Startup Due Diligence: What it Is & Why it Matters

Did you know that a disagreement between founders can lead to an entire startup business failing? In fact, 65% of startups fail due to founder conflict (Noam Wasserman, author of The Founder's Dilemmas). Even small disagreements can come to light during the startup due diligence process when investors look into your company before deciding to invest their money.

Read further or click on the table of contents for more helpful information on startup due diligence and what steps you should include in your due diligence checklist.

Table of Contents

• What is startup due diligence?
• The Startup Due Diligence Checklist
• How to Prepare for the Due Diligence Process — According to Experts

What is startup due diligence?

'Startup due diligence' is a phase that takes place before investors decide whether or not to invest. During this phase, angel and venture capital investors will audit your product, staff, and financial viability, research the market, decide equity and ultimately determine their risk.

If you’re a startup founder, you likely have your hands full, even if you have found prospective investors. Startup due diligence may seem like an enormous undertaking, especially with everything else on your plate. Yet, it’s also a good exercise for any company that wants to better understand its own economic health, viability, and problem areas that need fixing.

The Startup Due Diligence Checklist

Business Audit Phase

During the business phase, your investors will ask themselves how your teams work together, what processes need improvement, and whether or not their money will grow under the current circumstances in which your company operates.

Examining Your Organizational Structure and Processes

One important aspect for investors to analyze is how your company currently runs. This may mean examining the company hierarchy, different management teams and their roles, and even having employees take an assessment.

“Due diligence is a crucial process when evaluating startups for potential investment or partnership opportunities. It involves thoroughly assessing various aspects of the startup's business, operations, and financials to determine its viability and potential risks.” (Ahmed Agamy, MBA).

Investors want to know if your startup is ready and capable of scaling bigger with the money they provide you. A scalability assessment will examine your operations, infrastructure, technology, and overall readiness. Most startups will have unseen growth constraints that can be identified during this phase.

Pro Tip: Have these items to have ready during this step.

• A detailed organizational chart with roles and responsibilities clearly listed
• An easy way for investors to get a hold of your staff to schedule meetings or for a quick conversation (think calendar invites, emails, etc.)
• A detailed recording of all your current software and technology needs
• Your employee handbook
• Any other operational information they may need

Investigating Your System Processes

Every startup company has its own unique quirks and ways of doing things. However, an investor needs to be familiar with these quirks and able to identify key areas that need improvement. This step will look at your operational workflows, IT and compliance team, and risk management.

Pro Tip: Have these items to have ready during this step.

• A recording of any past cybersecurity assessments and steps you’ve taken to secure customer credit card information
• Have employees write a brief description of their personal work processes
• A detailed history of any important past software, security, or technology bugs you’ve encountered

Analyzing Your Management, Teams, and Staff

This step takes a closer look at the work culture you’ve created during your time as a startup. Have you heard the phrase “one bad apple spoils the barrel?” The same can be true of the people you employ.

Investors will take a look at who you’ve chosen for management positions, their experience and track record, and their alignment with both the startup’s values and the investor's values. They can also audit different teams to see how well communication is going, your retention rates, how well you’re doing at acquiring top talent, and succession planning.

Pro Tip: Have these items to have ready during this step.

• Employee handbook
• Detailed job descriptions for every member of staff
• A recorded history of the last year’s projects and turnaround times (divided by quarters)
• Job postings and interview questions for prospective hires

Technical Audit Phase

The technical audit phase of due diligence is when investors begin to predict how your product or services will do in the current market with customers. A great way to simplify this phase for yourself and investors is to do some basic calculations to determine your growth potential and current customer-related costs.

Determining Your Market and Growth Potential

A great way for investors to understand your market potential is by calculating your TAM (Total Addressable Market). TAM refers to the total market demand for a product/service. It’s the most revenue a business can possibly generate by selling their product or service in a specific market.

Investors will also look at market trends, growth projections, and the competitive landscape for your products and services.

Pro Tip: Have these items to have ready during this step.

• Your initial TAM calculation
• A written sales projection with relevant stats
• Competitor research, including websites, product offerings, SEO performance, and anything else that could show your position in the market

Understanding Your Ideal Customer

If your startup is speaking with investors, it’s likely you already have a pretty good idea of who your customers are and what attracts them to your product. Use this step to create a buyer persona if you haven’t already done so. Audit your average customer’s lifetime value (CLV) to see which things can be improved.

Pro Tip: Have these items to have ready during this step.

• Descriptive segmentation lists for Sales, Emails, Newsletters, and more
• Buyer personas (Check out this free template to get started)
• A calculation of your current CLV
• A calculation of your customer’s acquisition cost (CAC)

Financial Audit Phase

It could be argued that this phase is the most important part of due diligence for investors to perform. It’s also helpful for you and your executive team to get a pulse on your company’s current financial status, so no matter what investors decide, you can improve any financial woes the startup is experiencing.

