Due Diligence Process For Startups
If you plan on raising money for your startup, due diligence is about to become a big part of your life—whether you want it to or not.
But if the due diligence involved with startup fundraising seem complex, have no fear. Broken down into individual components, it becomes much simpler to handle. But first—what is due diligence, and why does it matter?
What is due diligence?
Broadly, due diligence is the process of confirming facts so investors avoid any unseen pitfalls. For instance, in an informal sense, if you’re going to buy a new car, your due diligence is to check online reviews, make sure it isn’t a “lemon,” and research the best financing available.
When it comes to buying or investing in bigger items than a car—like a business, for instance—the due diligence process becomes much more complex. In fact, it is a very standardized process If someone is going to fund your startup, they’ll conduct due diligence before signing agreements.
If you make it as easy as possible for them to obtain the information and answers they require, your funding process will proceed smoothly and expeditiously. If not, then not.
A brief history of due diligence
“Due diligence” wasn’t common parlance until 1933, when Congress passed the first federal Securities Act. It made dealers in securities—sellers and brokers—responsible for disclosing essential information about those securities to the people buying them.
It also defined due diligence—meaning, the minimum amount of information the seller had to dig up and disclose about companies and securities before making sales. As long as they performed and disclosed this due diligence, they weren’t legally liable for any losses the investor later incurred.
Why should due diligence matter to you?
Due diligence should matter to you because it matters to venture capitalist firms (VCs).
Any VC investing in your startup is answerable to limited partners (LPs)—the entities whose money makes up the fund they’re investing. These include pension funds, university endowments, foundations, finance companies, and rich people.
A VC that wants to invest in your startup is obligated to perform due diligence for the sake of the LPs. Beyond that, they need to do their homework to make sure your business is a good investment, so LPs know their money is in good hands.
If they fail to perform due diligence, a VC can reasonably expect to lose clients and reputation. So it’s in their best interest to be as thorough as possible.
Starting a startup?
The 3 types of due diligence
When a VC does their due diligence, they move through three stages of investigation.
- Screening due diligence. The VC sifts through hundreds of potential investments to find companies that are a good fit for the fund’s mandate or criteria.
- Business due diligence. Once a good candidate is selected, partners at the firm investigate to determine whether it will be a profitable investment. This includes looking at your business model, your product/service and its market fit, and your management team.
- Legal due diligence. If your company passes the first two stages, the VC’s lawyer moves in to make sure everything is in ship shape according to the law. They may query your own lawyer to get the facts.
Of these three stages, 2 and 3 are the most relevant for your business. They’re the ones for which you’ll need to provide the most documentation.
Due diligence at different startup stages
The amount of information about your business you need to gather and present to potential investors varies according to your stage of fundraising. At stages when you are not yet courting VCs, obligations on your end will naturally be smaller. The bigger the investment size, the greater your obligations when it comes to due diligence.
Due diligence at the angel investor stage
If an angel investor is helping to launch your company, there’s not much you need to worry about in terms of due diligence.
Chances are, you already have a trusting relationship with the investor. Angel rounds tend to be built on personal trust. After all, the financing paperwork used in angel investing and pre-seed financings do not afford many legal or financial protections for the investor -- early-stage investing operates on good faith and mutual trust between founders and individual investors. In many cases, the investor is often investing their own money—they aren’t beholden to to LPs and can independently decide to write a check without getting approval from managing partners, like in a VC fund.
However, it’s up to the investor to decide the course of due diligence. If, thanks to good referrals, they trust you, they’ll ask for cursory details, like a pro forma cap table and your incorporation paperwork.
If you’re less well-known to them, they may ask for more information and you can expect them to do back-channel reference checks before committing to invest.
Due diligence at the pre-seed/seed stage
Typically, pre-seed or seed investors won’t require extensive information before they invest in your company.
If you’re raising money through SAFEs or convertible notes, it’s up to the investors to decide which course of due diligence to take.
