Why Pre-Investment Due Diligence Has Become Essential For PEs & VCs

In recent years, the private equity and venture capital investment landscape in India has witnessed substantial shifts. Despite a decline in the overall deal value of investments in India, the number of deals in the startups has seen a considerable increase. 

May 2024 saw Indian startups raise $657 Mn through 100 deals, up 11% month-on-month (MoM) and 25% year-on-year (YoY)., However, this growth is not without its challenges.

The Rise of Governance Concerns In Startups

The surge in investments has been accompanied by an uptick in reports of regulatory non-compliance, impropriety and operational lapses. In 2023 alone, reports emerged highlighting governance lapses in at least five sizable Indian startups operating in areas such as edtech, multi-brand car servicing, technology and commerce, partner-model hospitality, food delivery etc.

To navigate the complexities inherent in the investment landscape, it has become essential for investors to effectively employ pre-investment forensic due diligence measures.

Corporate governance-related issues not only pose challenges for the businesses themselves but can cause significant financial and reputational loss to investors and other stakeholders associated with the businesses. To navigate these complexities, a majority of investments usually go through due diligence measures, before investors deploy funds.

Why PEs and VCs Must Prioritise Pre-Investment Due Diligence

In response to the evolving risks, investment committees have started demanding thorough pre-investment forensic due diligence to be conducted for internal compliance and to identify critical risks relevant to the target’s operating model and financial performance.

A forensic due diligence enables investors to identify areas of risk and obtain answers to questions which would typically not be addressed or may remain unidentified from other types of due diligence, such as a review of financial information and operating data. This is particularly true in the case of early-stage businesses, where such information is limited and not readily available.

Identifying Red Flags In Startups: A Due Diligence Checklist

Some key risks for early-stage businesses include reputational risk, risk of unknown political exposure, governance risks – such as the sanctity of numbers, unreported related party transactions, overstatement of financial and operational performance, and risk of unknown or unreported regulatory exposure.

Some indicators that should be checked in a well-executed pre-investment forensic due diligence include:

• Ambiguity regarding the sources of seed capital
• Understanding if the founder/promoter has a pattern of excessive control, weak interpersonal skills and rejects any advice given (including that provided by partners or investors)
• Changing industry or economic conditions
• Intense recent regulatory action in the industry
• Delays in the filing of financial statements / corporate records with the relevant authorities
• Frequent changes in statutory auditors or qualified opinions of auditors
• Availing statutory audit services from audit firms with limited experience, track record and reputation
• Appointment of family members and friends in important management positions, and second-tier management personnel lacking the necessary expertise, qualifications and experience
• High attrition of newly appointed senior executives (particularly in the first two years of employment) 
• A high degree of reliance on very few customers coupled with a high volume of related-party transactions
• Disproportionate concentration of business in certain territories or regions; and
• Any governance/ethical concerns associated with past business ventures or past employment of the founder/promoter 

In addition to protecting the financial interests of investors, proactive forensic due diligence also protects investors and their stakeholders from any reputational or financial damage arising from a sunk investment. 

In a market where information on early-stage businesses can be limited, pre-investment forensic due diligence acts as a sound safeguard, offering a comprehensive understanding of potential risks. 

At such a time, staying vigilant by using thorough due diligence for decision-making, is crucial to ensure the long-term success of investments in young businesses.