Due Diligence: What Every Startup Founder Needs to Know

Due diligence for startups can seem like a scary process. Afterall you want to make the angel investor comfortable enough to follow through and write that check. I’m going to give you my perspective on due diligence and some of the key factors to dur diligence for you to focus on so the process will be smooth as possible. Remember, every angel investor has their own process for completing due diligence on a startup but there are some basics you can focus on the get ready.

When angel investors like me cut checks for entrepreneurs, there’s often a multi-step process involved. First, the entrepreneur and I have to meet. Usually, there’s a presentation and a series of questions between the investor and the entrepreneur. If all that looks good, the next stage of the process is due diligence for the startup.

This step varies between investors as there are no universal criteria for what each investor will want to see. One investor might focus on one aspect of your business, like your IP, while another might want to know more about your growth potential.

However, while every investor might have different focus areas, they will all do due diligence on your startup before cutting you a check. Whether it’s $50,000 or $250,000, these investors are looking at handing over a substantial amount of money and, understandably, want to ensure that they have a reasonable chance of turning a profit on it. If you’re looking at outside investments into your business, here’s everything you need to know about preparing for due diligence for startups, including the parts of the process and how to pass it and, hopefully, get the check!

 

Table of Contents:

What Is Due Diligence for Startups?

Are There Legal Ramifications for Due Diligence for Startups?

What Do Investors Ask the Startup for During the Due Diligence Process?

  1. Financials
  2. Intellectual Property
  3. Corporate Documents and Minutes
  4. Information on Any Outstanding Litigation
  5. Employees and Founders
  6. Customer and Supplier Information
  7. Revenue Streams
  8. Business Model and Projections
  9. Cap Table
  10. Market

Don’t Worry If You Don’t Meet Some of These Criteria

Conclusion

 

 

What Is Due Diligence for Startups?

First, let’s start with the basics of due diligence. It’s a broad term that can encompass various things for different markets, but it has a relatively simple definition within startup investing.

Thompson Reuters broadly defines due diligence as:

“The process by which a buyer of or an investor in a company, asset or business investigates the records of the target to support its value and find out whether there are matters on which it requires further information or which it should use as a platform to renegotiate the price.”

When an angel investor conducts due diligence for a startup, it means that the angel investor will have accountants and legal professionals review and understand the company’s records. They’re trying to ensure that the financial records, intellectual property, and staff warrant the investment amount. People can stretch the truth quite a bit, and due diligence for a startup is how the angel investor, like me, verifies everything claimed during the pitch.

To illustrate this concept with a simple analogy, let’s suppose someone approaches you on the street and says that for $100, you can have a baseball card. The person claims that in two years, it will be worth $1,000. Sounds interesting! What would be your next move? You’d probably tell the person that, if that’s true, you’d happily buy the card, but you need some time to look into the claims.funding during an economic crisis

You might take the card to see if it’s authentic or a forgery. You might search online about baseball cards to see if this one is, indeed, a rarity. Essentially, you’d investigate the claims to make sure that this card is, indeed, a good investment. Or, in other words, you’d do your due diligence! If you felt that there was a good chance that the card would be worth $1,000 in two years, you’d probably buy it!

That’s what angel investors do for startups, before cutting them that final check!

Are There Legal Ramifications for Due Diligence for Startups?

At this point, the astute reader might be wondering what’s stopping a company from lying during this process? Why couldn’t a company hand over a false set of books or sales records to seal the deal? Would the angel investor ever know?

The answer is, invariably, yes, the angel investor will eventually know. Some startups try to “fake it til they make it,” but this is a bad strategy. There are substantial legal ramifications for misrepresenting your business during this process.

First of all, investors can explicitly write contracts providing for warranties and legal recourse for misrepresentation. These provisions make it possible to sue if the materials provided while conducting the due diligence for the startup prove to be false.

One of the more popular investment types is the SAFE note (developed by Y Combinator). In the SAFE contract, section 3(e) explicitly states that the company certifies that they have access to all the IP and materials necessary to carry out business now and in the future as proposed during the investment process. Section 3(a) has the company certify that it is in good standing with all necessary government bodies and can carry out business. Both of these sections, in part, bind the company to give truthful answers while conducting due diligence for the startup.

Furthermore, if the misrepresentations are severe (think Theranos), there are criminal penalties associated with selling securities without being fully upfront.

As such, entrepreneurs should take the due diligence process seriously. If necessary, hire outside counsel and accountants to make sure that you are providing the correct answers to a prospective investor. Providing accurate, verifiable data is essential to protect the founders personally and protect the company’s assets.

What Do Investors Ask the Startup for During the Due Diligence Process?

As noted earlier, there is no set of guaranteed set of questions that an angel investor will ask during the due diligence process. There are some checklists that some investors will follow, but there are no legal requirements that they ask those precise questions.

However, with that said, there are ten topics, in particular, that every investor will want to explore while conducting the due diligence for the startup.

1.    Financials

Every investor will want to see your historical financial records. Be prepared to send over your balance sheet, income statement, cash flow statements, the general ledger, and other pertinent financial documents. The investor will want to make sure that your business isn’t drowning in debt or have some other anomalies that would make it a bad investment.

2.    Intellectual Property

Your angel investor probably won’t ask to see the source code to your product, for example, but they will want evidence that you have the right to the IP that you’re developing. Patent information, trademarks, copyrights, etc. are vital for showing that your company can sell the products you pitched. Now, suppose you haven’t filed for patents or registered trademarks. In that case, you may wish to do so before approaching an angel investor to show that you’re serious about protecting your company’s intellectual rights.

