Startup due diligence is one of the most important components of the funding process for a new business…
The entrepreneur validates the opportunity to angels or VCs who have a potential interest in their company.
This validation, or the lack thereof, ultimately leads to the decision whether or not angels or VCs will execute the subscription documents, sign a check and invest.
Angel groups and VCs conduct due diligence of startup opportunities by investigating and evaluating it. The process enables the investor to make more informed decisions concerning the investment’s potential and their related level of interest. Its extent covers the entire life of the startup, beginning with its establishment and spanning into the potential future, to the extent it is reasonably predictable. The approach utilized by experienced players is typically intentional and reflective. It is, in essence, a discovery process. This enables the investor to obtain an in depth understanding of the company, its technology, business model, management team, culture, processes and ultimately, its investibility.
Nobody enjoys the process, neither the entrepreneur nor the investor. However, it represents homework to increase the potential of success with respect to a particular investment and their entire investment portfolio.
So what are the specific reasons investors in scalable startups conduct due diligence?
- Compliance with Angel Group or VC’s Investment Criteria – Angels and VCs considering an investment in a particular startup opportunity do so based on the assumption that the opportunity fits with their portfolios. Therefore, they establish criteria under which they invest, and the due diligence process enables them to confirm whether the opportunity meets that criteria. Some criteria are openly stated and apparent; they invest in certain industries / segments, certain geographies, at certain investment levels. Others are less obvious and may in fact never be shared with the entrepreneur. These may include, as an example, strategic alignment with other business to which they are affiliated. This screening against criteria begins with the initial contact with the investor and continues, long after the investment closes. This continued screening may, in fact, be related to the viability of additional investment in follow-up rounds.
- Company Valuation / Valuation of Assets – There are a number of methodologies which can be utilized to determine the value of companies and assets. In the case of mature, established companies, many of the methods are analytical in nature, such as DCF analysis. In the case of the scalable startup, which has minimal sales and potentially modest cash flows, such valuations are more difficult. In these cases, other issues, such as the quality and breadth of the management team, their interest in accepting coaching and counsel and ultimately their ability to execute must be strongly considered in addition to the customer validation of the concept, the “go to market strategy” and the potential size of the market. While due diligence is always important, it is this writers’ opinion that with startups, such due diligence is even more critical.
- Identification of Significant or Material Defects – Identification of defects which may be potentially fatal are of the highest priority to the investor as is doing so as early as possible in the process. Identification of material issues early in the process allows the investor and entrepreneur to address them and potentially establish mitigation approaches. If it is not possible to mitigate the risk, the investor has the opportunity to disengage reducing expenditures of further time and treasure on an opportunity which will never close. This benefits both parties.
It should be noted that an opportunity may present a fatal flaw to one investor, depending on their criteria but be fully acceptable to another. As such it should not be concluded that just because a fatal flaw exists, that the startup in un-investible. It is entirely possible other angels of VCs have differing criteria or approaches to mitigate the defined risk.
- Negotiations of Terms and Price – As mentioned earlier, due diligence provides validation! If reasonable terms and valuations were agreed in the term sheet and the company stands up to the startup due diligence scrutiny well, little negotiation likely remains. Experienced angel groups and VCs are desirous of startups that stand up well to their scrutiny as it not only validates their initial assumptions, but it permits them to move on to other deals, effectively using their scarce resources.
- Defining Representations and Warranties – Many of the assurances and promises to remedy which are made as part of the closing process are standard across deals. However, each company is different and each investor perceives risk differently. Due diligence helps to identify those items important to the parties. Entrepreneurs who have represented the facts accurately as the investors have proceeded through funding process are simply re-validating the opportunity.
Experienced entrepreneurs recognize that they are preparing for due diligence and investor scrutiny from the very beginning of the effort, even at the concept stage. They establish a structure and processes which support the development and growth of an investible company. Taking such steps in advance of the need for outside financing is enabling in that the company is already prepared when the need arises. More importantly, it assures the startup due diligence process will validate the opportunity.
Note: The author is not an attorney and FundingSage is not a law firm. FundingSage’s employees do not provide legal advice. We recommend that you seek the services of an attorney if legal advice is required.