On the other hand, if you’re doing a priced round at the seed stage, your due diligence process will closely resemble that of any other priced round, ie. Series A, Series B, etc.
It’s common for investors to request a pro forma cap table (like the one Capbase generates for you automatically) and documents of incorporation proving you’re incorporated in Delaware.
They are also likely to request any agreements between founders and the company like purchase agreements or confidentiality agreements.
No matter how you run your seed round, at bare minimum you should be ready to provide:
Your incorporation documents
- A pro forma cap table
- Your corporate bylaws
- Equity contracts
- Advisor agreements
Due diligence for priced rounds
Once you hit the priced round stage of fundraising, due diligence becomes more serious. Your investors include VCs among their ranks. You’ll need to provide a full suite of legal, financial, and operational documents. Typically, your largest investor will do most of the grunt work carrying out due diligence, while the other, smaller investors follow in their footsteps, using the information they dig up.
As part of a term sheet, investors will typically require that the company pay the VC fund’s legal fees. As a founder, it is often a good strategy to agree to a cap up front on those legal reimbursements.
Due diligence for a priced round may be expensive for your company if your formation documents were not accurately maintained, mainly due to legal fees to straighten up the mess. You may find yourself paying lawyers to gather and organize documents if you don’t have your information already collected and organized in a comprehensive document room. This is another instance where Capbase can make your priced round run smoothly, by accurately maintaining your company’s legal and financial records from the start.
The importance of the document room
Historically, a document room was an actual room where companies gathered paper files and investors as well as their bankers and lawyers would review the documents. These days, “document room” is a server or account where you store all documents relevant to due diligence—contracts, financial statements, board meeting notes, and more.
Having this information gathered on one server in a format that can be shared with VCs, and which they can use for their business and legal reviews, significantly reduces the amount of time spent on completing due diligence.
Plus, when you don’t collect them all in one place, you run the risk of losing important documents. That can be an expensive mess to clean up -- many startups spend tens of thousands on legal fees to do what is essentially corporate housekeeping to get their document room in order as part of their first thorough diligence process.
Series A due diligence checklist
Since the angel investor and seed rounds of fundraising don’t require much of you, due diligence really makes its mark during Series A. You’ll need to handle due diligence again for Series B, C, and beyond, but this is your first time facing it head-on.
To make the process easier, here’s a list of everything you need for Series A due diligence. Preparing this information ahead of time, before you even start talking to investors, can save you a lot of hassle in the long run, and make the due diligence process faster—so your startup gets funding ASAP.
Use this table to jump between subcategories:
Corporate records and charters
- Business plan and financials
- Intangible property
- Tangible property
- Securities and security issuances
- Material agreements
- Disputes and litigation
- Human resources
Corporate records and charters
- Complete minutes of directors’ and stockholders’ meetings
- Certificates of Incorporation
- Certificate of Designation
- Certificate of Rights
- Corporate bylaws
- Above information for any subsidiaries
- Entity organization chart, if there are any subsidiaries
- Officers and Directors of the company—name, age, position, 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 past three years (or until founding, if less)
- Relation of patents/copyrights to product or services
- Written company policy for dealing with intellectual property (IP)
- Any license agreements for IP
- Confidentiality agreements
- Any infringement allegations
- Real estate owned, used, leased, or subleased—deeds, leases, mortgages, sale contracts, etc.
