The due diligence process is where investors (mainly through there representatives) do a thorough inspection of the startup venture. The purpose is to verify the information supplied by the entrepreneurs and to identify any points of risk in investing in the firm. The extent of diligence varies depending on the stage of company development. In early-stage companies there is generally very little diligence, while later stage companies go through significant diligence. The areas of review are:
While the entrepreneur and investor must be aware of the diligence matters, the actual inspection should primarily be conducted by professionals (attorneys, accountants, and technologists). These individuals can do a far superior job in identifying the potential pitfalls or areas of risk. Below will provides some key points of research into each of these ares.
Financial Due Diligence
- Income Statement, Cash Flow Statement, and Balance Sheet – In early-stage firms, these documents can be very rudimentary. In any event the investor will verify ownership of assets and assess accounts receivable.
- Financial Projections – An accountant will compare the revenue and cost projections with the operational requirements. The purpose is to make certain that the cost projections match the necessary operational expenses associated with growth. Often there will be company, market, and economic risks associated with the operations that must be considered. Lastly, it will focus on the expectations for funding demand and the expected sources of capital.
- Capital Structure – What is the ownership structure and what effect does it have on the equity value of the company. This will include any debt instruments and their limitations on the company.
- Tax & Reporting Compliance – Has the company complied with all taxation and regulatory filing requirements. Are the tax filings accurately and appropriately executed.
Operational Due Diligence
- Product/Service Review – Review the market trends and characteristics for the product or service being delivered.
- Customers, Suppliers, Purchasers, Partners – Review for any vulnerabilities in operational relationships.
- Competitive Analysis – Review of the operational characteristics of the firm in comparison to competitors in the market.
- Marketing and Sales Channels – Review of efficiency and vulnerabilities in the marketing and sales process. This may include a comparative analysis of compensation structure for internal and external sales units. This will include an analysis of the method for driving new customers/clients.
- Research and Development – Technically proficient individuals will review the intellectual property and R&D for feasibility and potential in the market.
- Management & Personnel – Review the corporate organization structure and the roles of individuals in the organization. This may include identifying performance of key individuals and the identification of indispensable parties. It will further outline the ownership and compensation structure of these individuals.
Legal Due Diligence
- Corporate Governance Matters – Has the company complied with all corporate governance processes and procedures?
- Litigation – What litigation is pending by or against the company?
- Regulatory Environment & Compliance – What regulatory issues is the company facing. Most commonly, this may include tax, securities, environmental, and employee-labor compliance.
- Intellectual Property – Are the intellectual property rights secured in the company. How strong are the intellectual property rights?
- Insurance – What events are insured or bonded and where are the holes or risks in coverage.