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May 1, 2023

Preparing for due diligence: A guide for early-stage founders

Preparing for due diligence: A guide for early-stage founders

As an early-stage founder, the due diligence process can be overwhelming and intimidating. However, preparing for due diligence is crucial for securing funding and building a successful business. In this blog, we will provide you with a guide that breaks down everything you need to know to prepare for due diligence.

What is due diligence?

Due diligence is a process of investigation and analysis that potential investors, acquirers, or partners undertake to evaluate a company's business, financial, legal, and operational status before making a decision. The goal of due diligence is to verify that the information provided by the company is accurate and complete and to identify any potential risks, issues, or opportunities that may affect the investment or acquisition decision.

Types of Due Diligence

There are several types of due diligence that investors may conduct, including:

Financial due diligence

Financial due diligence is a specific type of due diligence that focuses on evaluating a company's financial performance, statements, and projections. Financial due diligence is typically conducted to assess the accuracy and reliability of the company's financial information and identify any potential financial risks or issues.

Some of the key areas of focus during financial due diligence include:

  • Revenue Recognition: This involves reviewing the company's revenue recognition policies and procedures to ensure that they are consistent with Generally Accepted Accounting Principles (GAAP) and industry standards.
  • Expenses and Cost Structure: This involves analysing the company's cost structure and expenses to ensure that they are reasonable and in line with industry norms.
  • Working capital: This involves reviewing the company's current assets and liabilities to ensure that they are being managed effectively and efficiently.
  • Capital Expenditures: This involves reviewing the company's capital expenditures, including any planned or ongoing projects, to ensure that they are necessary and aligned with the company's strategic goals.
  • Debt and Equity Structure: This involves reviewing the company's debt and equity structure to ensure that it is sustainable and appropriate for the company's needs.

Legal Due Diligence

Legal due diligence focuses on evaluating the legal status of a company, including its contracts, licences, permits, intellectual property, litigation, and compliance with laws and regulations. Legal due diligence is typically conducted to identify any potential legal risks or liabilities associated with the company.

During legal due diligence, the focus is on reviewing a wide range of legal documents and information related to the company, including:

  • Corporate Documents: This includes reviewing the company's articles of incorporation, bylaws, shareholder agreements, and other corporate documents to ensure that the company is legally formed and operates in compliance with applicable laws.
  • Contracts: This includes reviewing the company's contracts with customers, suppliers, employees, and other parties to identify any potential legal issues or liabilities, such as breach of contract, termination clauses, or indemnification provisions.
  • Intellectual Property: This includes reviewing the company's patents, trademarks, copyrights, and trade secrets to ensure that they are properly registered and protected and to identify any potential infringement or licensing issues.
  • Litigation: This includes reviewing any pending or potential lawsuits, claims, or disputes involving the company to assess the potential financial impact and legal liability.
  • Regulatory Compliance: This includes reviewing the company's compliance with applicable laws and regulations, such as environmental, labor, and consumer protection laws, to identify any potential violations or liabilities.

Operational due diligence

Operational due diligence focuses on evaluating a company's operational performance, processes, and systems. Operational due diligence is typically conducted to assess the company's ability to execute its business plan and achieve its strategic goals.

During operational due diligence, the focus is on reviewing a wide range of operational areas and processes related to the company, including:

  • Management Team: This includes evaluating the experience, expertise, and track record of the company's management team and assessing their ability to execute the company's business plan.
  • Sales and Marketing: This includes reviewing the company's sales and marketing strategies, processes, and results to assess their effectiveness and potential for growth.
  • Manufacturing and Production: This includes evaluating the company's manufacturing and production processes, capacity, and efficiency to ensure that they are aligned with the company's strategic goals and industry standards.
  • Supply Chain and Logistics: This includes reviewing the company's supply chain and logistics processes, including sourcing, procurement, inventory management, and distribution, to assess their effectiveness and potential for optimization.
  • Information Technology: This includes evaluating the company's IT systems, infrastructure, and security to ensure that they are reliable, scalable, and compliant with industry standards and best practices.

