Due Diligence: a Two-Way Street Every Startup Should Know About

By Maria Jones | Partnership Manager @ investors angel  Crowdfund Beat Guest Editor,
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Due Diligence is a complex and highly responsible process, and is one of the most important stages during fundraising and investment. Experienced investors already know which professionals to employ and what things to pay attention to in a potential object of investment – and we have already given them some advice in an earlier article. Meanwhile, some of the younger and less experienced entrepreneurs usually expect their due diligence with a sense of anxiety, perceiving it as something inevitable and unpleasant. Well, let’s talk about it, dispel the fears and put everything in order.

Put emotions aside, focus on business

Usually, when confronted by the perspective of an impending due diligence, businessmen tend to fall into one of the two extremes. Some of them are 100% certain that they have already done everything that’s needed by founding the company, and their business plan and current achievements are so self-evident, that no additional effort is required. Others become lost in a flurry of frantic preparations and team meetings in a drive to present a picture of a perfect startup to the investor. We believe that the second approach is not much better than the first one – rather, an entrepreneur is advised to find a happy medium between the two attitudes. One shouldn’t give in to panic, but it’s equally inadvisable to let everything slide. Even if you feel that you could win any investor by how good the processes run in your company, it still pays off to make an effort and prepare for the due diligence by performing several, quite simple tasks.

First of all, talk to your team. Certainly, the process of due diligence is a given for you and hardly a surprise, but does your team feel the same way? Let them know as much as possible about this important procedure, discuss all the nuances and pitfalls, take care to answer their questions. Let these arising challenges to become a rallying force for the team.

Secondly – gather your team (or at least its core members) and recheck the business plan together. Let the head of the company familiarize everyone with the investor pitch and make sure everyone has access to the latest version of the business plan. Make sure that all the processes of your business are properly documented, all employees are informed and have a common “picture” in their heads.

Also, make use of the occasion and take care to recheck the team’s status. Make sure that there are no ongoing conflicts between anyone, no upcoming changes to staff and the Social Media profiles of the personnel accurately represent their experiences and positions in the company.

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Finally, get in touch with the consumers and distributors of your product, as well as your partners. Make sure that your product or service fully satisfy the customers’ requirements and at the right moment your company can rely on their support. If it turns out that there are some problems and solving them will require some time: be honest and warn the potential investors about those issues and make sure to present them with a plan for improving the situation.

In this instance, there is no such thing as excessive care, and if you think that you need another check – don’t hesitate and do it. Just keep the main idea in mind – there should be no “surprises” for the investor.

The investor must know

The complexity and duration of the due diligence depends on several factors, such as the expected amount of investment, for example. Depending on the goals of a specific investor, it may take a couple or weeks, or protract for a whole year. But whatever the procedure is in your case, the investor will need to learn several key things about your company. Here are just a few of them:

How big is the market and what are its needs?

You can create a product that will seem ideal to you, but you will not be able to make people pay for it, if they just don’t need it. Every investor understands this simple truth, so they are likely to want to talk to potential buyers before making a decision, and a good place for them to start are the people who you can refer to. In short, you’ll be doing yourself and the investor a favor if you prepare a list of buyers to refer to beforehand.

What is the current status of your business and its finances?

Your investor will want to see a full-scale, accurate market capitalization sheet of your startup. And that’s only fair, given that if the entrepreneur has a flawed credit history, open court cases or was declared bankrupt at some point in the past, the current enterprise’s chances of success suddenly become significantly lower. How successfully have you been reaching your financial and business milestones? Did you have some pre-existing investments? How distributed is the current stock ownership? Be ready to answer all those questions.

Product or service readiness

This aspect is covered by both the technical and legal parts of the due diligence. Both the product itself and its manufacturing process are under investor’s scrutiny at this stage. The entrepreneur has two primary tasks laid out before them. First, they have to make sure that the products quality and functionality are in 100% compliance with those that are declared officially, and that the company will be able to keep up with those standards in the long run. And second, they have to make sure that the target product or service are their own intellectual property, i.e. they have the right to produce them.

Is everything good with the team?

This point is the most important for small teams, where every person plays a more important role and is responsible for larger parts of the whole process – so don’t be surprised if the investor wants to talk to everyone in person. What does the investor want to see? How talented everyone is, and how committed are they to the common cause; your team’s strengths and weaknesses; your management style. A single incompetent person in a responsible position can make the whole team dysfunctional – and you do understand that that could compromise the entire enterprise?