3.    Corporate Documents and Minutes

To invest in your company, any investor will want to know that your corporation has the right legal structure and is up-to-date with all registrations. For corporate entities, expect to produce your articles of incorporation, letters of good standing, and annual meeting notes. If your company is an LLC, you’ll likely have to show its incorporation documents and evidence that your company is in good standing with the appropriate government authorities. Your investors are looking to verify that all your corporate forms are in order, avoiding potential fines and someone being able to pierce the corporate veil.

4.    Information on Any Outstanding Litigation

If your company is involved in any lawsuits, you’ll invariably have to produce documentation about them, including their potential outcomes. An investor will need to consider those before coming onboard your enterprise. As an extreme example, if someone is suing your company for $10 million and you only have $100,000 in assets, then any investor would probably give pause before cutting a check (or more likely hold off investing until there was a clear outcome).

5.    Employees and Founders

Angel investors will likely want to know more about the company’s early employees. More often than not, angel investors invest in teams, not in individuals. They’ll want to do their due diligence on the team to ensure that it has the talent necessary to execute and deliver high-quality products. Angel investors want to see a team with diverse skills, ranging from product development to sales to marketing. Before writing a check, an investor may wish to speak with individual key team members to get their business perspective.

6.    Customer and Supplier Information

While the due diligence won’t involve an investor sitting down and going through each one of your customers to check to see if they like your product or service, the investor will likely want to know more about your key customers and vendors. If there are people that comprise a substantial part of your business, they’ll want to know that. Similarly, if there are people who are integral suppliers to your industry, an angel investor will want to know that your working relationships with them are healthy.

7.    Revenue Streams

As part of the due diligence process, expect investors to dive deeper into your key revenue streams. If you sell a subscription service, they’ll want to know various metrics like your churn rate and your cost per acquisition. Angel investors will want to know that the revenue streams will continue to grow in the future. For example, if they discover that the business has 1 million subscribers only because of a free one year trial, that’s not a stable revenue stream. On the other hand, if the due diligence reveals 100,000 customers are paying $10 a month with a low churn rate, that’s a business that will pique their interest!

If your business is still very much in the proof-of-concept phase, that’s alright too. An angel investor will then look at your potential revenue streams and think about what those might look like and how your company can grow.

8.    Business Model and Projections

In all probability, you will have likely discussed your business models and forecasts in meetings before the due diligence stage of the investment process. However, during due diligence, the investor will deep-dive on this topic and ensure that those forecasts and models are accurate and have a high chance of happening. They will also evaluate your overall business model to ensure that it puts your company on the path to success.

9.    Cap Table

An angel investor will want to analyze your capitalization table to make sure that it’s not too diluted already. If you’ve taken on substantial investments in the past, be prepared to explain them more and reassure the angel investor that their position won’t have the same dilution level.

10. Market

Expect your angel investor to do thorough due diligence on the market for the products or services that your business produces. Suppose you’re selling VOIP subscriptions, for example. In that case, an angel investor will likely dive deeply into how many VOIP customers are there, who do they use, what’s your startup’s main competition, and many other market-related questions. They’ll want to ensure that the company they’re investing has a sizable market share to conquer and have a competitive edge.

Don’t Worry If You Don’t Meet Some of These Criteria

Every startup asks for angel investment at a different level or time within the life of their startup. Some are more established than others. Some get angel investors when they already have customers spending real money. Others seek angel investors when they’re still working on a proof-of-concept. The above ten topic areas are guidelines for areas that your prospective angel investor may cover as part of their due diligence process. Your angel investor probably won’t refuse to cut you a check because you didn’t file a patent for your IP. However, they will refuse to give you one if they discover that your company has no legal right to market or sell the IP in the first place!

Conclusion

Assuming you represented your company accurately as part of the investment pitch, due diligence for startups isn’t particularly challenging. You may have to produce quite a few documents and have some of your staff members talk with the prospective investor. However, if your paperwork is in order and your numbers check out then you’re unlikely to lose out on the deal after this process completes.

With that said, please keep in mind that it is often better to under-promise and over-deliver than the other way around. Suppose your presentation takes conservative numbers, and an investor’s due diligence reveals that there’s the potential for your company’s financial projections to be even higher. In that case, they’ll be incredibly excited to invest in your business! Conversely, if you promise the moon and the investor discovers there’s only a 1% chance of that happening, they will find it harder to write the check.

Finally, ensure that you promptly answer a prospective investor’s questions. Even if that’s just an acknowledgment with an ETA of when you’ll get the information to them, that’s better than leaving them hanging and waiting. Show your investor that you’re serious about getting past the due diligence phase and bringing them on board to help your business grow!

Due diligence for startups might sound intimidating at first, but it’s an essential part of any investment deal. Fortunately, with prompt responses and a general expectation of what to expect, your business can quickly meet the challenge and provide the necessary documents and assurances to make the investor comfortable writing you that check.

 

Jonathan hung, Angel InvestorAbout the Author

Jonathan Hung is one of the most active angel investors in Southern California, his mission is to drive value creation within each portfolio company. In support of this mission, he serves as Co-Managing Partner at – Unicorn Venture Partners.

Jonathan and his team target investments in US companies that have global market potential with a focus on long-term growth expansion to East Asian markets.

Jonathan developed his investing prowess as a Managing Member for his family office fund, J Heart Ventures, which made investments in start-up companies such as Gyft, ChowNow, Miso Robotics, Clover Health, Bitmain, to name a few startups he funded.

Jonathan has various degrees from the University of Southern California, London School of Economics, Massachusetts Institute of Technology, and The Wharton School at the University of Pennsylvania.