By Fernando Berrocal
If you want to raise money for your startup, due diligence is important. If the due diligence required for fundraising appears overwhelming, have no fear, it becomes easier to manage when you break it down into distinct components. In this article, we’ll explore what "due diligence" is, and its importance.
Due diligence is the process of verifying facts so that investors don't fall into any unexpected traps. When buying or investing in larger assets, the due diligence procedure becomes much more complicated. In reality, it’s a pretty standardized procedure. Before signing agreements, anyone interested in funding your business will undertake due diligence. Your funding process will run smoothly and quickly if you make it as simple as possible for them to receive the information they need.
A brief history of due diligence: Until 1933, when Congress approved the first Federal Securities Act, due diligence was not a familiar term. It made securities dealers (sellers and brokers) responsible for revealing critical information about securities to those interested in purchasing them. It also established due diligence or the minimal amount of information about businesses and securities that a seller must gather and disclose before making a sale. They weren't legally liable for any damages the investor suffered as long as they did their due diligence and revealed it.
Why should you care about due diligence? Due diligence is important to Venture Capitals (VCs) firms, so it should be important to you. Limited Partners (LPs), the entities whose money makes up the fund in which they're investing, are accountable to any VC investing in your startup. Pension funds, foundations, financial corporations, and wealthy individuals are among them. For the benefit of the LPs, a VC that wants to invest in your startup must conduct due diligence. They also need to complete their study to determine whether the business is a suitable investment, so LPs can rest assured that their investment is safe. A VC might expect to lose clients and reputation if they fail to complete due diligence. As a result, it's in their best interests for them to be as comprehensive as possible.
The 3 types of due diligence: When a VC conducts due diligence, they go through three stages:
- Screening due diligence: The VC sifts through hundreds of possible investments to locate businesses that fulfill the fund's mandate or criteria.
- Business due diligence: When a good candidate is found, the firm's partners examine to see if it will be a successful venture. This involves an examination of your business model, product/service market fit, and management team.
- Legal due diligence: If your business makes it through the first two stages, the VC's lawyer will step in to make sure everything is legal. They may question your lawyer for information.
The second and third stages are the most important for your business. They're the ones you'll have to supply the most documentation for.
Due diligence at different startup stages: Depending on where you are in the fundraising process, the amount of information you need to acquire and offer to potential investors changes. When you're not courting VCs yet, your responsibilities will naturally be smaller. When it comes to due diligence, the larger the investment, the more your responsibilities.
Due diligence at the Angel Investor stage: There's not much you need to worry about in terms of due diligence if an angel investor is assisting you with the launch of your business. Most likely, you and the investor already have a trusting relationship. Angel rounds are typically based on trust. The financing paperwork utilized in angel investing and pre-seed financings does not provide any legal or financial protections for the investor; early-stage investing is based on confidence and good faith between entrepreneurs and individual investors. In many circumstances, the investor is investing their own money and, unlike in a VC fund, is not obligated to LPs and can write a check without seeking clearance from managing partners.
The investor, otherwise, has complete control over the due diligence process. If they trust you because of good referrals, they'll ask for basic information like a pro forma cap table and your incorporation documentation. If you're not well-known to them, they may request additional information, and you may expect them to conduct back-channel reference checks before investing.
Due Diligence at the Pre-seed/Seed Stage: Pre-seed or seed investors usually don't need a lot of information before investing in your business. If you're obtaining funds through SAFEs or Convertible Notes, the investors get to choose which due diligence path to take. If you're executing a priced round at the seed stage, your due diligence procedure will be similar to any other priced round, like Series A, Series B, etc. Investors frequently seek a pro forma cap table, as well as certificates of incorporation confirming your business, which is formed in Delaware. They are also likely to request any agreements between the organization's founders, such as purchase or secrecy agreements. No matter how you run your seed round, at the bare minimum you should be ready to provide. Your incorporation documents are A pro forma Cap Table, Your Corporate Bylaws, Equity Contracts, and Advisor Agreements.
Due Diligence for Priced Rounds: Due diligence becomes more serious once you reach the pricing round stage of financing. VCs are among your investors. You must submit a complete set of financial and operational documentation. Typically, your greatest investor will undertake the majority of the grunt work when it comes to due diligence, while the other, smaller investors will follow in their footsteps and use the data they uncover. Investors will often demand that the company pay the VC fund's legal fees as part of a term sheet. It's typically an excellent practice for a founder to agree to a cap on legal reimbursements upfront.
If your formation records were not kept up to date, due diligence for a priced round could be costly for your business, owing to legal expenditures to clean up the mess. If you don't have your information collected and organized in a complete document room, you may find yourself hiring lawyers to acquire and organize records.
Series A due diligence checklist: Due diligence particularly shines during Series A because the angel investor and seed rounds of fundraising don't ask much of you. You'll have to deal with due diligence again for Series B and beyond, but this is your first time. Here's a list of everything you'll need for Series A due diligence to make things easier. Preparing this material ahead of time, before even speaking with investors, may save you a lot of time and money, as well as speed up the due diligence process, ensuring that your business receives funding as soon as possible. To navigate between subcategories, use these items:
Corporate records and charters:
- Business Plan and Financials.
- Tangible and Intangible Property.
- Security Issuances.
- Material Agreements.
- Debt, Disputes, and Litigation.
- Human Resources.
Corporate Records and Charters:
- Complete minutes of directors’ and stockholders’ meetings.
- Certificates of Incorporation, Designation, and Rights.
- Corporate Bylaws.
- Above information for any subsidiaries.
- Entity Organization Chart, if there are any subsidiaries.
- Officers and Directors (Name, Age, Length of Service, Current Salary, and Bonuses).
- Organizational Charts (Internal operational manuals and org charts).
Business Plan and Financials:
- Financial statements - Detailed Profit and Loss, Balance Sheets, and Cash Flow going back three years (or until founding, if less).
- Audited Financial Statements, if available.
- Financial Projections.
- Business Plan and Budget Covering the past three years (or until founding, if less).
- Trademarks, Patents, and Copyrights.
- Relation of Patents/Copyrights to Product or Services.
- Written Business Policy for dealing with Intellectual Property (IP).
- Any Confidentiality Agreements and License Agreements for IP.
- Real estate owned, used, leased, or subleased—deeds, leases, mortgages, sale contracts, etc.
- Other leases, Insurance Policies, and All Asset Lists.
- Borrowings, Secured or Unsecured (all relevant documents).
- Debt Schedule.
- Financing Arrangements and Statements.
- Investor Financing Documents.
- Liens or Encumbrances.
- Surety and Business Loans.
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