Due diligence is an investment in the future of a startup. It allows the startup to secure the best outcome in an investment round or attract a potential buyer in acquisition deals. It is advisable to prepare for due diligence well in advance.
Although due diligence may seem distant for many early-stage startups, it is important to be aware of it early on. Due diligence refers to a thorough and objective examination of a company's operations.
"Due diligence is a kind of scrutiny that reveals how a company is really doing", says Marko Sorri, CEO and business coach at the Startup Factory.
Typically, due diligence is associated with conducting a funding round, business acquisitions, exit situations, or mergers involving share transactions or changes in ownership structure.
Investors or potential buyers conduct due diligence before making a final decision to invest in a company or acquire the entire business or a portion of it. Due diligence can influence investment or purchase interest and the valuation of the target company.
"In practice, the investing or buying party examines what is the true picture that emerges from the paperwork. Due diligence ensures that things are as they have been presented, thus avoiding unpleasant surprises later on."
"Due diligence is a kind of scrutiny that reveals how a company is really doing,"
- Marko Sorri
Sorri emphasizes that venture capitalists and other investors who invest other people's money are bound by a duty of care, which requires a thorough examination of the investment target.
The extent of the due diligence process may vary depending on factors such as the complexity of the target company's business or the level of knowledge the investor or buyer has about the company, its markets, and the industry.
Due diligence consists of various dimensions depending on the nature of the company's business. For example, legal due diligence involves reviewing contracts, technical due diligence examines the quality of the company's product or service, and financial due diligence focuses on where the money is spent.
"The level of the company's business, its history, industry, life cycle stage, and the background and interests of the investing or buying party affect the starting points of due diligence", says Sorri.
"The level of the company's business, its history, industry, life cycle stage, and the background and interests of the investing or buying party affect the starting points of due diligence"
-Marko Sorri
Essentially, due diligence aims to identify business risks, assess the likelihood of risks, and find ways to manage them. In addition to risks, due diligence may also reveal positive factors that speed up the due diligence process.
"Investment or business negotiations often take a long time. During negotiations, a startup may win a significant bidding competition or recruit a top-notch expert. It is worth highlighting successes because they can work in favor of the startup."
When a company undergoes a thorough due diligence process, its financing eligibility improves, management level enhances, and the sales process accelerates. Ideally, due diligence demonstrates that the company has done things right.
"However, not all first investment rounds for startups succeed, but lessons can be learned from them. Due diligence can be seen as an investment that helps in the future and provides an opportunity to test the company's financing eligibility," Sorri points out.
Startups should familiarize themselves with due diligence sooner rather than later. When an investment round or exit situation approaches, the due diligence process can be time-consuming and energy-draining if things have not been considered in advance.
Sorri recommends that startups establish an agile management system from the beginning and expose themselves to due diligence. This way, the company knows what information to collect and store continuously. It may be difficult to retrieve all relevant material retrospectively.
"For example, a startup can store all communication with accountants and auditors. This allows the company to demonstrate the issues that have been addressed and resolved," Sorri suggests.
The documents involved in due diligence form a vast collection. It may include shareholder agreements, information about agreed responsibilities, previous financing agreements, cost structures, financial statements revealing key figures, and employment agreements and employee retention methods.
"For example, a startup can store all communication with accountants and auditors. This allows the company to demonstrate the issues that have been addressed and resolved"
- Marko Sorri
"It is advisable to compile all information in a cloud service and periodically verify whether anything is missing or if everything is up to date. When an external party conducts due diligence, it is easier to examine the information in a data room than from separate paper folders."
Due diligence is a comprehensive process in which a startup participates by investing time and providing information. However, due diligence can be expedited and streamlined when well-prepared and when documentation is systematically organized.
Proper due diligence provides a solid foundation for successful negotiations in financing and business acquisition situations. Given the critical importance of due diligence for a startup's success, it is worthwhile to seek expertise from an external specialist.
An external expert can be valuable in identifying and selecting key performance indicators (KPIs). A performance measurement system tracks how well a company achieves its most important objectives.
As part of due diligence, KPIs demonstrate the development steps a company has taken and how the management will drive the company forward.
Advice on due diligence can be sought from funding providers, organizations involved in growth funding rounds, crowdfunding platforms, or auditors. Direct advice can also be sought from venture capitalists or business angels.
Sorri also mentions The Startup Factory's Incubator, where comprehensive preparation for due diligence can be achieved during the two-year coaching program.
"In the Incubator, startups have a great opportunity to build due diligence and financial eligibility with the help of a skilled coach. The goal is to attract investors and buyers to the company."