An Investor’s Guide To Due Diligence In Early-Stage Startups

Due diligence (DD) is the investigative process of reviewing a company’s economic, legal, fiscal, and financial aspects in light of a planned business or financial transaction, such as a joint venture or investment. DD is more than just gathering additional facts and data before making an informed business decision; it is a common process used by all types of business associations, whether it is a fundraise, merger, or acquisition.

Due diligence is not an obligatory legal concept, but its jurisdiction is close to the concept of notice or taking preemptive steps to ensure a fool-proof transaction.  In the Indian context, it means a particular standard of care that must be taken by entities before entering into business agreements and is similar to ‘digging up dirt’ about someone! 

It’s such a widely used concept that today, almost all purchases or acquisitions warrant due diligence — whether it’s a purchase of a property, business, or any other asset. 

Early-stage due diligence is a complex process that a venture capital firm undertakes to understand the risks and evaluate potential investment opportunities in a business, as well as its scalability and growth potential. It helps the investor make an informed decision about investing in such a company.  

When conducting due diligence on a company, there are numerous factors to consider, especially in the early stages.

Business & Management

Understanding a company’s business and scope is critical for anyone considering investing in it. A company’s core is its business, and understanding the business is critical. 

It assists the investor in comprehending the industry in which such a business operates, its business model, competitors, and market trends in that industry. This is an important factor in determining whether the investment is worthwhile. In addition, it is critical to understand the management team, including their expertise, experience, reputation, dedication, and skills.

In order to be confident enough to invest, it is critical to examine the management team’s market understanding and approach to the business. The company’s vision and the CEO chart the course for the company. As a result, this is also an important factor in due diligence.

Risks 

The primary consideration should be the potential risks of investing in the company. Risks are unavoidable in the early stages of any company. However, in order to form an opinion about a company, it is critical to understand how risks can be mitigated by the company and the steps that have been taken. 

The degree of risk is the actual factor of due diligence because it determines the amount of effort required to mitigate such risk.

Product/Service & Marketing Strategy

The main distinguishing feature of a startup is its unique product or service that differs from current market trends.  This is an important consideration when conducting due diligence because it confirms the scope of the business. So, talking to the target customers and assessing the impact of the products/services has to be the central part of good due diligence. 

Next, the market strategy being used by the company becomes relevant to ascertain their market knowledge and awareness towards their competition. Marketing is a huge aspect of every business and it is a key factor to consider while conducting due diligence.

IP & Technology 

To claim ownership, any and all novel inventions must be protected by IP. Every type of registered IP comes with a set of rights that can be used to create great opportunities for the company, such as monopoly-like business in the invention, and exclusivity in marketing and distribution.  

Due diligence is important to confirm those rights. Technology, on the other hand, has become an integral part of every startup. The more tech-centric a company is, the more important it is to have technology skills on the founding team. 

As a result, both intellectual property and technology become critical factors to consider for due diligence because they are critical to the company’s operation and growth.

Financials 

Financial planning is critical in the early stages of a business. The financial requirements of a company differ from one another and from one industry to the next. It is important to make the right assumptions and prepare financially for the growth of the company. 

From the initial capital to all stages of funding, it is critical to be prepared and aware of the company’s financials. The financials of a company, particularly the debts and liabilities, play an important role in funding because they demonstrate the management team’s experience and knowledge, and they are naturally a key factor for due diligence.

Funding

The two main aspects of funding that must be considered are the company’s current cash balance as its ability to run the business and the amount of capital required by the company before an exit. 

These two factors provide a clear understanding of the company’s financial stage as well as the financial risk that follows. These are critical factors to consider when conducting due diligence on early-stage companies.

Legal

The main legalities to focus on for early-stage legal due diligence are the corporate capitalisation structure, a company’s statutory compliance with applicable regulations, third-party contracts, employment agreements, tax and audit compliances, and, as previously discussed, IP registration requirements. 

Any judicial or administrative proceedings must be considered in addition to the legal requirements for due diligence.

Exits & Pay Offs 

An IPO or acquisition are the two most important exits for a company. The main factor to understand as part of due diligence is how the company will achieve liquidity to investors prior to a financial exit in the case of an IPO and why another company is making an investment by acquiring this company. 

If the company has planned for this, it is wiser to invest in such a company because it promises a financial return, which is the primary reason one wants to invest in any early-stage company. This is definitely a key factor for due diligence.

Relevant & Appropriate Jurisdiction Selection

Given the global nature of today’s businesses, it has become critical to seek legal advice on company structuring as well as selecting the right jurisdiction for each business, based on factors such as ease of doing business, legality and developed laws and policy, among others. 

That being said, these are not the only factors to consider for due diligence, and they are a few important ones that should not be overlooked, among several others that are better defined and discussed individually for different types of businesses or industries. 

As it has been wisely said, ‘knowledge is power’ due diligence ensures that there is no knowledge imbalance and ascertains information superiority.