The Importance of Due Diligence for Startups: Lessons from Success and Failure: NL12

What Is Due Diligence?

At its core, due diligence is an investigative process undertaken by investors, regulators, or founders themselves to verify the accuracy of a business’s financial, legal, operational, and compliance information before making critical decisions like investments or partnerships.

It typically covers the following areas:

1. Financial Due Diligence: Auditing financial statements and tax compliance.
2. Legal Due Diligence: Ensuring legal contracts, IP rights, and regulatory filings are in order.
3. Operational Due Diligence: Evaluating business operations and scalability.
4. Market Due Diligence: Assessing the product-market fit and competition.
5. Technical Due Diligence:

Starting a business is thrilling, but the excitement can sometimes overshadow one critical aspect: due diligence. Many startups have faced severe consequences due to negligence in their due diligence process, while others, who meticulously handled it, have thrived.

Starting a business is exciting, filled with potential for innovation, disruption, and rapid growth. However, the journey from concept to commercialization is fraught with risks. One of the most overlooked yet critical components of a startup’s success is due diligence—the process of thoroughly investigating all aspects of a business to ensure compliance, mitigate risks, and attract investors. Unfortunately, many startups fail to prioritize due diligence, resulting in financial losses, legal trouble, or even complete shutdown.

In this article, we’ll explore how due diligence can make or break a startup, with real-life examples of startups that either thrived because of sound due diligence practices or suffered due to neglecting this critical process.

Why Due Diligence Matters for Startups

Due diligence is the foundation on which trust with investors, partners, and customers is built. For investors, it means thoroughly investigating a startup's finances, operations, legal standing, and team. For startups, it means ensuring that your business is transparent, compliant with laws, and financially sound. Let’s break down the reasons why due diligence is so crucial.

1. Financial Stability and Investor Confidence

Investors need to be confident that the startup’s financials are accurate and that the founders have a clear understanding of cash flow, liabilities, and growth potential. Any discrepancies can raise red flags and cause investors to pull out. For example, Zomato, India’s leading food delivery service, underwent intense scrutiny during its IPO. The company had meticulously prepared its financials, including customer acquisition costs, profit margins, and future projections. This transparency helped Zomato secure over $1.2 billion during its IPO.

On the flip side, Stayzilla, a once-promising Indian homestay startup, failed largely due to financial mismanagement. It couldn't justify its spending, leading to cash flow issues that spiraled out of control. A lack of due diligence in their financial strategy caused Stayzilla’s downfall, demonstrating that poor financial planning can sink even promising startups.

Formula for Financial Due Diligence:

• Current Ratio = Current Assets / Current Liabilities A ratio above 1 means the company can cover its short-term liabilities, which is crucial for securing investments.

In Stayzilla’s case, a poor current ratio, meaning its liabilities far outweighed its assets, would have signaled impending trouble early on.

2. Legal Compliance and Intellectual Property Protection

Startups are often built on innovative ideas, and protecting intellectual property (IP) is essential. For example, Oyo Rooms, one of India’s fastest-growing hotel aggregators, faced legal issues early on due to non-compliance with local laws regarding hotel licenses and contracts. However, Oyo quickly revamped its due diligence process, ensuring all partnerships were legally sound, which allowed it to continue scaling.

In contrast, Theranos, the infamous U.S. health tech startup, serves as a cautionary tale. The company misled investors and regulators about the functionality of its blood-testing technology. Had investors conducted thorough technical and legal due diligence, they would have discovered the flaws in Theranos’ claims much earlier. The lack of IP and regulatory compliance ultimately led to the company's collapse and the indictment of its founder.

Checklist for Legal Due Diligence:

1. IP Registration: Patents, trademarks, and copyrights.
2. Regulatory Compliance: Industry-specific licenses and certifications.
3. Contracts: Review of employment, vendor, and partnership agreements.

3. Team and Operational Due Diligence

A startup's success often hinges on its founding team’s capability and the structure of its operations. Investors want to know whether the team is experienced, how equity is distributed, and whether the startup can scale operations efficiently.

Take the example of Paytm, which scaled from a mobile recharge platform to a digital payments giant. Paytm’s founder, Vijay Shekhar Sharma, ensured that the company's operations were scalable and well-structured. Paytm managed its due diligence well, particularly in expanding its digital payments business. Its operational diligence included ensuring its platform could handle millions of transactions securely and without downtime.

Paytm Payments Bank failed to put in place an internal mechanism to 'detect and report' suspicious transactions as stipulated under the anti-money laundering law and was unsuccessful in conducting due diligence of its payout service, the FIU said in its order that imposed a fine of Rs 5.49 crore on the digital entity.

