If you’re at the helm of a fast-growing startup in the multi-billion dollar global startup economy, there’s likely going to be a point when you’re looking to bring more investors on board or participate in a merger. If (or when) this happens, you’ll need to tackle something called due diligence for startups. Due diligence for startups refers to an auditing process involving a transparent and thorough investigation of your startup's financial and accounting aspects.
Due diligence for startups can be intimidating, but it’s critical to get it right. Potential investors want to ensure that the reality of a startup’s financials is understood and that the hard data and facts support the investment.
Here’s everything you need to know about due diligence for startups.
When Does Due Diligence Occur?
What exactly is due diligence for startups, and when would it occur in the life of your company? Due diligence is a methodological approach to looking at everything that might impact a startup’s value. This can include lawsuits, issues with former employees, business errors made earlier in the startup's life, and general financial and accounting information.
Due diligence aims to reveal all potential risks to interested investors before they decide to put their funds into the startup. Because of this, the due diligence process happens after an investor (whether a VC firm, angel, or another type) decides to invest in your startup. For example, this might occur after you present your startup to your potential investor.
Due Diligence Checklist for Startup Founders
When it comes to due diligence for startups, leaders and founders need to be prepared to present any and all necessary information. This information covers everything from the product to the startup's legal aspects. Here is a basic checklist to get you started on what you might need for due diligence (please note: your due diligence process might require different or additional information).
Product and Company Information
What are your products/services, the use cases, and the company's structure? What are your future growth plans, who are the partners, and what are the economics of your product and company? It’s essential to have this information ready at a moment’s notice.
Market Information
This addresses the market size and competition, your target customer base, and their pain points. Investors want to know where you stand amongst everyone else in your field.
Assets and Liabilities
You’ll need to present detailed records of all assets and liabilities associated with your startup. This might include physical and intellectual property, as well as any debts.
Accounting Books
You’ll also need to present your accounting books during the due diligence process. This might include bank account and credit card reconciliations, employee expense information (such as business expenses), and monthly financial reports.
Audit/Tax Information
Taxes are a critical part of due diligence for startups, including tax savings and credits, 1099 management, and sales tax strategies. Investors will also be interested in any past inaccuracies on tax returns and if your startup is under audit by the IRS.
Cashflow
In order for startups to grow securely and healthily, they need to have their cash management under control. During due diligence for startups, you might need to present information on vendor payments, workflows, cash flow analysis, and banking. Many startups fail due to cash flow problems, so investors might be particularly interested to see how your business is faring in this area.
Financial Reporting
Regular financial reporting and analysis are critical for startups to make realistic and effective future strategies. These reports are also a key part of the due diligence process because potential investors will be interested in the state of your startup today and where it’s likely headed.
Due Diligence Best Practices for Startups
Due diligence for startups is about far more than just presenting information to potential investors: it’s about showcasing just how rock-solid your startup is. With that in mind, here are some best practices for due diligence for startups.
Remember the Human Component
During due diligence, investors look at your startup, including the founders and executives. They’ll be looking not only for potential “red flags” but also for things that make the investment a perfect match (financially and culturally). This means that the human elements of a startup (such as the story, background, and past decisions of the leadership team) also carry weight in this process.
Keep Excellent Financial Records
The due diligence process involves holding a startup’s financials under a microscope, and because of this, the business’s financial records need to be robust and pristine. This is not the time for lost documents or incorrect math.
During due diligence, the financial records need to be clear and accurate. Because of this, investing in accounting services for your startup might be worthwhile.
Don’t Forget the Market
Investments will depend not only on your startup but also on the market. In order to best make your case for an investment, startup leaders and founders should conduct a thorough market analysis, including an aggressive look into competitors and new industry trends.
Address Any Risks
Due diligence is not the time to keep secrets. If you’re aware of any potential risks or issues on your radar, it’s best to share this information with your potential investors. This is particularly true if it’s information they could otherwise find out on their own accord.
Clarity Is Best
When investors consider putting money into your startup, they will look for legal agreements throughout your organization. This means all employees (even contractors) should have legally-binding contracts (instead of word-of-mouth arrangements) and that, in general, there should be an abundance of verifiable records.
Potential Benefits of Due Diligence for Startups
Due diligence for startups can be a huge undertaking and might seem intimidating. But there’s good news: due diligence for startups can actually have some pretty great benefits. Here are a few.
More Attractive to Investors
One of the main goals of the due diligence process is to bring on new investors, and often, it positions startups to be more successful to investors. When startup leaders and founders have excellent businesses, keep great records, and showcase this information to investors, they can attract investors who genuinely believe in their business and product.
Encourages Great Record-Keeping
If you’re not already keeping excellent books and airtight financial records, due diligence will help change that. Due diligence requires extensive financial information and flawless records. If you’re preparing for due diligence, you’ll first need to shore up your record-keeping.
Creates Transparency All-Around
The due diligence process is critical because it is extremely transparent, revealing key information to investors and startups. This means that both interested parties learn valuable information about the other and helps ensure that investors are a good match for startups and vice versa.
Gets Ahead of Any Issues
When due diligence is executed properly, it can be very revealing. For example, a startup might not realize why it’s not growing as it wants to until it deeply delves into its financial records.
Due diligence can also help avoid any costly startup mistakes. Investments often involve large amounts of money, and any missteps during this process can be expensive. Due diligence provides clarity and transparency into the deal, benefiting everyone involved.
Forges Valuable Relationships
Whether due diligence ends in an investment at that time or not, one thing is sure: it can still lead to valuable relationships and is a time to showcase your startup. Even if an investment falls through, you never know what will happen in the future or who knows who. Because of this, you should take the due diligence process as an opportunity to showcase your startup in its best light.
Due Diligence for Startups
As an emerging startup, bringing on new investors is incredibly exciting and can lead to a new period of growth for your company. Because of this, due diligence for startups is crucial and requires precision, transparency, and of course, an abundance of financial information.
And if you’re looking to ensure your accounting and bookkeeping are up to snuff for due diligence, we’ve got your back. We offer a wide ray of accounting services for startups that will be incredibly useful during the due diligence process.
That includes bookkeeping, taxes, HR and payroll, accounting, financial reporting, and cash management. Get started with our accounting services for startups today!
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