In the dynamic world of startups, the ability to attract investment isn't just about seeking out investors; it's about making your business investment-ready.
A key hurdle to being investment-ready is the idea of due diligence. Potential investors will follow a due diligence process to make sure that your company is a viable fit for their investment. But founders don’t need to leave the due diligence process entirely in the hands of the investors; founders can prepare their startups ahead of time and increase their chances of attracting the right investors.
Due diligence is a complex process, but it doesn’t have to be an impossible one. Start with focusing on what’s important, and build out a framework for success throughout the early investment stages.
What’s due diligence?
Due diligence in the investment process refers to the comprehensive and detailed analysis conducted by investors to assess a company's financial, legal, operational, and strategic status before finalizing an investment. This process is crucial as it enables investors to uncover any potential risks, liabilities, or red flags that might affect the investment's return or the company's long-term viability.
For the company seeking investment, due diligence is an opportunity to demonstrate transparency and reliability, showcasing the solidity of its business model, the robustness of its financial records, the legality of its operations, and the potential for future growth. The thoroughness of this process not only protects investors but also ensures that the company is well-prepared for external scrutiny.
By preparing for the due diligence process ahead of time, founders can demonstrate trustworthiness and a willingness to work together with any potential investors.
The funding process
The funding process for an early-stage startup typically unfolds over several stages, each with its own goals and timeline.
Crafting a compelling business plan:
Create a business plan that resonates with investors. That means focusing on market needs, innovation, and clear financial projections. A business plan is more than a simple document; it's a roadmap that shows you have thought deeply about your business's journey.
Finding the right investors:
Early-stage startups often rely on self-funding, friends, and family, or small-scale angel investors at first. Angel investors might allow the team to expand while the MVP is refined and preparation is conducted for future rounds.
At the earliest stages, investors are less concerned with in-depth due diligence. They’re investing in the idea and the team, rather than a proven product.
As the company grows and enters seed or Series A funding and beyond, due diligence becomes increasingly important. Startups rely on proven (if limited) market traction to engage with venture capital firms to scale operations, expand market reach, and diversify products. Investors dive deeper into due diligence to make sure the company is prepared for further growth.
Negotiating terms and closing the deal:
The terms of investment, equity, and control are negotiated, followed by legal documentation and formalizing the agreement.
After securing funds, startups focus on using them as per their strategic plans while maintaining regular communication with investors to deliver set goals. These goals can include annual recurring revenue (ARR), client retention, product development, etc.
Overall, the funding process for an early-stage startup can take anywhere from a month to a few months, depending largely on the due diligence process - and how prepared the startup is to undergo that process. Better preparation on the startup’s side can mean a quicker due diligence process and faster funding.
Performing due diligence
Due diligence involves a close look at every aspect of your startup, from the ground up. The idea is to look into every corner of the company to find what’s wrong, or what could go wrong. This protects the investor’s funds and positions the startup for the greatest success.
Crucially, there’s no need to wait for a set point in the process to start due diligence. Every funding round requires some measure of the process, but formal due diligence becomes more complex as the company grows.
Due diligence is not a simple process. Investors will scrutinize various aspects of a startup to assess its viability, the potential for growth, and the risks involved. This typically includes:
- Financial analysis: Investors closely examine the startup's financial statements, cash flow, revenue projections, burn rate, and financial management practices. They seek to understand the company's current financial health and future sustainability.
- Business model and market potential: A thorough review of the startup's business model, market size, and growth potential is conducted, in which investors look for a clear, scalable, and sustainable business strategy.
- Product or service viability: The uniqueness, competitiveness, and stage of development of the startup's product or service are critical. Investors assess the technology or innovation behind it, the problem it solves, and its market fit and demand.
- Legal compliance and risks: Investors review incorporation documents, intellectual property rights, employment contracts, and any past or potential legal issues.
- Management team and company culture: Investors often invest in people as much as they do in ideas. The experience, skills, and track record of the founders and management team, as well as the company culture and employee relations, are key factors.
- Customer and market validation: Evidence of market traction, such as customer feedback, sales data, and market research, is evaluated. This helps in gauging the market acceptance and potential scalability of the product or service.
- Operational efficiency: The startup's internal processes, supply chain management, production capabilities, and technology infrastructure are reviewed for efficiency and scalability.
- Strategic positioning and competitive analysis: Understanding how the startup positions itself in the market and its competitive landscape, including an analysis of competitors, market trends, and potential barriers to entry.
- Exit strategy: Investors are interested in understanding the startup's exit strategy, including future plans for mergers, acquisitions, IPOs, or other ways investors can realize a return on their investment.
- Use of funds: How the startup plans to use the invested funds and its strategies for future funding rounds are also a point of interest for investors.
Each investor may weigh these factors differently based on their investment strategy, experience, and the specific market or industry.
The due diligence process is a crucial step where startups need to demonstrate transparency, preparedness, and potential to secure investment. By preparing in advance, startups can position themselves to stay ahead of the competition and stand out to investors.
How to prepare for due diligence
Preparing ahead for the complicated due diligence process can hugely benefit and speed up future investment. Preparation typically involves looking at four major aspects of the startup and getting their due diligence ready.
A startup’s financial statements, cap table, and founding documents should all be included in a due diligence process. Make sure that you have all the necessary information ready to hand in an easy-to-understand format.
What’s the startup’s current organizational structure? How many employees does it have? Are there any special arrangements with those employees, such as a stake in the company, or individual ownership of particular patents? Be sure all available information is accurate and up-to-date.
Vendors and customers
Customer information should not only include the basics, such as the total number of customers but should also include relevant details such as contracts, terms and conditions, etc. This section of a due diligence portfolio should contain basic contract templates for future customers.
In addition to identifying existing stakeholders and any relevant contracts, this section clarifies business arrangements with partners and investors. Existing loans and money owed to other parties will also require identification.
Navigate due diligence with Eldison
Due diligence can be a daunting task. That’s why we recommend preparing now for investment later. To help, we put together a complete due diligence checklist that summarizes key areas you should focus on to have your due diligence ready.
If you’re looking for help navigating the due diligence process, contact us! We bring all the legal and compliance expertise you need to impress potential investors and secure the funding you need to succeed.