Read more at:?https://www.ndtvprofit.com/business/fiu-paytm-charges Copyright ? NDTV Profit

Contrast this with Housing.com , which saw a spectacular rise and fall. One of the key reasons for its downfall was internal turmoil within the founding team, including public outbursts by the CEO and a lack of clear operational structure. Investors pulled out as they realized the company lacked strong leadership and operational efficiency. In 2015, ?Rahul Yadav ?CEO was ousted from Housing.com after the company's board said that his behaviour towards investors, the ecosystem, and the media was believed to be "unbefitting of a CEO and detrimental to the company”.

https://www.moneycontrol.com/news/business/rahul-yadav-haggled-with-info-edge-to-raise-funds-for-broker-network-at-99-discount-to-last-valuation-10733721.html

https://inc42.com/buzz/caught-in-battle-between-board-and-cofounder-will-bharatpe-become-another-housing-com/

Formula for Equity Distribution:

Founder Equity = Total Equity × % Ownership Stake        

Clear equity distribution, with founder vesting schedules, can prevent disputes later on, as was the case in Housing.com .

4. Market Due Diligence and Scalability

Understanding market size, customer behavior, and scalability is essential for investors. Startups like BYJU’S, the education technology company, carried out extensive market research before expanding their offerings. Due diligence showed that the Indian education sector was ripe for digital disruption, allowing BYJU’S to secure massive funding and become a global leader in edtech.

The insolvency process against Byju's was originally initiated in June 2024 by NCLT in Bengaluru following a plea by BCCI alleging default by Byju's in paying the board approximately ?158 crore related to sponsorship deals for the Indian cricket team's jerseys.26 Sept 2024 . In June 2024, the National Company Law Tribunal (NCLT) admitted Byju's parent company, Think and Learn, to the IRP.?The NCLT also suspended the company's board of directors and appointed an interim resolution professional (IRP) to run the company.

·?????? The company has also faced issues with US lenders who are demanding $1 billion in unpaid dues.

·?????? The company's employees have complained that their salaries and tax deposits have been delayed or missed.

·?????? The company's fortunes have declined due to regulatory issues.?

https://www.hindustantimes.com/india-news/supreme-court-orders-status-quo-in-byju-s-insolvency-01727341657565.html#:~:text=The%20insolvency%20process%20against%20Byju's%20was%20originally%20initiated%20in%20June,the%20Indian%20cricket%20team's%20jerseys .

?https://www.livemint.com/companies/news/byjus-says-auditors-bdo-resigned-due-to-initiation-insolvency-proceedings-outlines-ethical-concerns-manipulative-tactics-11725680492232.html

In contrast, TinyOwl, a food delivery startup, failed because it overestimated its market size and burned through cash too quickly. Poor market research and failure to scale operations resulted in its eventual closure.

Challenges that TinyOwl faced:?

·?????? High cost of logistics:?TinyOwl faced high operational costs?

·?????? Oversaturated market:?The food delivery market was oversaturated?

·?????? Mass layoffs:?TinyOwl had to lay off a large number of employees?

·????? Over-hiring:?TinyOwl over-hired to meet growth targets, which led to organizational issues?

·??????Lack of business leads:?TinyOwl didn't have business leads in every city, which led to inefficiency?

?

Market Penetration Formula:

Market Penetration = (Customers Acquired / Total Market Size) × 100        

BYJU’S succeeded by analyzing this formula and knowing how much of the education market it had penetrated, leading to strategic scaling decisions Current situation Byju's As of September 2024, Byju's is facing multiple financial challenges, including:

·?????? Insolvency:?The company is undergoing insolvency proceedings, with claims of dues exceeding $1.5 billion.

·?????? Tax liabilities:?Byju's faces a tax liability of approximately Rs 850 crore.

·?????? Employee dues:?Current and former employees have claimed unpaid dues of over Rs 300 crore.

·?????? Financial report:?Byju's has failed to file its financial report for the year FY23, and it is unlikely to file its financial report for the year FY24 on time.

·?????? Auditor resignation:?Byju's statutory auditor BDO India resigned in early September 2024.?

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Other challenges Byju's has faced include:

·?????? A decline in online learning demand after the end of pandemic restrictions

·?????? Concerns over aggressive sales tactics

·?????? A workforce drop from 60,000 to 25,000?

?

#Byju's is currently contesting the continuation of insolvency litigation at the Supreme Court of India.

#TinyOwl, could not thrive for 2 years, ignored these calculations and expanded too fast.

5. Export and Global Expansion Due Diligence

For startups looking to expand globally, thorough due diligence of export regulations, international market conditions, and foreign investment policies is critical. Startups like Zoho, a cloud-based business solutions provider, succeeded globally by adhering to international regulations, including Import Export Code (IEC) requirements and data privacy laws like GDPR in Europe.

