In the world of startups, the path to funding is rarely straightforward. It requires meticulous planning, a clear understanding of your business’s value, and a robust strategy to convince potential investors of your venture’s potential. One crucial step in this process is preparing for investor due diligence.
What is Investor Due Diligence?
Investor due diligence is an intensive investigation process carried out by potential investors to assess a startup’s business model, financials, management team, and overall investment potential. This process is critical for investors to make informed decisions and mitigate investment risks.
Why is Due Diligence Important for Startups?
For startups seeking funding, due diligence serves as a litmus test for their readiness to receive investment. It’s an opportunity to showcase their business’s strengths, address potential weaknesses, and demonstrate their commitment to transparency and good corporate governance.
Investor due diligence not only influences the decision to invest but also impacts the terms of the investment, including valuation and deal structure. Therefore, preparing adequately for due diligence is essential for startups to secure favorable investment terms.
Preparing for Investor Due Diligence: A Step-by-Step Guide
Step 1: Understand Your Business Value
The first step in preparing for due diligence is understanding your business’s value. This involves evaluating your financial performance and growth prospects, which can be captured through various financial metrics and valuation methods.
Common financial metrics used to evaluate startups include:
- SDE (Seller Discretionary Earnings): SDE is a valuation metric used for early-stage companies with less than $5 million in annual revenue. It is calculated as Revenue – Cost of Goods Sold – Operating Expenses + Owner Compensation.
- EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): EBITDA is a more accurate valuation metric for mature companies with more than $5 million in annual revenue. It is calculated as Net Income + Interest + Taxes + Depreciation + Amortization.
- ARR (Annual Recurring Revenue) & MRR (Monthly Recurring Revenue): ARR and MRR are valuation metrics for pre-seed and seed-stage startups with a minimum $2 million in ARR, a forecasted year-over-year growth rate of 50%, and a reduced reliance on founder involvement.
Startups must also establish a company valuation statement that presents the financial value of their business. The valuation method will depend on the nature of the startup’s business, such as whether it’s a SaaS business or a product-based enterprise.
Step 2: Maintain Up-to-date Financial Statements
Startups must maintain up-to-date financial statements, including a balance sheet, income statement, and cash flow statement. These financial statements paint an accurate picture of the startup’s financial health and are integral to the due diligence process.
Startups should leverage cloud accounting software like QuickBooks or Xero to keep their books and prepare their reports. If required, they can also outsource their bookkeeping to service providers like Enkel to optimize their day-to-day bookkeeping.
Step 3: Develop Accurate Financial Projections
Investors will want to assess the future profitability of the startup by examining their financial projections. These projections should indicate future revenues, expenses, and growth patterns, and be based on a combination of historical data and realistic market predictions.
Step 4: Maintain an Accurate Cap Table
A capitalization (cap) table is a spreadsheet showing all the startup’s investment transactions. As the startup goes through more funding rounds, the cap table becomes more complex, including details of IPO or M&A transactions, lists of venture capital funds, and legal documents outlining events like stock issuances, transfers, and cancellations.
Step 5: Create an Organizational Chart
An organizational chart provides a visual representation of the roles and relationships within the startup. It offers quick insight into the startup’s structure, team members’ duties, and collaboration dynamics, making it a critical element of the due diligence process.
Step 6: Secure Intellectual Property Documents
Startups need to show lawful ownership of all intellectual property (IP) assets. They must also assure prospective investors that they aren’t infringing on others’ IP rights or facing any legal action involving IP rights.
Step 7: Compile Material Agreements
Startups should compile all material agreements, including lease or purchase agreements, business insurance policies, loan documents, and terms of service. Having these documents readily available expedites the due diligence process and demonstrates the startup’s commitment to transparency.
Step 8: Use a Smart Document Management System
Having a smart document management system in place streamlines the document retrieval process and ensures the accuracy and completeness of information. This system allows startups to compile, present, and share necessary information quickly and securely.
Step 9: Prioritize Intellectual Property (IP) Ownership
Startups must ensure they own all of their IP and have taken steps to protect it. They should file for patents, trademarks, and copyrights, and secure trade secrets under Non-Disclosure Agreements (NDAs).
Step 10: Prepare Early for Due Diligence
Startups should prepare for due diligence early by getting their legal and corporate affairs in order. This includes maintaining up-to-date corporate records, securing IP ownership, and preparing a data room for investor due diligence.
Step 11: Plan for Timing
Raising funds takes time. Startups should plan for at least a few months for a full round of funding. Having adequate runway prevents startups from being in a disadvantageous bargaining position due to a shortage of funds.
Example: Brampton Angels Fundraising Due Diligence Checklist for Startups
- Corporate Structure & History
- Articles of incorporation
- Corporate by-laws & operating agreements
- Board of Directors and Shareholder meetings’ minutes
- Past & Current Shareholders Agreements
- Documents provided to directors & shareholders
- Board of Directors: List members with experience & skills
- Business Advisory Board: List members with experience & skills
- Company’s officers
- Legal Counsel & Auditor details
- Financial Information
- Annual financial records (audited) since inception
- Current financial statements & trial balance
- Financial projections with:
- Up-to-date business plan
- Financial plan for the next 3 fiscal years
- Major growth drivers & prospects
- Explanation of business seasonality & predictability
- Explanation of projected capital expenses & working capital arrangements
- External funding expectations & details
- Capital Structure details
- Other financial information including financing history, tax positions, and accounting policies
- Description of each product with:
- Major customers & applications
- Historical & projected growth rates
- Market share & technological change rate
- New products & enhancements timing
- Cost structure, profitability, and warranty details
- Description of each product with:
- Competitive landscape description
- Competition defense mechanisms
- Company-conducted primary & secondary market research
- Marketing, Sales, & Distribution
- Strategy & implementation
- Major customers & partners details
- Business generation methods
- Sales force model & structure
- Marketing plan feasibility
- Research & Development
- R&D organization description
- New product pipeline details & risks
- Management & Personnel
- Organization chart
- Headcount projections by function & location
- Senior management bios with:
- Compensation details
- Employment agreement details
- Non-disclosure & non-compete agreements
- Significant employee relations issues
- Legal & Related Matters
- Details on lawsuits against and by the company
- List & status of intellectual property like patents, copyrights, trademarks
- Insurance coverage summary
- Summary of material contracts
Investor due diligence is a rigorous process that requires meticulous preparation. By understanding their business value, maintaining accurate financial statements, and getting their legal and corporate affairs in order, startups can navigate the due diligence process effectively and secure the funding they need to grow their business.
Remember, preparation is the key to success in the due diligence process. The more prepared a startup is, the more attractive it becomes to potential investors. So, start your preparation today and take a step closer to securing your next round of funding.