“Enough about me, let’s talk about you!”

There is one important thing that a lot of entrepreneurs don’t understand or forget about, and that is that the startup may just as easily conduct the investor due diligence. Why not? You and your company are not just property for someone to command. You too have the right to know everything that concerns you and thus secure your position. Someone wise once said that the interaction between a company and its investor is not unlike marriage – you are entering a close relationship for years, so you have to know every little detail about each other and build mutual trust.

Besides the obvious reasons, conducting investor due diligence can be useful for you in other ways. Firstly, it can allow you to quickly understand what the investor is up to. Yes, it’s one of the largest misconceptions among entrepreneurs to think that all investors have good intentions. The truth is that every player in this game has their own interests in mind, and those are always the number one priority for them.

However, let’s not dramatize here. Just imagine the impression you can have by expressing your wish to do your own due diligence! Such intentions always indicate that the person is approaching their business responsibly, and it’s certainly not usually expected from a startup – most people are used to the idea of a young entrepreneur who is ready to carry out every request of the investor and eagerly wait for feedback. Trust us, you are quite likely to impress the investor by taking the initiative.

Before providing any specific recommendations, we would like to clarify something. It’s widely known that there are different kinds of investors; in particular, there is important difference between institutional (VC, private equity firms, etc.) and private (such as business angels, or just people fitting your financial criteria) investors. Now, most of the the things we are going to be talking below are more in regard to private investors, because in some cases the people from this segment can be less reliable than the institutional investors.

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So, investor due diligence. This process is significantly different from the one conducted by the investors – in their case it’s a multi-layered process which requires the work of professionals from many different fields. In your case it’s just a deep, detailed background check, which covers many questions, but still completely feasible for you to do on your own. Let’s cover the main questions that this check has to answer.

Motives

Which goal is the investor after? There are several main options and the first one is the return on investment. The investor puts their money in a startup, taking all the risks into account and hoping that the potential profits pay off in the long run. This approach is especially popular when investing in startups at their early stages of development, when the chance of failure is at its highest, but the ultimate return can also be several times higher than the initial investment.

The second option is portfolio diversification. Your investor doesn’t want to “put all their eggs in one basket”, so they have a whole portfolio of different investments. They know that a portfolio speaks volumes about an investor, so they are actively working on diminishing the combined risk of that portfolio and plan on gaining in the future. That is a very reasonable wish, which can compel an investor to put their money in your company.

The third option is strategy. For example, it’s quite probable that in your company, the investor has identified a good opportunity for a merger with another enterprise, which they already have in their portfolio.

If it turns out that the investor’s actions don’t fall under any of these categories, that is a good reason to become wary of their intentions.

Background and recommendations

It won’t hurt to learn certain facts about your potential investor’s business experiences. For example, which companies have they invested in, during the last couple of years? How large and diversified is their portfolio? Specific attention should be paid to the number of the companies from their portfolio which were financed in full.

This part is pretty self-explanatory. Investment partners, clients, companies, legal agencies and companies that the investor has put their money in in the past: all these can be good sources for additional information. Even if the only recommendation that the investor can provide is coming from their legal consultant, that is already a positive signal.

Investment capabilities

A good investor’s functions and opportunities lie far beyond the scope of simple financial activities. Besides making sure that they will just be able to close the deal in a timely manner, you should try to understand what else will they be able to bring to the table. You probably want to see a person as your investor, who knows how hard it is to build a successful business from scratch; who knows the process of fundraising at every stage inside out and is always ready to help. Maybe you want your investor to have experience in some particular field? The choice is yours.

Naturally, these are not all of the criteria which you can use to determine an ideal match between your company and an investor: those are so numerous as to warrant an article of their own. The main thing that an entrepreneur should understand is that investor due diligence is an integral part of the process.

Finally, we’d like to emphasize one more time that the most adequate reaction an investor can have to your desire to conduct your due diligence is consent and cooperation. Of course, there may be questions as to what are you up to. In that case, it’s best to answer that you’re conducting your own due diligence based on advice from your legal counsellor, so that both you and the investor can make use of the process. But even after learning about the legal counsellor’s involvement, an investor can insist on not cooperating with you in any way. In that case, you should think carefully if you really want to work with that person!

 

 

 

 

 

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