Diving Deep Into Your Startup’s Financials

You would probably never blindly give money to an investment without first knowing if it’s a good one. An easy way for both angel and venture capital investors to guess how their investment will perform is by getting into the nitty-gritty of your financial status.

This means they will ask for things like balance sheets, cash flow statements, income, and sales predictions. If you have different revenue sources they will need to analyze those, as well as your operation costs, capital expenditures, debts, liabilities, and debt repayment plans.

Pro Tip: Have these items to have ready during this step.

• Income statements
• Balance sheets
• Sales and financial projections
• Cash flow statements
• A list of all current and past revenue sources
• Current operation expenses
• Capital expenditure budget
• Payroll documents
• All financial documents that pertain to your debts and repayment schedules

Legal Audit Phase

If there’s one phase on this checklist where you want a seasoned professional, it’s this one. Work with a trusted lawyer to gather all important documents and ensure that your company's legal status is unimpeachable.

Review Startup Documents & Agreements

Reviewing legal documents means getting a deep insight into any legal risks that could impact your financial status, future growth, and operations.

Philippe Roche, CEO, describes this as “ensuring regulatory compliance” or ensuring “your startup is in compliance with all relevant laws and regulations. Any legal hiccup can be a deal-breaker.”

Pro Tip: Have these items to have ready during this step.

• Bylaws
• Shareholder agreements
• Past board meeting minutes
• Articles of incorporation

Assess Your Intellectual Property and Contracts/Agreements

Investors will need to look at all your intellectual property, patents, copyrights, trademarks, and more to get a good idea of what you actually own as far as your products go. Any confirmed, pending, or future contracts and agreements must also be reviewed.

Pro Tip: Have these items to have ready during this step.

• Any documents related to your intellectual property (IP)
• Supplier agreements
• Employee contracts
• Lease agreements
• Customer contracts
• Documents related to pending litigation
• Documents related to compliance with local, state, and federal laws and regulations

How to Prepare for the Due Diligence Process — According to Experts

Keep Detailed Documentation

“Navigating the world of startups can be a roller coaster ride, and one critical stage you'll encounter is Due Diligence. This process, usually initiated by investors, is about deep-diving into your business, scrutinizing every detail before committing to an investment.” (Philippe Roche, CEO).

Roche’s advice includes keeping “Detailed documentation. Have all your financial statements, business plans, IP rights, customer contracts, employee agreements, etc., meticulously organized and readily available.”

Organizing and detailing documentation ensures the due diligence process goes smoothly and paints your startup in a positive light. Investors want to put their money in businesses that have their act together, and organized documentation is an important part of this.

Pro Tip: Check out this blog on different organizational skills ever startup leader should have.

Plan for Months of Due Diligence

Most startup founders don’t realize just how long due diligence can take. In fact, “the depth to which an investor (through a Law or a CA firm) can go can be very, very deep.

This means that if you've received a DD term sheet, you will be spending the next few months (yes, MONTHS) focussing on only that. And your promised investment is delayed by months” (Guhesh Ramanathan, CEO).

If you don’t adequately plan for the time and effort it takes to perform due diligence, the process will either drag or stop altogether as investors pull their interest. Consider assigning one of your team members to focus solely on due diligence or create a list of responsibilities that each employee needs to complete.

Pro Tip: There’s a big difference between strategic and tactical planning when it comes to business goals like due diligence. Check out this blog for more information.

Prepare for Deep Scrutiny and Investigation

Sometimes, startup owners aren’t aware of just how in-depth a due diligence process can be. Peter Sorgenfrei, CEO, explains that investors will look at your equity structure, risk management, growth potential, founding team, employee backgrounds, financial statements, expenses, salaries, product, full code, scalability, and more.”

You can prepare for this level of scrutiny by ensuring you have no skeletons in your closet. This could include addressing past disgruntled employees, cybersecurity threats, bad debt, or anything that would put an investor off if they found out about it.

Pro Tip: Did you know that complete transparency and honesty are actually negotiating tactics that you can use during due diligence? This is due to many reasons, but mostly because honesty paired with lower risk makes your company more valuable and more likely to get even more funding.

Tackle the Startup Due Diligence Process Successfully

If you prepare and approach your investors with honesty and straightforwardness, there‘s no reason you shouldn’t successfully complete the due diligence process.

Remember, you don’t have to do this alone. You will want to involve anyone at your startup who can make a difference in raising funds. If you’re still not sure where to start, check out this free startup kit or join an online startup community to get advice from other professionals who have gone through due diligence.