- Other leases
- Insurance policies
- All asset lists
Securities and security issuances
- Stock and options holders (complete list)—including issuance/grant dates, original issuance prices, exercise prices
- Stock books and/or ledgers
- Capitalization table
- Vesting schedules
- All agreements tied to securities, including all those between shareholders and the company
- Proof of qualification under federal (Rule 701) and state blue sky laws, regarding the issue or transfer of securities
- Borrowings, secured or unsecured (all relevant documents)
- Debt schedule
- Financing arrangements
- Investor financing documents
- Financing statements
- Liens or encumbrances
- Company loans
- Correspondence with lenders re: defaults or alleged defaults
- Agreements, understandings, instruments, etc. for which you’re obliged to received payments higher than $25,000
- Any judgment, order, writ, or decree to which your company is a party
- Any joint venture or partnership agreements
- Any consulting contracts
- Any and all agreements made by your company outside the normal course of business
Disputes and litigation
- Current litigation (summaries of all)
- Any accusations of infringement from outside parties—including correspondence
- Correspondence or agreements related to labor organizing, unions, or strikes
- Any consent decrees relating to your company’s actions
- Documents relevant to any internal investigations
- List of all employees—including their titles, base salaries, bonuses, department, job function, date of hire, etc.
- List of all contractors—including their titles, base salaries/rates, bonuses, department, job function, date of hire, etc.
- Executive employment, severance, and change in control agreements
- Copy of salary structures, plus compensation philosophy and methodology
- Any and all employee benefits—including summary of plans, number of employees and their respective plans, employee and company contributions, copies of contracts or agreements with Third Party Administrators (TPAs)
- Summary plan document for Employee Stock Ownership Plan (ESOP) or Employee Stock Purchase Plan (ESPP)
- Detailed list of employees who have received options or restricted stock units (RSUs)
- Standard form of offer letter
- Severance and deferred payment policies and plans
- Employee handbook
Series A due diligence timeline
Once you’ve decided to accept a deal from a lead investor, your typical due diligence timeline will look like this.
Due diligence timeline: The beginning
- Introduction. The lead investor brings a wider team into the process—including external advisors, who may perform specific types of due diligence, ie. legal, financial.
- Terms of access. You and the lead investor agree on terms of access—what kind of information they can access. This includes confidentiality undertakings, scope, and limitations on the investigation, as well as standard communications protocol and points of contact.
- Data room. You provide the relevant documents to the lead investor via your data room.
- Timeline. You and the lead investor agree on an timeline—deadlines for receiving information, as well as deadlines for issuing the due diligence report and, if necessary, returning to the negotiating table.
Due diligence timeline: The process
- Information requests and Q&A
- Site visits by the due diligence team
- Interviews with management
- Discussion of findings; internal communications; progress reports; working through any procedural issues between you and the investor.
- Preparation of due diligence report(s)
- Lead investor reads the report and discusses it with different stakeholders
- Investor considers what the report reflects about the valuation of your company, and whether any new terms must be negotiated for the sake of protecting their investment
- Meeting between you and the investor to negotiate changes or additions to the terms of the transaction.
Due diligence for mergers and acquisitions (M&A)
In the event you sell your business, the buyer will go through a due diligence process that is, on the whole, very similar to one for investing. However, there are some factors they’ll focus on which are more relevant to M&A than to fundraising:
- Liabilities. Beyond the liabilities listed in your financial reports, what else is your company liable for? For instance, environmental issues of are you involved in any ongoing litigation?
- Fit and potential conflicts. How do your product and business fit with the buyer’s other entities? Are there any potential conflicts, eg. competition between products?
- Definitions. For instance, how is “working capital” being determined, for the purpose of the acquisition? Do you and the buyer have conflicting definitions?
- Operations. Do you have enough money to keep the business running and maintain standards of operation in the time between the due diligence process and the deal being closed?
- Personnel. Will the seller provide essential team talent? What is the likelihood of retention after the deal goes through?
Capbase makes due diligence easy
One of the easiest ways to slow down the due diligence process is by failing to provide the investor and their lawyers with all the documents they need.
When you use Capbase, your document room is automatically populated—so it’s easy to share all your legal documents, all in one place.
And as you bring on investors, Capbase will automatically update your cap table. That means faster funding for your startup, and less time dealing with paperwork.
Written by Stefan Nagey
Serial entrepreneur engineering & business leader who co-founded and led his last to a $14M Series A financing and a successful exit. Years of experience leading teams & building scaleable, secure software systems.
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