Most Common Due Diligence Mistakes Startups Make And How To Avoid Them

Investing in a startup is considered a tricky business, and with good reason, since there is no guarantee for returns or gains. To navigate these challenges, venture capitalists and angel investors typically engage seasoned startup consultants to conduct meticulous due diligence prior to investing. 

This essential process involves a detailed analysis of the startup’s financial, commercial, legal, tax, and compliance conditions based on historical data and other pertinent factors. Such comprehensive due diligence is critical as it not only provides a deep understanding of the startup’s business model, market demand, and growth potential but also sets the stage for subsequent negotiation and investment decisions. 

Despite its importance, startups frequently encounter pitfalls during this phase due to various oversights. This article delves into these common mistakes and offers guidance on how to effectively avoid them. 

Legal Due Diligence Mistakes

Legal due diligence is essential for assessing risks associated with contracts, litigation, intellectual property rights, regulatory compliance, and more. Common pitfalls include:

1. Inconsistent terms in agreement:  Conflicts often arise from discrepancies between bespoke and standard contract terms. It is crucial to ensure clarity and consistency in all contractual terms to avoid disputes.
2. Agreement inadequacy:  Many startups lack proper documentation for key agreements such as employee stock options. This oversight can alarm investors, who expect all significant agreements to be well-documented and up-to-date, especially in international settings.
3. Stamp duty not paid on agreements:  Like other taxes, stamp duty is mandatory and must be paid timely. Failure to do so can invalidate documents and attract penalties, undermining legal standing.
4. Equity promises without documentation: Oral promises of equity compensation are risky and should be formally documented to prevent future legal complications. This includes clear terms for stock options, warrants, and grants.
5. Inadequate IPR protection: Protecting intellectual property is critical. Startups must ensure proper contracts are in place with all parties involved in product development, from consultants to contractors, to safeguard ownership rights.

Financial Due Diligence Errors

Accurate financial due diligence is pivotal to uncovering risks and verifying the stability of financial information before finalising any investment. Common errors include:

1. Irregularities in filing returns: Comprehensive tax due diligence is imperative to uncover any significant tax liabilities that might affect investor negotiations or decisions. This detailed scrutiny goes beyond the basic checks performed during regular tax returns.
2. Neglecting regular book updates: Maintaining accurate books of accounts is a legal requirement under the GST Law. Failure to update books regularly can result in penalties, seizures, and tax assessments on unaccounted goods and services, which can deter potential investors.
3. Ad hoc accounting treatments: Occasionally, ad hoc adjustments are necessary to reflect the true financial status of the company. These include entries for unique transactions, error corrections, or adjustments outside the normal accounting cycle. Each entry must be justified and documented to avoid future discrepancies.
4. Non-compliance with statutory payments: Statutory payments, including income tax, social security tax, health insurance, pension contributions, among others, are legally mandated. Non-compliance can significantly impact employees’ benefits and expose the company to legal penalties.
5. Foreign payment non-compliance: Compliance with FEMA regulations for international transactions is crucial. Indian companies must ensure that all foreign payments involving Foreign Direct Investment (FDI) submit Foreign Liabilities and Assets (FLA) returns annually and borrowers must report External Commercial Borrowing (ECB) transactions monthly to the RBI to avoid penalties and legal complications.
6. TDS non-compliance:  It is crucial to correctly deduct tax at source as per the TDS regulations. Failing to file TDS returns timely results in a penalty of ₹200 per day, and not providing accurate details or delaying the filing can incur additional fines ranging from ₹10,000 to ₹1 lakh.

Compliance Due Diligence

Compliance due diligence is an exhaustive process aimed at verifying a business’s adherence to both governmental and non-governmental regulatory requirements. Common compliance failures include:

1. Failure to maintain minutes and update statutory registers: As mandated by the Companies Act of 2013, failure to properly maintain minutes and update statutory registers can result in significant fines for both the company and their executives.
2. Missing share certificates: Not issuing or updating share certificates within the required timeframe can lead to penalties, affecting the legal proof of ownership and complicating shareholder transactions.
3. Lack of govt registrations: For businesses, especially those in sensitive sectors like banking and healthcare, failure to secure necessary government registrations can lead to suspension of business licences and severe penalties. Compliance with international data protection laws like CCPA and GDPR is crucial for companies operating or aiming to operate in the EU, enhancing data security and facilitating business partnerships.

Summing up

Effective due diligence is crucial for startups navigating complex legal landscapes. By proactively addressing gaps in legal, financial, and compliance due diligence, startups can mitigate risks, ensure regulatory compliance, and foster sustainable growth. Remember, thorough due diligence is not just a requirement; it’s a strategic investment in the startup’s future.