For most start-ups and small businesses, due diligence is something to be endured when a potential investor undertakes an audit process before committing to investing in your company. The intensity of that audit often depends on the amount of investment involved. That much should be obvious to any viewer of the business reality TV shows ‘Dragon’s Den’ in the UK or ‘Shark Tank’ in the USA.
Accuracy and Transparency is Essential
Sometimes, due diligence can be as simple as a face-to-face conversation, especially if you are a start-up looking for pre-seed funding. More usually the process can involve business lawyers, accountants, and a lot of paperwork. Honesty and integrity as well as accuracy and transparency are paramount because the aim of due diligence is risk mitigation. Everything you say must match up with the data you provide because the truth will always come out in the end. Err on the side of disclosure.
Preparing for due diligence is a great opportunity to do an internal audit as well as verifying the growth plan that will be a major part of your pitch. Proper preparation also allows you to defocus on the day-to-day stuff and get an updated overview of your business which can reveal areas worth optimising even before the investor gets involved.
What Investors Will Ask
Typically, investors will have a standardised checklist to go through, although it’s likely that each investor will ask different questions. Seeking the help of business and legal consultants like Motion Paradox can make due diligence easier by preparing in advance all the most common documents that investors will usually require. Given the sensitive nature of the data you will disclose, common practice is to enter into a confidentiality agreement with the potential investor, although the efficacy of these agreements is open to question.
Your business plan and financial records are the most common data points investors ask for. The aim of reviewing this information is to make sure that your pitch matches up with the concrete numbers and you are not saddled with debt. Start-ups often have multiple co-founders so make sure any documents detailing your ownership structure are up to date and ideally include a credible contingency plan for disagreements where there is 50/50 equity between founders. Angel investors and venture capitalist (VC) investors will also likely insist on seeing properly produced minutes of stakeholder or leadership meetings as well as complete openness about any legal issues, pending or threatened, that you may face.
Customer Data, Sales Revenue and Market Knowledge
Investors will want to know about your customer base and supply chain as well as gaining an understanding of your revenue streams, cost per customer acquisition and pipeline projections. As part of the due diligence process, investors will likely undertake an intense review of your competitors and the overall state of the market, so ensure you can answer any questions a potential backer may have to demonstrate your understanding of the space you are in and how you fit into it.
Ensure Contracts are Watertight
Your existing employment contracts, client contracts and vendor contracts are all likely to be a critical part of any due diligence exercise. Many start-ups and SMEs draft contracts without expert guidance, basing those documents on internet templates or what they perceive to be “common practice.” A serious potential investor will soon discover whether those off the shelf contracts actually protect your company, and hence their investment, and are sustainable in the long run. They will look far more favourably on your business if you have put in place bespoke contracts and services since, from their perspective, that will mitigate any risk and assist you in scaling properly.
Intellectual Property Rights
Potential investors will want to take a look at your Intellectual Property (IP) rights, so if you have not already done so, file for any patents and trade marks before meeting them. Your IP rights are a key economic differentiator for investors, particularly for technology start-ups. Even if you have a really great app or product, without IP protection (patent information, copyrights, design rights, trade marks) they will argue that a tech giant could offer the same thing at scale for free, so why should they bother investing in you?
Ask anyone in business and they will likely say that people tend to do business with other people, so even if all the numbers add up, the success of your company depends on you and your team. As part of due diligence, both your business and you personally are probably going to be put under the microscope. Potential investors may wish to speak with you and your team individually to get an idea of the personalities, values, and skills.
Establish a Data Room
You can get a head start on bringing in investment by building a data room to streamline the due diligence process, housing all the information most investors are likely to want to see in one convenient location – short pitch, team background, business and marketing plan, details of contracts and software licences, financial statements and IP assets. Virtual data rooms are now the norm, but whichever cloud sharing/hosting platforms you choose, you should ensure they offer both ease of access and high levels of encryption and security, since much of the information you place there will be business sensitive and confidential.
Investors in start-up businesses in particular will also likely initially propose a term sheet. Term sheets are agreements that outline the key components of the investment deal and although not legally binding, it’s still important to have access to sound legal and business advice at this stage of any negotiation After an investor has proposed a term sheet, they will need to verify all of your information to be sure that what you are selling them is real. A well-constructed data room will conveniently give them all the detail and confidence they need.
The Motion Paradox team of start-up business and legal consultants, based in London and Los Angeles, can help you through the process of due diligence, providing informed feedback on your completed plans, preparing bespoke contracts and securing your IP assets so you can convince VC or angel investors to back your vision.