What is Due Diligence? How to Prepare For It & Avoid Mistakes
Last updated on August 3, 2022 by
“Due diligence” is an important step in fundraising. It is also a key aspect in mergers and acquisitions and corporate finance. In this article, we will mostly focus on its role in fundraising.
When it’s time for a potential investor or acquirer to perform a due diligence investigation on a target company, the business will have most likely wowed them with an impressive idea, business plan, or model. The interested party is now looking to confirm important details and metrics about the company in order to make a more informed decision about going through with the investment or not.
This assessment will cover a few major things: the company’s people, money, product, and equity, which can be categorized as legal or financial due diligence. Most items will apply to any investors being pitched, but usually each one will provide the target company with a checklist so that they don’t miss anything that is specifically important to the investors.
If due diligence is something your company is preparing for, you’ll want to know what you’re expected to provide. The investor you’re working with will tell you exactly what they’re looking for.
However, depending on the type you’re working with, what that investor is expecting may vary. Below is a primer on the basics that will apply to whoever you’re pitching, as well as a review of what due diligence is and why it is important.
What is Due Diligence?
The term due diligence is used in finance to generally describe the process of researching the details and possible risks of a future investment.
Specifically, when it comes to fundraising and the sale of a security (shares of a company, for example), due diligence has a more specific meaning.
In this context, due diligence means an “independent analysis and verification of information presented to the investor”, with the “independent” aspect being key to the process. As part of its pitch to potential investors, most companies “present” their information in the form of a presentation, pitch deck, or business plan—a type of document or presentation which describes the potential investment.
Due diligence is a method—among other methods—through which an investor or buyer “checks out” the information provided and assesses whether a company is a promising investment or not.
It is typically performed by various underwriting professionals and their attorneys, including equity research analysts, broker-dealers, or fund managers. You’ll likely see individual investors perform due diligence as well, although they are not usually required to perform due diligence by law.
Why Is It Important?
Due diligence is an important part of any major investment or purchase. It helps investors understand the risks and opportunities of investing in a company, and gives acquiring companies a stronger idea as to whether or not an M&A deal fits into their business model and/or portfolio of existing companies.
It is also something the law requires a lead investors in a fundraising round to perform in order to maximize their legal protection. This requirement—which is derived from the Securities Act of 1933—deals with an underwriter’s (the investing group or acquiring company) and their attorney’s liability and protection involving due diligence.
For example, if you have a fund or investor group interested in investing, the “lead” will want to perform due diligence in order to learn more about the company and protect themselves against claims from other investors—for whom they were the lead—if the investment goes south. Individual or private investors are not typically required to do any diligence, but they will typically perform it in order to understand the risks and nature of the deal.
The issuer or company selling shares doesn’t perform any due diligence of their own (other than reviewing the investor and making sure their strategy and goals align with the company’s wants and needs), but they are very much involved in the due diligence process. Your role as the issuer is to provide all of the information that investors request during the due diligence process. They collect this information to better understand exactly what it is they are investing in. It’s important that you stay organized and transparent.
This may sound straightforward, but it takes time and attention to detail. You must disclose everything, no matter how unappealing you think it might be to your investor. If you handle the process well, it bodes well for the success of the potential investment.
Now, depending on what stage you are in, and whether you are seeking funds from an angel investor or a venture capital (VC) firm, this process will look slightly different. How to prepare for due diligence is covered below.
Preparing for Due Diligence
Now that you have a better understanding of what due diligence is and why it’s important, let’s review how to prepare for it.
Because due diligence reports are a long and tedious process, we recommend that you create your “document room” right when you found your startup so that you have a way to organize and easily access all of your important documentation.
Before computers, companies had a literal room where they stored all of their important documents so that it could be easily accessible during due diligence and at any other times during which they might be needed.
Nowadays, the document room is housed on a server, but should be equally organized. To be sure that everything is in order and that you haven’t accidentally misrepresented your company, we recommend that you hire an expert to help, or at least work very closely with a lawyer who is familiar with the process.
Usually, your potential investors will give you a checklist of the exact materials they will require, but the basics are the same across the board.
As you should know by now, your investors are investing in your founding team almost as much as they are investing in the product itself. They want to know about your story, your experience, and how you fit with your co-founders.
Much of this will have been discussed in your early conversations and your pitch meetings, but be aware that it will continue to be a major factor in their decision to invest. Depending on how big you are, they will also want to know about other early, key employees.
Consider being transparent about any unpleasantness that has come up with past employees as well, especially if there is any litigation involved.
Investors want to see the way your business has performed and what your cash flow has been like so far. As an early-stage life sciences company, you may not yet have cash flow, in which case you want to show your projected revenue. You can do this by providing detailed plans for pricing and sales, and exactly where your product is in its stage of development.
