Understanding the Importance of Due Diligence

Due diligence is an investor’s detailed examination of a startup’s potential to become an investment. Although at this stage of seed funding, the evaluation of a potential investment will be less complicated than in a later round, due diligence is still a critical process in establishing the startup’s viability, temporary and long-term sustainability, and financial commitment level. For startup founders, it should be considered an opportunity to demonstrate the level of operational capability they have in operating their startup and creating an opportunity to be trusted by investors. With only a small percentage of all startups receiving seed funding, a well-prepared due diligence package will give the startup a competitive advantage over other similar startups.

Getting Organized Early for a Smoother Process

Beginning early with and remaining organized will allow a startup founder to prepare a due diligence document much faster that will allow quicker closure of any prospective investments.

Start preparing for due diligence as soon as you begin discussions with your investors. Smart startups create a diligence-ready mentality from day one and continuously organize and structure their documentation to omit ambiguity. A legal entity should always be organized correctly in accordance with state and local registration requirements and there should not be ambiguity concerning its existence due to incomplete or missing documentation. A startup should establish a method of having a record and all supporting documentation for its financials and keep them up to date and accurate. A startup should keep documentation on all key areas of operations to demonstrate where the company is positioned successfully at any point in time.

Building a Secure and Accessible Data Room

Establish a secure digital repository (data room) as soon as you can. A data room is where you will store all your startup’s important information in an orderly, secure format that allows you to share it as needed with your investors. Think of your data room as an information library that contains only current and accurate documents that can be easily accessed by our current or future investors.

Key Areas Investors Will Examine During Due Diligence

During seed due diligence, many investors will evaluate several key areas in their decision-making process in determining whether to proceed with a potential investment in a startup. Preparing for and demonstrating these areas in an organized fashion while being readily accessible will help enhance your success.

Team Preparedness: Who’s Behind the Startup

When making an investment in a startup, in addition to evaluating the product offering, many investors will place a significant amount of weight on the people who make up the startup team. Create a complete bio for each founder and key team member. Highlight everyone’s relevant experience and skills that contribute to the team’s success. Execute a signed document (Founder Agreement) that shows the terms governing the founder’s ownership percentage, equity split, and vesting schedule. Create an advisor profile of the persons providing tactical assistance for the startup or strategic ongoing value. Provide evidence that your team members and the overall team have a shared vision, possesses the credibility to execute on it, and have the expertise to carry out their responsibilities associated with the plans and goals of the startup as defined in the Business Model & Market Validation section below.

Business Model & Market Validation: Proving Real-World Demand

It is important to provide sufficient proof that your startup provides a valid solution to a market problem and has a business model that will allow it to be profitable. Along with a regularly updated pitch deck and business plan – which contain your value proposition, target customer, market size, competition, and go-to-market strategy – include any traction that your startup has received to date (pilot programs, customer/user data, letters of intent, early revenues, etc.). Prepare to describe what differentiates you from your competitors and how you are positioned relative to them.

Financial and Legal Documentation: Transparency and Accuracy

Even at the seed stage, companies should conduct financial due diligence. Your Financial and Legal Documentation should include basic financial statements (Income Statements, Balance Sheet, and Cash Flow Reports) with current values and updated information. If you are not generating revenue, include complete financial forecasts, budgets that show how you plan to spend raised capital, and projected milestones beyond the amount of time you expect to have cash on hand. Moreover, you must know your “burn rate” and “cash runway.”

Finally, you will need to build a repository of everything necessary from a legal perspective for your company. You will want to gather your incorporation documents, shareholders agreement, cap table, outstanding convertible notes, contracts, and your company’s tax returns. It must be clear that your company is in good standing and has no hidden liabilities, as any errors or omissions in these documents could result in delays to, or risk to, a deal being struck.

Technology and Intellectual Property: Proving Ownership and Protection

If your startup has any proprietary technology or is dependent on proprietary technology, and if you wish to attract investment, potential investors will require proof that you have instituted safeguards to protect such technology. The documentation that proves ownership of intellectual property (IP), whether a code or design or patent, needs to show that the IP has been assigned to the startup, through signed agreements. The documentation should include a list of all patents or trademarks that have been applied for and will also need to include the status of the development of the startup’s product or any other tech milestones that have been achieved. The potential investor would also want reassurance that the technology being developed has the potential for scalability and will be secure. The investor would want to know that the startup has followed any legal requirements related to data security or compliance.

Structuring a Complete and Professional Data Room

An organised data room will have a logical structure with organised folders for:

• Corporate Documents: Articles of Incorporation, Capitalisation Table, Board Resolutions
  Financial Information: Current and Projected Financial Statements, Budgets/Forecasts
  Legal Documents: (Contracts), Intellectual Property Documents, Employment Agreements and Regulatory Filings
  Product/Market Related Information: Decks, Metrics, Market Research Prepared
  Compliance/Tax Documents: Tax Returns, Permits and Licenses
• Ensure that everything is up to date and labelled as such. Do not wait for investors to request it – the presence of a fully developed data room conveys a significantly more professional impression and enables you to save time.

Being Proactive and Transparent About Business Risks

Many founders feel the necessity to hide a weakness in their operation/structure; however, transparency is far more powerful. If the business has risks, such as a key position yet to be filled, early technology problems or potential legal liabilities, it is essential that these be acknowledged and identified. There must be an accompanying action plan for these risk factors. Acknowledge your current challenges and then act responsibly to address them. Surprises discovered during due diligence can damage your reputation. However, being honest with your disclosures creates trust between you and your investors. When possible, prior to formal due diligence, resolve anything that you can, including, inconsistent documents, missing signatures, and anything else that might be questioned. For anything else, be prepared with a well-thought-out explanation for the investor during the formal due diligence process.

Leveraging Professional Support: Why ERB Is a Trusted Partner

The preparation for due diligence can be time-consuming and intricate, particularly for early-stage founders. This is where a knowledgeable partner can help; ERB has provided outsourced CFO services to startups for over 30 years as a complete solution for startup financial management, providing bookkeeping, payroll, tax compliance, and investor-ready reporting for startup founders.

ERB understands investor expectations for financial reporting and provides clear financial statements, realistic forecasts, and legal entities for compliance. ERB also assists with the formation of US corporations and partnerships, federal and state tax filings, and maintaining your company’s cap table; all these items are essential components of the due diligence process.

Partnering with ERB allows you to devote your time to business development, while ERB prepares your financial records and assures you have a compliant enterprise. The credibility associated with ERB demonstrates to an investor that you have all the necessary financial components in place and are in position to move forward with the additional growth that will be provided by the funding.