How to Prepare for Due Diligence

Preparing for due diligence can be a daunting task, but it is essential to ensure that your company is ready for investment. Here are some steps you can take to prepare for due diligence:

  • Organize your financial information - The first step in preparing for due diligence is to organize your financial information. This includes creating detailed financial statements, such as income statements, balance sheets, and cash flow statements, and making sure that all financial information is accurate and up to date.
  • Document Your legal and regulatory compliance - Make sure that all your legal and regulatory compliance documentation is up-to-date and organized. This includes any contracts, licences, patents, and regulatory filings.
  • Create a data room - A data room is a secure digital space where you can store all your financial, legal, and operational information. This makes it easy for investors to access the information they need during the due diligence process. You can use a data room service like Intralinks or Merrill to create a data room.
  • Be transparent and honest - During due diligence, investors will be looking for any red flags or potential issues that could affect their investment. It is essential to be transparent and honest about your company’s strengths and weaknesses.
  • Anticipate questions and concerns - Take some time to anticipate the questions and concerns that investors may have during the due diligence process. This will help you prepare the information and documentation that investors may request.
  • Prepare your team - Make sure that your team is prepared for the due diligence process. This includes educating your team on the due diligence process, assigning specific team members to be responsible for providing information, and creating a timeline for completing due diligence.
  • Seek professional advice - Consider seeking professional advice from an attorney or accountant to ensure that your company is fully prepared for due diligence.
  • Practice your pitch - Investors will want to hear your pitch and understand why your company is a good investment. Make sure that you can clearly and concisely explain your business model, market opportunity, and competitive advantage.
  • Understand the investor's perspective - It's important to understand the investor's perspective and what they are looking for during due diligence. Investors are looking for companies that have a sound business model, a clear path to profitability, and a strong management team. They will also be looking for potential risks and issues that could affect their investment.
  • Conduct your own due diligence - Before investors conduct their due diligence, it's a good idea to conduct your own due diligence. This will help you identify any potential issues or risks and address them before the investor does. It will also give you a better understanding of your company's strengths and weaknesses, which will help you prepare for the investor's questions and concerns.
  • Prepare your financial projections - Investors will want to see your financial projections to understand the potential return on their investment. Make sure that your financial projections are realistic and based on sound assumptions. Be prepared to explain how you arrived at your projections and how you plan to achieve them.
  • Update your business plan - Your business plan should be up-to-date and reflect any changes or updates to your business. Investors will want to see a clear and concise business plan that outlines your market opportunity, competitive advantage, and growth strategy. Make sure that your business plan is well-written and includes all the necessary information.
  • Review your intellectual property - Intellectual property (IP) is a critical asset for many companies, especially in the technology sector. Make sure that you have all your IP properly registered and protected, including any patents, trademarks, or copyrights. Review any licensing agreements or contracts related to your IP to ensure that you have the necessary rights and protections.
  • Identify your key performance indicators (KPIs) - Investors will want to see that your company is performing well and is on track to achieve its goals. Identify your key performance indicators (KPIs), such as revenue growth, customer acquisition, and customer retention, and track them regularly. Be prepared to share your KPIs with investors and explain how you plan to achieve them.
  • Be prepared for negotiations - During due diligence, investors may raise concerns or issues that need to be addressed. Be prepared to negotiate and find a solution that works for both parties. It's important to maintain open and honest communication with the investor and be willing to compromise if necessary.

In conclusion, preparing for due diligence can be a time-consuming process, but it is essential to ensure that your company is ready for investment. By organizing your financial information, documenting your legal and regulatory compliance, creating a data room, being transparent and honest, anticipating questions and concerns, preparing your team, seeking professional advice, and practicing your pitch, you can ensure that your company is fully prepared for due diligence.