Startups

A guide to due diligence for startups

Charles BrecqueCharles Brecque
Last updated on:
March 5, 2022
Published on:
November 23, 2021

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Startup companies often require investment to grow usually pitch their business idea to potential investors. A startup pitch will explain the business' story and vision. If an investor is interested in investing whether they're an early-stage investor or venture capitalist, they will often do some form of due diligence on the startup before investing which goes beyond the information supplied in pitch deck. This guide explains what due diligence is and what it involves to help startups prepare themselves and raise funding with confidence.


What is due diligence?

In the context of startups, due diligence is a series of checks an investor might run on a startup to confirm that certain aspects of the business are true or to confirm that the investment is a good strategic fit. The second goal of due diligence is to identify potential red flags which were not disclosed prior to the due diligence. Due diligence can also be performed by an acquirer before making a potential acquisition.


Who does due diligence?

The type of due diligence a business will need to go through and who will do the due diligence will depend on the stage of the business and the size of the deal. For example, a founder fundraising £100,000 in pre-seed funding for their early-stage company will go through less checks from angel investors than a company raising £1M in Series A funding from a venture capital fund or a company being acquired for £100,000,000 by a corporate. Investors will often do the due diligence themselves for early stage investments which usually means having multiple conversations with the founder in order to understand their vision, approach and whether they have the right skills to navigate uncertainty. Due diligence for a large acquisition will often be carried out by lawyers and accountants who will ensure that the documents and financial numbers and forecasts are in check. Due diligence can also include background checks of the co-founders and key management team which can be carried out by third parties.


What is the due diligence process?

The due diligence process involves going through a due diligence checklist which is verifying that the company under review can answer questions and provide adequate supporting documentation when necessary. For example, the checklist might request the proof of identify of directors and the disclosure of the company's audited accounts which will reveal the company's financial records such as its capitalisation table balance sheet, financial statements, income statements and business plan. Due diligence checklists also include reviews of contracts  (redacted when necessary) such as stock option or employment agreements to ensure that the company's intellectual property rights and cash flows are sufficiently protected and that the company is not bearing unreasonable liability or capital expenditures in its agreements. The due diligence checklist can also include a review of patents, trademarks and copyrights to ensure the company's IP is sufficiently protected. In parallel with these activities, startup due diligence often involves interviews of the management team to better understand the strategies which led to these numbers.


Due to the sensitive nature of the information being disclosed, it is common for organisations to enter into a confidentiality agreement with the party doing due diligence. Using a platform like Legislate helps standardise contract templates and terms which helps automate compliance and due diligence because the parameters of each contract are known and fixed. The data uncovered in this due diligence process can also help validate the company's business model, valuation, customer base and the metrics around their business transactions.

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When do you do due diligence?

Due diligence occurs before a financial transaction occurs. For example, at target companies ahead of mergers and acquisitions. Private equity and venture capital firms will also do due diligence on the company they are investing in. Due diligence might also occur in the context of a regulatory investigation or after breaches such as a cybersecurity failure. Startups should prepare for due diligence from day one by having the right documentation in place and organising documents so that they can be easily access if and when they need to go through due diligence. Being organised from the start makes the process more efficient and smoother.


What is the outcome of due diligence?

The outcome of a due diligence process is a due diligence report which summarise the due diligence activities and will allow the investor or acquirer to make their investment decision or M&A deal. As long as the company has provided all the required documentation and the due diligence has not identified red flags, M&A transactions or investments will receive a green light to proceed in the form of a term sheet outlining the terms of the deal. As a startup, it is important to be upfront with your potential investors or acquirers about risks and any areas of your business they might have concerns about. Having the conversation early on ensures that a path forward can be established before these risks are labelled as red flags.

How Legislate can make your due diligence process efficient

Legislate is a contract management platform which offers standardised templates which are lawyer-approved and easy to understand. Contract terms are set by answering simple questions from a limited set of options which means that someone doing due diligence only needs to look at one agreement type to understand the structure and contents of all the contracts of the type. Legislate's virtual data room for your contracts makes producing statistics about employment data such as the number of employees with a certain notice period straight forward. Using Legislate for you contracts also ensures that your agreements are robust and have the right IP and confidentiality provisions which an acquirer or investor will expect. To get started, create your employment contracts and consultancy agreements with Legislate by reading a tutorial and signing up.


About Legislate

Legislate is a contracting platform where business owners can create contracts to help grow and develop their business. Legislate's employment offer letters and contracts are key in protecting your IP and Legislate's NDAs are crucial to ensure you can have conversations and partnerships to help develop your business and brand. Book a demo or sign up today to put the confidence back into contracting.

 

The opinions on this page are for general information purposes only and do not constitute legal advice on which you should rely.

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