Startups that fail to conduct such due diligence can face regulatory penalties or even be banned from operating in certain countries. For instance, Uber faced numerous legal battles when expanding into international markets because they neglected local transport regulations and labor laws in many regions.

Key Steps for Export Due Diligence:

1. Obtain Import Export Code (IEC) through the DGFT portal.
2. Comply with foreign direct investment (FDI) guidelines specific to the country.
3. Adhere to local laws related to data privacy, consumer protection, and employment.

Lessons from Startups That Thrived with Due Diligence

Startups like Flipkart and Zerodha have thrived because they meticulously managed their due diligence processes.

• Flipkart, while scaling, ensured that its compliance, contracts with suppliers, and customer data security were top-notch. This enabled the company to secure large investments and eventually be acquired by Walmart.
• Zerodha, a leading stock brokerage firm, adhered to strict financial and regulatory due diligence, ensuring compliance with SEBI (Securities and Exchange Board of India) regulations. As a result, Zerodha grew into a highly profitable, bootstrapped startup.

Why Is Due Diligence Important for Startups?

Startups are often under immense pressure to scale fast, so it can be tempting to cut corners when it comes to compliance or financial audits. However, poor due diligence can:

• Disrupt Funding: Investors lose confidence in startups that lack transparent financials or legal standing.
• Attract Fines or Legal Trouble: Non-compliance with regulations can lead to lawsuits, fines, or shutdowns.
• Hinder Expansion: Neglecting trade or international compliance can block overseas expansion.

Let’s now explore real examples of how startups managed or mismanaged due diligence.

1. OYO Rooms: How Poor Legal Due Diligence Created Issues

OYO, the once-hyped budget hotel chain, faced significant issues due to negligence in its legal due diligence. Despite rapid expansion, OYO’s failure to thoroughly check contracts with hotel owners led to multiple lawsuits and even closures of properties. It impacted their relationship with both property owners and customers, leading to bad press and a decline in customer trust.

• Lesson: While expanding fast, OYO did not ensure airtight contracts or regulatory compliance with local laws, leading to a series of legal troubles.

2. Zomato: Financial Transparency Pays Off

In contrast, Zomato, the food delivery giant, has consistently maintained transparency in its financial dealings and due diligence. Before their IPO in 2021, Zomato worked meticulously on cleaning up its books, ensuring financial audits were accurate and tax filings were up-to-date. This diligence helped them gain the trust of investors and made their IPO one of the most successful in recent times.

• Result: Zomato raised over $1.3 billion through its IPO, and its share price was initially over-subscribed, demonstrating the power of proper financial due diligence.

4.??? WeWork: The Downfall Due to Financial and Legal Oversights? -

https://www.imdb.com/title/tt11188154/

One of the most notorious examples of failed due diligence is WeWork. Initially valued at $47 billion, WeWork’s valuation plummeted after it was revealed that it had huge financial mismanagement issues, and its founder, Adam Neumann, had unchecked power. They lacked transparency in their financials, and certain conflict-of-interest issues weren’t disclosed, causing potential investors to pull out.

The Cult of We?emphasizes the impact that blurring the line between partying and professionality can have on a company. Reckless spending combined with poor decision making led to a dysfunctional workplace in which everyone feared what Neumann might do next.?

Instead of using typical profit and loss reporting measures, WeWork created its own “Community-Adjusted EBITDA”, which reported income net of many major operating expenses. This allowed WeWork to give the impression of financial success without being profitable.?

• Impact: Their IPO was canceled, and the valuation dropped by over 80% in months.
• It proved that bigger isn’t always better, and thoughtless expansion can drive the seemingly best companies into the ground.

4. Paytm: Structuring Compliance for Success

India’s fintech giant, Paytm, has maintained stringent due diligence when expanding its services across various domains like e-commerce, finance, and UPI payments. Paytm worked hard to meet strict Reserve Bank of India (RBI) guidelines and ensured that all its financial services were compliant with KYC (Know Your Customer) norms, which built immense trust among users and investors alike.

• Outcome: As a result of its compliance and diligence, Paytm successfully raised over $2.5 billion during its IPO and is one of the most widely used digital payment platforms in India.
• They are still contesting the continuation of insolvency litigation at the Supreme Court of India

5. How Due Diligence Affects Startup Valuation

Now let’s talk about startup valuation and how due diligence can impact it. A startup’s valuation is based on various factors, including market size, revenue projections, team expertise, and due diligence findings.

