Having a successful seed funding round is a huge accomplishment for any startup; However, before an investor can formally agree to provide funding to a new company, that company must pass through the due diligence stage, which is an extensive review by prospective investors of all pertinent items regarding your business prior to committing any money. Due diligence allows the investor to verify that all the information that you have provided them is correct and provides the investor with an assessment of potential risks associated with your company. Therefore, the due diligence process provides the investor with the opportunity to gain a detailed perspective of how your company operates and to reinforce your credibility or identify any issues. If you are properly prepared for due diligence, you will not only expedite the funding process, but you also build the investor’s trust. Therefore, if you produce unexpected information or inconsistencies during this process, it could jeopardize the deal.
Key Areas To Prepare For Due Diligence
During the due diligence process, investors typically review a startup’s core attributes, such as:
- Corporate documents: Have all the documents that represent the formation and governance of your company available (e.g. incorporation documents, bylaws, stock ownership records). The investor will review these documents to determine the legal formation and ownership of the company. If your records do not have information that corresponds with the way you have presented your company (e.g. unclear equity splits, lack of formal approvals), this may raise a warning sign for the investor.
- Financial records: Be prepared to provide financial statements and forecastsq for the investor to examine. The investor will carefully review your revenue, expenses, cash flow, and financial projections and ensure that the information matches. Expect questions and delays if the financial figures you present to the investor at the meeting differ from the books.
- Legal & Ip: Make sure that your major contracts, regulatory documents, and intellectual property (ip) rights are all in order. The investor will ensure that you own the key assets of your business, such as your technology and your trademarks, and will ensure that you do not have any hidden liabilities and/or lawsuits.
- Founders and key team members: Be prepared to provide the investors with the backgrounds of the founders and key team members. An important part of the investors’ review will include assessing the management team’s experience and integrity. A strong, transparent management team will give the investors confidence that the company will be able to successfully carry out their plans.
- Market and product traction: Provide evidence of your market opportunity and product traction to date. Investors will want to see how big your market is, your competitive advantage, and how fast your customers or users are growing before determining your potential as a company. Evidence of real interest in your product, such as pilot users, early revenue, or partnerships, will strengthen your argument.
Tips For A Smooth Due Diligence Process
Follow these steps to complete due diligence quickly and efficiently:
- Start early: Don’t wait for the investor to request it – get started preparing documentation well in advance of response requests from the investor. The companies most successful in treating due diligence preparation as a continuous process will begin working on it long before the requested date and therefore will not experience distress created by scrambling at the last minute.
- Stay organized: Create a secure shared folder or “data room” and keep your due diligence files organized logically, not just in chronological order. Therefore, once your financial, legal, and equity records are complete and up to date, the due diligence process will consist of verifying the information rather than looking for the information.
- Conduct a mock audit regularly: Conduct a mock due diligence review regularly to assess the efficiency of your own due diligence preparation process. An investor checklist helps you identify documents that might be missing or don’t have enough information before they are flagged by the investor during the audit process.
- Be transparent with investors: Openly communicate issues/risk with investors (e.g. if you know that you have issues with sales or distribution). Having a plan on how to resolve outstanding issues shows integrity. Investors will value honesty – not being forthright about an issue found in the due diligence process will erode trust and credibility. Be sure that you align your messaging (in your presentation, conversation with potential investors, etc.) with what is on your documentation, as a significant / major variance could be interpreted as a red flag.
FAQ
when does due diligence take place in a seed finance round?
Due diligence will occur following the investor expressing their serious interest (often once they issue an offer/term sheet) but prior to finalizing the funding. In other words, due diligence is one of the last steps(s) in the process before closing the investment.
what type of information will be requested from investors during the due diligence process?
A range of documents will typically be requested during due diligence: articles of incorporation, cap table/stockholder record, historical/current financial statements and projections, major contracts, intellectual property documentation, and details about the founders/management team. In essence, anything that can help validate your company’s representations and obligations can be requested.
how long will due diligence take for seed investments?
There is no set answer. A simple seed due diligence review can take several weeks to complete, and a more comprehensive review can take multiple months. The time it takes to finish the review is largely dependent upon the investor’s thoroughness and the speed with which all information is provided.
will the founders be evaluated as part of the due diligence process?
yes. Investors will assess the ability and integrity of the founders as a part of their assessment. They may want to know more about the founding team and may also conduct reference checks, because the quality and integrity of the team is vital to the ultimate success of a start-up.