What is Due Diligence?
Due diligence is an investigation that targets any risk of a business from a legal perspective. This usually occurs before acquiring a business or company or before a merger.
Its purpose is to have knowledge of the risks prior to purchase, before committing to an investment, it is important to understand what you are buying and what you are getting into.
Due diligence on a startup can be divided into two components:
Industry due diligence refers to looking at the big picture and understanding the industry, the incumbent players in the market, the competitors, what competitive advantage the startup has, what their chances of success might be, and similar research.
Legal and corporate due diligence: This involves a detailed investigation of the startup, the founders, contracts, corporate structure, product, compliance, contracts, offering, and more.
Why Is Due Diligence Important for Investors?
Some of the primary reasons for conducting due diligence are ;
- It gives a better understanding of the organization: Due diligence is necessary to give investors the information that they need to know about their target company in order to structure its purchase.
- Helps them know the value of the target company: Due diligence informs the investor of some of the following: contingent liabilities, restrictions on businesses, pending litigations, insurance policies, employee benefits, intellectual property rights etc.
- Informs the drafting of relevant documentation: The information obtained during a legal due diligence process is particularly helpful in allocating risk when drafting representations and warranties, pre-closing and post-closing indemnification rights of both parties.
- Identify impediments to closing a transaction: During the due diligence process, parties can identify and sometimes address impediments that might delay or hinder the transaction’s success. Some of the actions a legal due diligence expert will focus on are:
Basically, performing due diligence is like doing your “homework” on a potential deal, for example, before you hire an employee you would first do a reference check to check their background, so you can verify the information on an applicant’s resume and assist your organization in deciding if an individual is a suitable person for the job, this is the same thing for organizations which is why due diligence is essential to making informed investment decisions.
Investors need due diligence to lower the risk of them losing their money, reduce the chances of making bad investments, to paying more than they should for investment and increase their chances of seeing a return on their money.
What do you need to be ready for Due Diligence?
- Understand your market: you want to look at the opportunities in your market
- Review your document: you must be able to review your documents such as history, referrals on past ventures, previous investors how the company leadership is organized how the company started, the right permit right tax documents if your company is incorporated etc.
- Be realistic-size of the opportunity: is there a gap in the market and is the gap worth promoting investing ROI or what’s the endgame you need to ensure you have a realistic view of your organization, realistic valuations and returns you can bring and how much of the market can your capture and convert to tangible value
- Check for signatures: Every single contract – client, supplier and employee – needs to be signed by both parties and should be current. Outdated or unauthorised contracts are essentially worthless when it comes to due diligence, particularly if they are to be novated to new ownership.
Although this is in no way a comprehensive list, these are merely some suggestions to pre-empt some of the more common due diligence failures, so take action early to ensure that you are not leaving yourself open to renegotiations, which will not be in your favour.
What do Venture Capitalists want to see?
People think valuation is the most important but it’s not for angel investors what they mostly care about in descending order are –
- Valuation; The ability to add value
- The industry sector, the market, your business model, product, fit,
- Your management team; important qualities in a management team are what an investor sees that can turn their investment into profit
- Industry experience; It’s important who’s in charge knows the nuances of the market and capturing value, creating and/or maximizing gaps in the market
- Ability; can they deliver? have they delivered before do they have a track record of delivering, how is the chemistry between the team, how do they work together?
- Passion; Are they passionate people who can create value and prosperity not just for the staff but for investors as well
- The entrepreneurial experience; An entrepreneur doesn’t necessarily mean founding something but how their decision-making skills have helped the company truly flourish if they have led other organisations to become truly successful.
Final thoughts
The importance of due diligence cannot be over-emphasized, it is important for investors and founders to have the due diligence properly performed by experts
You will need to have self-discipline in maintaining the records of the venture, such as daily operations documents and details.
It is always good to split the responsibilities amongst the Co-founders for recordkeeping and timely reviews. This not only helps the entrepreneur to keep the due diligence outcome positive but also ensures that they have daily data at their fingertips.
