Due Diligence From An Investor's Point Of View

Due diligence refers to the process of researching a business you are considering investing in.

Gaining a deeper understanding of the company is the goal of due diligence, which will help you decide whether to move on with your investment after doing so and if so, on what terms? A share purchase agreement's warranties are frequently modified to take into account the findings of the due diligence procedure.

You would normally aim to discover more throughout the due diligence process about the following topics:

o??what the business does and who its important customers are;

o??its financial situation and history;

o??who the key stakeholders, including key employees, are;

o??and the overall health of the organization.

o??any key risks that the business might be facing,

o??and whether the business is likely to be a good fit for you.

The due diligence procedure is often carried out through a combination of oral and written discussions. This mixture is crucial. You will have the chance to evaluate the organizational culture and learn more about the main players during conversations and meetings. You can find the information and other details you need to thoroughly examine the company in the written communications.

How in-depth you want your due diligence research to be is entirely up to you. More thorough due diligence is expected if your investment is larger and you are less familiar with the company and its major stakeholders.

The more time you spend getting to know the company before you invest, the lower the chances of you being surprised later.

What Occurs Throughout Due Diligence?

Each VC firm has its own way of conducting due diligence, and each potential investment requires a unique approach. But there are several categories of information that almost every deal team needs to gather insights into:

·????????Financial

·????????Legal

·????????Market

·????????Product

·????????Business model

·????????Founder and/or management team

Financial

The company’s financials may be the most important information a VC deal team needs to assess the potential of startup investment. No matter the firm and no matter the target company, there is a long list of financial statements and information to gather, including:

• Income statement
• Cash flow statement
• Balance sheet
• Financial projections
• Schedule of bad debt and/or write-offs
• Accounts payable
• Current accounting system
• Leases
• Inventory
• Materials contracts
• Product margins
• Customer contracts and invoices
• Customer acquisition cost
• Customer lifetime value
• Customer churn rate
• Intellectual property

Typically, a VC firm will send a due diligence checklist to the startup and task the founder or management team with gathering all the relevant documentation.

Legal

In legal due diligence, a deal team should look for any red flags that may indicate a mismatch between the startup’s legal standing and what they have reported to the VC firm. This area of due diligence is also concerned with assessing the VC’s level of control in the investment. A deal team should ask for documentation including:

??????????????????????Articles of incorporation

??????????????????????List of shareholders (including angel investors) and percentages owned

??????????????????????Bylaws and amendments

??????????????????????Annual reports

??????????????????????Compliance with state and federal laws

??????????????????????Any legal claims against the company

??????????????????????Any outstanding liabilities

Market

The market a startup is competing in is as important as the product the startup sells. VC deal teams must determine how sound the market is and the potential for the company to grow in the market in the near future. Information to gather here includes:

• Market size
• Market growth trends
• Competitive landscape
• Sales volume
• Product pricing

Product

Even if the financials, legal, and market look promising, if a startup isn’t selling the right product in the space, they’re in, they aren’t likely to succeed. When VC firms look at a startup company’s products during due diligence, they’re looking for these key metrics:

• How well-built is the product? (i.e., do substantial changes/updates need to be made before it’s more than a minimum viable product, or for software companies, it’s important to know if is there a substantial amount of tech debt that may hinder growth)
• How the company delivers value to customers
• ?How differentiated the company’s product offering is compared to what else is available in that market

Business model

To understand how the VC firm is going to make money, they need to understand how the company is set up to deliver their product or service. The information a deal team is looking for here includes:

• The current business model, i.e., how the company sells its products
• Customer perception of the product’s value
• Potential for recurring revenue
• Scalability of the business model

Founder and/or management team

A VC firm’s team members and investors spend a lot of time with portfolio companies’ founders, co-founders, and/or management teams—so it’s important to learn about these key players early in the deal process. If there are obvious personality conflicts—or worse, conflicting values—the VC firm may lose confidence in their ability to work well with the startup. Not to mention, the company’s founding team is an indicator of the company’s trajectory. The founding team’s capabilities are often assessed by gathering the following information:

• Amount of relevant experience
• Related professional credentials
• Track record with other companies they have founded/led
• Exit strategy and IPO plans

While the founder or co-founders may be the most important leadership factors in a seed-stage or early-stage startup, for later-stage startups, the rest of the management team should be taken into consideration too. Tracking key changes in leadership roles can often be an indicator for VCs to follow-up on an opportunity if they’re looking for a potential new deal.

Can Due Diligence Ruin A Transaction?

Startup investors must invest time and money in their due diligence, so they usually have a deal in mind before beginning the process.

Nevertheless, transactions can fail during due diligence.

This occurs mostly because the investor discovers information that the corporation, whether unintentionally or unwittingly, omitted to disclose.

Therefore, having total candor with your potential investors during the early stages, pre-due diligence, and technical due diligence will significantly improve your chances of making it through the due diligence stage and obtaining that crucial investment.

The difficult process of obtaining venture financing will take up the time and effort that you would typically devote to your company.

Getting it done successfully, however, means the key to growth and survival of a business and an entrepreneur’s dream.