You’ll also need to include promising data and possibly use relevant competitors who are generating revenue as a comparison point. Negative cash flow is expected at this point, so be sure to show exactly what you’ve been spending your money on and how it will contribute to your growth.
If you do have revenue you’ll need to provide details on where it comes from, as well as revenue that you expect to add in the future. You should expect to see your revenue grow, which is what will attract investors, but be realistic. Don’t inflate numbers just because you want to impress your investors.
Future investors also want to see what other commitments you have, like loans, other investments or contracts with suppliers. You’ll need to provide a complete set of financial statements, annual tax documents that include floating charges, all balance sheets, and profit and loss statements. You’ll need to provide a detailed budget with all of your expenses as well, including salaries.
The information needed will be different depending on what kind of product you are developing or selling, but either way, make sure that there are no outstanding intellectual property concerns. You’ll need to show documentation for any licensing, copyright, trademarks, or patents.
It may be obvious, but you have to be legally allowed to sell what you’re selling. If you haven’t quite sorted this out, we encourage you to do so before you even reach due diligence.
Your investors will want to understand how your product is made and how you plan to distribute it. They will review the lab equipment, the production process, each component of the product itself, and its packaging, and where all materials are sourced. Are you selling it to large entities like hospitals, or directly to consumers?
Depending on the answer, your distribution process will be different and require different materials. They will also make sure that the product can be produced at scale, and that it is as innovative as it claims to be. If there is a software element involved, be prepared for a full code review.
They will also be looking at how well your product fits into the existing market and that it has a competitive edge over anything similar. You will probably already have this information from your pitch decks, but your investors will do their own research to make sure they agree with your estimate of how much of the market you can capture.
Your Equity, Ownership, and Debt
Naturally, your investors want to own a significant portion of equity in your company, or investing won’t be worth it. They will closely examine your existing ownership and how it’s structured, any debt you have, and the current equity dilution, which they can see on your capitalization table.
The way your existing equity is structured will determine the types of deals you make with new investors. All of this should be put together with and approved by your legal counsel.
Your Risks and Liabilities
All investors are taking on some risk when they decide to invest in a startup, and different investors have different levels of risk tolerance. As we mentioned in our article on fundraising options for startups, investors want to see that you have explored and planned mitigation strategies for risks you can foresee, including any litigation you’re currently involved in.
It may be painful to disclose some of these items, but trying to hide them just won’t work. In fact, you can fa ce serious legal consequences for misrepresentation.
Other Important Documents
These include (but are not limited to) shareholder and board meeting minutes, letters of good standing, articles of incorporation, and corporate bylaws. If you have any press releases, or formal media communications, include those too.
We can’t stress this enough: document everything, and organize it. You never know if you’re going to need it, and odds are good that you will during due diligence.
Common Mistakes & How to Avoid Them
This is a big one. If your investors are unable to get the information they need because you haven’t made it accessible, they will not invest in you. It doesn’t matter that you have everything in place and your idea is incredible, they need to see it all on paper. As we said before, start documenting early and store things in an organized, easy-to-sort way.
Lack of Formal Documentation
We know that the nature of startups is that things move quickly and change often, which means that many agreements are made informally, with handshakes and over drinks. While this may work in the beginning, it has the potential to get messy, and investors want to avoid mess at all costs. Before seeking funding, it’s a good idea to make sure that your business relationships and equity are all legally documented.
Intellectual Property Complications
The most common and time-consuming hiccups in due diligence are intellectual property issues, which vary widely depending on the product itself. Consider the patents, trademarks, and licensing that you’ll need as soon as you start developing your product so that no issues set you back later. It’s important for these to be resolved as soon as they are identified because they can have a huge impact on your business growth. Resolving IP issues may or may not require legal intervention, but we recommend having a good IP lawyer in case it does.
If you’re currently generating revenue, and can provide cash flow measures to your potential investors, it’s important that you be realistic. If investors see an alarmingly high burn rate, or revenue growth that seems too good to be true, they may not proceed with the deal. Use your board members and advisors to help guide you in creating achievable financial goals.
If, however, you’re pre-revenue, and have no cash flow to speak of, or significantly negative numbers, then investors will look for something else to rely on, in terms of numbers, to determine the value and potential future value of your company: your drug pipeline or similar company comparisons.
If you have a pipeline to evaluate, it means they’ll be looking at how many drugs are in your pipeline, what the target indications are, what stage of development the drugs are in, and what the value of the pipeline to someone else might be. It’s important to be transparent during this evaluation, as well as realistic.
Due diligence is not for the faint of heart, but once you’re there, we know you can do it.
What we’ve provided here is a basic overview of what you need to provide for a smooth due diligence process: financial and equity information, contractual obligations, evidence of a strong team, and inspiring but realistic business goals.
For a more comprehensive list of what you might be asked to provide, check out VC List’s Startup Investment Due Diligence Checklist.