clear that while fintech remains a potentially highly lucrative investment sector, investors must be more proactive in derisking their investments.

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In the past, investing in technology startups was the preserve of venture capital firms with huge bankrolls and exclusive access to industry bigwigs. Nowadays, as the number of startups continues to increase and information about startups, founders and other industry players becomes more accessible via various platforms, it’s much easier for individuals to invest in promising startups.

These investors are referred to as angel investors in acknowldgement of their importance to startups at the early stages. This is because VC firms are traditionally more inclined to funding proven business models. Thus, for many startups, getting investments from angel investors is often the difference between shipping the initial product and getting enough traction to attract institutional VC funding, and dying off due to lack of funds.?

Although early-stage investors typically get very favourable terms to compensate for the increased risk, angel investors must nevertheless take steps to reduce the risks in their investments as much as possible. Due diligence is one of the ways of doing that, and it involves a thorough evaluation of all aspects of a startup to establish its legal, financial and technical viability.?

Before the due diligence begins, the parties sign an NDA (Non-Disclosure Agreement). That is because the process involves sharing the sensitive data of the company with regard to its financials, operations, legal, and other information. Afterward, the investor will typically share a due diligence checklist containing requests for relevant information and documents. Based on my experience representing investors and startups alike during due diligence processes, the following are the most important aspects that angel investors must pay particular attention to.?

Corporate and Contractual

The goal of this aspect of the due diligence process is to come to a conclusion about the risk exposure of the company from legal and contractual standpoints. It involves an assessment of the company’s incorporation status at the companies registry, including verifying the validity of its registration, evaluating the contents of its governing documents, and establishing whether there are any liens on the company’s property.?

The second aspect is equally crucial because investors must be aware of any contractual rights, obligations, or liabilities that the company might have. This involves going through the company’s agreements with other individuals or companies to establish which companies the company has secured partnerships and service provision commitments agreements with, and what outgoing commitments the company has made to partners, the founders, previous investors, or any other parties.?

Regulatory Compliance

It is also important to evaluate whether a company has been in line with the corporate laws (federal and state) where it is domiciled because a non-compliant company would be at risk of receiving fines or having its incorporation status suspended or even terminated.

Extensive sector-specific regulatory due diligence is also crucial to establish that the startup is not in violation of any of the laws applicable to it due to the industry in which it operates, its products/services, or its mode of operation. For instance, operating certain businesses without a license can lead to regulatory penalties for the company and in some cases, even criminal charges.

One caveat though – the very nature of tech startups and the disruption they bring is that they often do not fit into existing regulatory frameworks. Take cryptocurrency, for instance, and NFTs. Assessing and determining whether the business’ prospects are worth that regulatory risk is part of the investment process. (and as The Generalist put it in their “Tech in Africa” feature (highly recommended), “For entrepreneurs and investors in Africa, eight times out of ten, it’s better to beg forgiveness than ask permission". Those who take the risks are sometimes the ones who reap the largest rewards. Just ask Garry Tan, founder of Initialized capital, whose $300,000 investment in Coinbase’s Series A at $0.15 per share netted him $2.4 Billion after the company went public this year. That’s 6,000x. Six thousand.?

Technical and Intellectual Property

The intellectual property of a tech startup is often its most valuable asset. This is because, unlike traditional companies where companies use buildings and machinery to manufacture products, a tech startup’s products and services are produced using its software codebase, and it acquires and maintains itsmarket share primarily through its digital brand marketing. Thus, in conducting due diligence for angel investment, it’s important to verify that all relevant intellectual property is vested in the company as opposed to the founders or employees and that the company has taken the necessary steps to register its intellectual property.?

Another aspect of this section of the due diligence process is ensuring that the company is not exposed to potential litigation or liability generally due to infringements on the intellectual property rights of other companies or persons. This involves ensuring that all the software tools that the company’s employees use are properly licensed and that the licenses are not being violated in any way.?

Tax and Financial

Here, the analysis is made with regard to historical data for the company or possibly on specific projects, review of forecast performance and funding requirements, and scrutinizing all the documents related to the company’s tax compliance. This includes corporate tax as well as other types of tax which the company might have been obligated to pay or withhold from counterparties and remit to the tax authorities. Tax compliance is very crucial for tech startups, especially as they begin to scale. Failure to comply fully with tax law can have serious consequences including financial penalties and an inability to enter contracts with certain corporations and government agencies.

The financial evaluation is equally crucial, to ensure that the company’s finances have been managed with prudence and accountability up to that point. It typically involves an audit of the startup’s financial projections, financial statements, models, or other details of their business, products, services, or market potential.

Human Resources

HR due diligence involves understanding the country’s system of employment contracts, labour laws, labour relations, regulatory policies, work culture, and industry standards, and ascertaining the degree to which the company is compliant with them. Again, a failure on the part of the company to comply with all relevant laws and regulations can lead to legal liability. There is also the risk of disgruntled employees suing the company?or making damaging statements in public, which can lead to financial loss and reputational damage.

In this section, it will be important to review the employment contracts between the company and all its employees, whether on a full-time, part-time, or contract basis. Any in-house HR policies that the company has implemented must also be reviewed to ascertain that they are fully compliant with the relevant laws and regulations.

Conclusion

Due diligence is a very crucial process that must be conducted in a painstaking manner to ensure the accuracy of the conclusions that will be drawn. Those conclusions have a high level of significance because they will help the investor make a well-informed decision regarding whether to proceed with the investment or not. Despite that, due diligence is best conducted in a prompt manner to ensure that investors can still take advantage of opportunities, should they decide to. It is thus important that angel investors engage experts with extensive experience in conducting due diligence, to ensure that they get the information required as quickly as possible without compromising accuracy.?

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Please note that this article is for informative purposes and is not to be taken as financial or legal advice. Please consult your legal and financial advisors before making any investment decisions.

What else do you consider before investing in startups. Do share your thoughts in the comments and please remember to share this with anyone whom you think would benefit.