Due Diligence – for start-ups!

You’re raising venture capital funding for your software company. You’ve had a meeting with partners of a VC firm and get the good news that they want to proceed to the next step: Due diligence.

But what happens next? What is due diligence and how can you increase the odds of getting VC backing?

WHAT IS DUE DILIGENCE?

It’s the process through which an investor evaluates a proposed investment for its cost, benefits, and risks.

In cases involving start-ups, there will always be some unknowns. But the investor will want to make reasonable efforts to understand the basis on which assumptions and valuations are being made.

WHAT ARE VCs CHECKING FOR?

You’re potentially investable because of the product you’ve built, the team that developed it and the market you’re trying to capture.

VCs will want to satisfy themselves that the assessment they’ve made of these things is accurate or realistic as possible.

As the saying made famous by former US President Ronald Reagan goes: “Trust but verify.” Due diligence is all about verification.

HOW DOES DUE DILIGENCE WORK?

A VC team will collect material for inclusion in a “qualification memo” to be circulated among their relevant staffs and stakeholders. The memo will be kept as a record for the fund and its investors about investment. This memo is an important document for your investors. You should help them make it as accurate as possible.

WHAT YOU ARE LIKELY TO BE ASKED TO PROVIDE:

  • Some consumer/ user references
  • Some professional references for each founder
  • Incorporation documents
  • A capitalization table
  • Patents and filings for patents you have claimed
  • Financial statements since the company’s founding
  • Prior financing documents

TIPS:

  • Be wary of any investors offering to “invest on the spot.” If it sounds too good to be true, it probably is. Credible investors don’t behave like this.
  • You should warn your customer referees that they will get one call from each VC doing due diligence on you that you appreciate them taking 30~45 minutes to talk. VCs may ask them about their really experiencing problems that your product supported to solve; their previous solutions and their comment about your product’s cost, time and quality.
  • Send over all the requested documents at the start of the process, rather than drip-feeding emails over a period of days.
  • Help VCs produce an accurate and realistic document
  • Anticipate the questions you will be asked and prepare in advance
  • Line up your customer or user referee beforehand and ensure they have what they’ll need
  • File requested documents in one go, early in the due diligence process.

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