Amit Bhateja

Introduction

Investing in startups is a very lucrative opportunity for investors, but it can be a risky venture too. What if the startup does not work? What if the perfect pitch they saw is not delivered? What if returns are not timely and enough? To make sure that all the doubts are cleared, investors must conduct due diligence- a process which vets all the claims made by the startups before committing to any capital. Think of it this way: you will not buy a TV without reading the reviews, brand reputation, features, customer service, etc. 

The practice of due diligence is quite common when investing in startups; it investigates and verifies all key aspects of the startup in detail. Taking time and patience to complete the process of due diligence can minimize the risk, uncover hidden red flags, and maximize the chances of getting good returns by investing in promising, scalable startups. 

In this guide below, we talk about due diligence, its importance, and how to use a step-by-step approach to conduct due diligence before investing in startups. 

What is Due Diligence?

Due diligence is the simple way to audit the startups before agreeing to their fundraising request. It is a detailed investigative process that investors carry out to gain better understanding of the startups. It uncovers any risk indicators that might not have come out during the pitch presentation. 

Due diligence alerts help investors assess the future performance before investing in startups. There is no hard and fast process or method for due diligence for startups. Sometimes it can be a simple conversation post the pitch or other times it can be a detailed scrutiny into all the aspect of the business. It is not an uncommon process, and startups prepare for due diligence audits when pitching for investment. 

Importance of Due Diligence 

• Mitigates the risks for investors
• Validates the startup’s claims and confirms the potential 
• Asses founder credibility and team expertise 
• Ensures transparency in transactions with accurate information
• Ensure that the startup’s goals align with the investor’s goals and expectations
• Maximizes returns by identifying the right startups with solid foundations  

Not giving time to due diligence increases the risk of financial losses, frauds, and investing in startups with weak business models.

Types of Due Diligence?

For a full evaluation before investing in startups, different types of due diligence are conducted. Each covers a different aspect of business:

1. Financial due diligence
2. Lega due diligence
3. Market due diligence 
4. Operations and execution due diligence
5. Technical due diligence
6. Social and environmental sustainability factors 

These can be further broken down for detailed analysis. Not every startup requires all types of due diligence checks. 

Step-by-step guide to conducting effective due diligence before investing in startups 

There are 4 Ps of due diligence: People, Performance, Philosophy, and Process. These help make an informed decision about investing in startups and whether it is a viable investment. 

Step 1: Business Model and Market Potential 

Business due diligence is a way to evaluate a startup’s market potential and gain critical insight into the scalability, sustainability, viability, and growth potential of the startup. It provides details on if the startup can strengthen its position in the market over time. It gives the realistic expectation on growth to the investor. 

Questions to ask:

• What is their business plan and model?
• Why have they selected the particular model?
• What problem are they solving?
• What is the current market size and projected in 3-5 years?
• Who is the target market?
• How big is the market opportunity?
• What is the competitive advantage?
• What impacts their adoption and growth?
• What are the key performance indicators, and how well are they met?

Documents to ask for 

• Detailed business plans and pitch deck 
• Market research reports and look for positive and negative trends
• Customer Acquisition Costs and Lifetime Value 

Due diligence alerts 

• Burn rate concerns 
• No clear path about profitability and scalability
• Homogeneity in growth 
• Overestimation of market size
• Weak or irregular customer demand 
• Declining metrics 
• Low entry barriers in the startup niche 

Step 2: The Founding Team Due Diligence

The strength of a startup depends largely on how strong the founding team is. The clarity of the team brings clarity in all its operations. 

Questions to ask:

• What kind of experience and expertise does the leadership team have in the industry?
• What are their past commitments, for example, past ventures and their failures and successes?
• How committed is the team to long-term success?
• How much company share is with the founders?
• Ask for their performance in every area, including sales, product, engineering, marketing, finance, and operations.
• Are there any skill gaps, and how do they plan to fil them?

Documents to ask for:

• Founder profiles and professional details
• Team organization chart and employee ownership share
• References from the past employees, investors, and employers 

Due Diligence Alerts 

• High attrition rates 
• Low personal ownership
• Lack of knowledge in the industry 
• Lack of diversity 
• Frequent turnovers 
• Dependency on single founder 
• Lack of training programs for employees

Step 3: Financial Health and Revenue Model Due Diligence

In this step, verify whether the pitch numbers match the concrete numbers. Financial stability is directly related to the growth potential. 

Questions to ask:

• What are the cashflow overviews?
• What accounting policies do the startups follow?
• What is the current revenue and projected growth?
• Do they have a runway?
• What is the average burn rate?
• Have they had funding before, and if yes, how was the capital used?
• Are there any outstanding liabilities or debts on the startup or the founder team?

Documents to ask for:

• Profit and loss statements of the last few years or the balance sheet 
• Cash flow statements
• Previous funding details and Cap Table
• Revenue and Expense Breakdown Statement Summary report

Due Diligence Alerts

• Negative cash flow numbers 
• Fudged revenue model and undisclosed liabilities
• Inconsistences or missing data in the financial statements
• Improper use of funds and frivolous expenditures 
• Unexplained assets and liabilities 

Step 4: Product and Technology Due Diligence

This step is crucial to check if the product fits the market.

Questions to ask

• Is the product still in the development or prototype stage?
• Has it been tested in the market?
• How does its USP measure against the competitors?
• It the product or technology scalable, secure, and adaptable?
• Does it solve the problem?
• What is the core technology used?
• Can they prove ownership and licensing?

Documents to ask for:

• Product Roadmap and Development Plan
• Patents, IP, or Proprietary tech documents 
• Customer reviews and feedback

Due Diligence Alerts 

• High churn rates
• Poor feedback 
• Heavy dependency on third-party services 
• No clear plan for future iterations and product improvement
• Lack of strong security protocols 

Step 5: Legal and Compliance Due Diligence 

This step safeguards your investment against legal disputes and any losses that might be incurred because of lack of compliance. 

Questions to Ask:

• Are there any outstanding lawsuits against the startup?
• Any regulatory disputes or issues?
• Does the startup have the necessary licenses and trademarks obtained through proper channels?
• What are the employee contract terms?
• Have all the shareholders signed on the dotted line?
• Are there any legal disputes over intellectual property?
• Are corporate governance laws followed?

Documents to ask for:

• Employee contracts 
• Shareholder agreements
• Business registration and Legal Entity Documentation
• Pending or Past Lawsuits

Due Diligence Alerts

• Undisclosed legal disputes
• Non-compliance to rules and regulations
• Lack of formal contracts for employees or partners, vendors, loans, etc. 
• Lack of transparency in providing legal documents

Step 6: Competitive Landscape Due Diligence 

This is an important step to take before investing in startups. The great idea might look good in the pitch but might not stand against the competition. 

Questions to ask:

• Who are the direct and indirect competitors?
• What is the plan to win against competition?
• What is the product/service’s USP?
• Is their solution easily replicable by competition?
• What are the startup’s plans to position itself in the market?

Documents to ask for:

• SWOT analysis 
• Competitive Benchmarking reports 
• Market Share Analytics 

Due Diligence Alerts 

• No clear plan to differentiate from competitors 
• Over saturated market with high entry barriers 
• Weak competitive strategy
• Vague market competition analysis 

Final thoughts 

Making an informed decision regarding your investment is important for securing the capital and also making a decision on the exit strategy. Evaluate the risks carefully against the promised returns and potential returns. If necessary, get help from legal and financial advisers to understand the documents. Before finalizing your investment in the start, make sure you have all the facts and figures confirming that it is a high-potential and well-managed startup. 

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