Due Diligence For Startups

A lot of entrepreneurs begin their startup journey with an idea or technology but to see their product come to life, they need to attract the attention of potential investors. Thereafter when the entrepreneur and the investor agree on investing in the startup the major obstacle faced by such entrepreneur is the radical due diligence process. A startup’s lack of knowledge of the due diligence process, especially if the entrepreneur doesn’t come from a legal or accounting background can create obstacles from obtaining investors’ attention.

Broadly defined, due diligence is a comprehensive review or examination of material facts and records. Usually, the investor executes the due diligence process prior to initiating the investment process to gain a full financial and legal understanding of the startup including the liabilities and risks. The most crucial step for the investor here is to complete the due diligence process to resolve the two fold objective i.e. to protect his interest as an investor and to avoid any future unnecessary legal actions by the regulatory agencies.

Some entrepreneurs don’t prepare for the due diligence process, assuming the idea or technology will speak for itself. This is the step of the investment/funding process, where surprises in the evaluation and documentation can derail the investment. A study done in 2007 by Angel Capital Organisation found that investors that put in at least 20 hours of due diligence were likely to have five times more positive returns than investments made with time less spent on due diligence.

Due diligence when conducted intensively may be a long and painful process for the startup and the investor, however it acts to strengthen a successful investment relationship. A rigorous due diligence process can help clear the speculations of a given investment opportunity and assist investors in making a well informed decision. For the startup, due diligence helps develop a better sense of the business.

Entrepreneurs or founders should prepare themselves with the below mentioned extensive but not exhaustive requirements for the due diligence to make the process as smooth as possible:

Part I: Basic Information

  • Founders:

When evaluating the founding members, the importance is placed on the founder’s relevance to the product or market. Furthermore, background checks, credibility check and interviews serves as an important role in screening of the founding team.

  • Product or Service:

The Product or Service is assessed and evaluated on its application and an understanding is made on how the revolutionary idea or the proprietary technology will fill the void in the present market scenario.

  • Industry and Market Analysis:

Industry and market analysis sets the stage for understanding the target market, market trends, key demographics, existing competitors and barriers to entry.

  • Company’s Statutory Records:

Permanent Account Number, Tax Deduction & Collection Account Number, Memorandum of Association, Articles of Association, Minutes, and Statutory Registers as maintained under the provisions of the Companies Act, 2013 are gathered and evaluated for better understanding of the key information and statutory compliance of the company.

  • Press Releases:

All news or press releases issued by or with respect to the startup or the entrepreneurs is gathered. This helps in maintaining and boosting the startups visibility or brand value and is assessed to understand the reach and achievements of the startup.

  • Stakeholders:

List of current stakeholders of the company is evaluated to understand who holds interest in the startup and whether such interest might create any integrity issues with the investor.

  • Agreements and Contracts:

Founder agreement, shareholders agreements, joint venture agreements, employee agreements and other agreements, contracts or commitments to which the startup or any of its stakeholders are a party are gathered to understand the legal compliance standard of the startup including the liabilities or risks inherent with it.

Part II: Securities and Financial Statement

  • Account Books and Financial Information:

Account books refer to the records in which all financial information (transactions) is recorded and maintained. The importance of such document is to evaluate the financial performance of the startup and to make sure that the startup is complying with the Indian accounting standards.

  • Capital Structure:

Details of the authorised, issued and subscribed shares of the company are prepared so that it indicates the vesting interest of the securities holders. Such is also required to understand whether any changes in the capital structure will be required to give effect to the investment.

  • Debt:

The identification of all debt is crucial information required in the due diligence process. Learning the total amount owed, terms of repayment and collateral issued as security is important to understand the financial stability of the startup.

PART III: Revenue and Customer Information

  • Sales:

During due diligence, the investor checks sales against customer list to verify that the startup has the customers it says it does. Sales are also evaluated to judge the performance of the startup.

  1. Revenue:

Description of recurring, non-recurring revenue, product and non-product related revenue, including royalty, licensing, trademark or patent revenues are evaluated to understand the revenue generation efficiency of the startup.

  1. Customers:

List of customers ranked by sales or other parameters is prepared to understand the type of target market and to gain the feedback of the customers towards the startup. Such information also includes review of agreements with major customers and accounts receivable reports.

PART IV: Tangible and Intangible Properties

  • Property:

Listing of all assets owned, leased, subleased, or used along with copies of all deeds, leases, sales contracts, sublease contracts, etc. is done to evaluate the net worth of the startup and further it also helps to prepare its valuation report.

  • Trademarks, Patents and Copyrights:

Schedule of all intellectual property owned by the company is organised and prepared in order to understand who owns the exclusive rights over the creation of the intellectual property. Such prima facie acts as proof of ownership making it easier to enforce the intellectual property right in court in case of any disputes.

PART V: Litigation and Claims

  • Litigation and Disputes:

Summary of all litigation and disputes including outstanding and settled are assessed in order to obtain clear picture of the legal compliance standard including the liabilities or risks inherent with it.

  • Governmental Investigations:

To have an understanding of the standards of corporate governance in the company the summaries of regulatory investigations are prepared to which the startup is or was a subject.

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