Valuation Formula:        

Valuation typically follows the Discounted Cash Flow (DCF) model, which values a company based on its expected future cash flows. Here’s the simplified version of the formula:

https://corporatefinanceinstitute.com/resources/valuation/dcf-formula-guide/#:~:text=The%20discounted%20cash%20flow%20(DCF,power%20of%20the%20period%20number.

Valuation =????????? Cash flow?/ {(1+Discount?Rate) n}

Where:

• Cash Flow is the net income expected.
• Discount Rate reflects the risk associated with future cash flows.
• n is the number of years into the future.

If due diligence uncovers issues such as financial discrepancies, non-compliance, or legal risks, the discount rate (risk factor) increases, reducing the overall valuation of the startup. Conversely, startups with clean financials and legal standing have lower risk, leading to higher valuations.

6. Common Pitfalls in Due Diligence and How to Avoid Them

Many startups fall into the same traps when it comes to due diligence. Here are some of the most common pitfalls and how you can avoid them:

6.1. Ignoring Financial Audits

Mistake: Startups often skip professional audits, especially during early stages.

• Result: Inconsistent financials can turn investors away.
• Fix: Hire a professional auditor or a CA to regularly audit your financial statements.

6.2. Weak IP Protection

Mistake: Startups, especially in the tech space, fail to secure patents or trademarks.

• Result: Competitors can steal intellectual property, leading to market losses.
• Fix: Always register your IP with the Indian Patent Office and ensure it's protected internationally if you plan to expand.

6.3. Non-Compliance with Tax Laws

Mistake: Overlooking tax filings and non-compliance with GST or income tax rules.

• Result: Tax penalties and fines can destroy profitability.
• Fix: Stay up-to-date with tax laws, automate GST and tax filing processes.

7. A Comparative Analysis: Startups That Thrived vs. Startups That Failed

Success Story: UrbanClap (Urban Company)

UrbanClap, now Urban Company, took due diligence seriously from the beginning. They ensured compliance with all labor laws, registered IP rights for their platform, and followed a rigorous financial audit process. This helped them secure large rounds of funding and grow rapidly while maintaining the trust of both service providers and consumers.

• Result: They raised over $500 million and expanded into multiple countries, including the UAE and Australia.

Failure Story: Theranos

Theranos, the once-celebrated healthcare startup, faced a catastrophic downfall due to misrepresentation of its technology and financials. Investors failed to perform proper technical due diligence on the claims made by the company, leading to a complete collapse when the truth about its faulty technology surfaced.

• Impact: The founder faced legal action, and the company was liquidated, losing billions in investments.

8. The Financial Impact of Skipping Due Diligence

Let’s take a quick look at the financial implications of poor due diligence.

Imagine a startup raising INR 10 crore in funding with an expected return of 20% over 5 years. However, due diligence later uncovers legal disputes, resulting in lawsuits and additional costs. Let’s calculate the financial loss:

Initial?Expected?Return=10?crore× (1+0.20) 5=24.88?crore

Due to legal fees and settlement costs amounting to INR 4 crore:

Actual?Return=24.88?crore?4?crore=20.88?crore

By neglecting legal due diligence, the startup loses INR 4 crore, severely impacting profitability.

The Cost of Negligence

Neglecting due diligence can cost startups far more than time or effort—it can lead to the collapse of the entire business. Whether it’s failing to protect intellectual property, mismanaging finances, or ignoring regulatory compliance, the repercussions of due diligence negligence can be devastating.

Startups that invest time and resources into ensuring financial transparency, legal compliance, operational efficiency, and market scalability are the ones that thrive in the long run. On the contrary, those that rush through the due diligence process—like Theranos, Stayzilla, and TinyOwl—end up paying the price for their oversight.

In the fast-paced world of startups, thorough due diligence is the safety net that ensures long-term survival. As the saying goes, "Failing to prepare is preparing to fail." So, start with due diligence, and success will follow.

Why You Can’t Afford to Ignore Due Diligence

As the startup ecosystem grows more competitive, due diligence will remain a critical differentiator between startups that scale and those that fail. Whether it’s keeping your financials clean, staying compliant with tax and labor laws, or securing intellectual property, startups must focus on proactive due diligence to gain investor trust and avoid pitfalls.

In summary, learning from the successes of startups like Zomato and Paytm and avoiding the mistakes of OYO and WeWork will ensure your startup is not only fundable but also sustainable for the long term.

Key takeaway: Startups that prioritize due diligence build a strong foundation for growth, whereas neglecting it can result in financial, legal, and operational nightmares.

By learning from the failures of others and leveraging tools like current ratio formulas, market penetration calculations, and equity distribution formulas, startups can navigate the complex terrain of entrepreneurship with confidence and clarity.