What Founders Must Know About Investor Due Diligence

Founders raise capital to help fuel product development, scale operations, attract talent and even gain a competitive advantage in the market. Average seed investment rounds are $3 million, but intense due diligence takes place from:

• Founders
• Investors

Investors will assess the company, market traction, product and other factors as part of their due diligence before feeling confident enough to invest in the market.

Founders will also conduct their own due diligence to verify that the investor is a good strategic fit for the company’s future.

Both parties must perform their due diligence on teams, financials, the market and more, which we’ll discuss in greater detail below.

What is Due Diligence and Why is it Important?

Due diligence is a way of avoiding fraud and is the first step to raising funding. Investors will conduct in-depth investigations into your business to better assess:

• Current risks
• Market conditions
• Potential rewards
• The competitive landscape

Business owners will do the same and “vet” the investors to learn if they’re:

• A good fit for the company
• Hands-on or hands-off
• Known for offering additional funding rounds

Due diligence works both ways. You want to raise capital from an investor that you trust, and they want to know the risks and potential upsides of investing in your business.

Investors prefer transparency, but this is also a time of reflection for your business. Use due diligence as a self-assessment tool to identify core weaknesses, address shortcomings and adjust your strategies to strengthen your market position.

Types of Due Diligence

Due diligence evolves as your business grows. Investors will look at different areas of your company if it’s a startup or a later funding stage. Main areas of concern include:

Team

Investors are investing in your team. Expect background checks on all founders and leaders in the business. A few key areas that will be assessed include:

• Experience and skills
• Leadership qualities
• Cultural alignment as pertains to the investor’s philosophy
• Track record of success or failure with other businesses

You can showcase these key pieces of information to investors by showing your team’s education, work and industry experience. Show your team’s passion and vision, and be upfront about weak areas of your team that the capital will help correct.

Financial 

Investors want to manage risks, which is why financial due diligence is one of the most intensive and technical. Areas where the most attention is given are:

• Financial statements
• Income and balance sheets
• Cash flow statement and management
• Revenue streams, profit margins and growth trends
• Burn rate and runaway with current funding

Your accountant or CFO can help you present your financials in a transparent, favorable way.

Market

Does the company have room for growth? Are customer needs and pain points being met? Comprehensive market analysis will take place to:

• Evaluate current market size and growth potential
• Existing competitors and their strengths and weaknesses
• Customer needs and pain points
• Regulatory environment and how it impacts the business’s ability to grow

Technical

Due diligence may also focus on the company’s technology infrastructure to assess its security, functionality and scalability.

Key areas of focus include:

• The company’s tech stack, frameworks and libraries used to build the product in order to assess its scalability
• Analysis of the system’s architecture, including how it stores data, its security measures and its disaster recovery plans

Technical due diligence is complicated, but it really only applies to organizations in the tech sector.

Legal

Legal due diligence focuses on how the company complies with relevant regulations, both domestic and international. For investors, this process is all about mitigating risk and ensuring the company is operating within the legal framework.

Several things may be reviewed, including:

• The company structure and legal standing 
• Intellectual property ownership and potential infringement issues that may arise
• Contracts and agreements to identify restrictions or potential liabilities
• Pending lawsuits, judgments or other legal matters that may impact the company’s future

As you can see, there are many types of due diligence, and each one has its place. While these processes offer many benefits, challenges and drawbacks should not be overlooked.

The Pros and Cons of Due Diligence

Due diligence is a valuable exercise for both investors and founders. Yes, it’s time-consuming and there are challenges, but it also offers a wealth of benefits.

Let’s weigh the pros and cons. 

The Advantages

For companies, due diligence:

• Identifies areas of improvement, allowing you to implement more strategic changes and present a more compelling case to investors.
• Builds trust with investors, as it opens up communication between both parties.
• Helps attract investors who align with your company culture and long-term goals.

For investors, due diligence:

• Uncovers potential risks, liabilities and other issues before committing to the investment.
• Sets realistic expectations and provides a sense of security for everyone involved.
• Provides clarity on the business’s finances to avoid losses or conflicts with founders and the team.

The Drawbacks

Although there are many advantages to this process, there are some challenges and drawbacks to consider.

• The process can be lengthy, requiring a great deal of resources from founders who may already be pressed for time.
• Sharing sensitive company data can be concerning, especially if the fundraising round is not a success.
• Due diligence may reveal a misalignment between investor expectations and the founder’s vision, leading to a failed funding round.
• It doesn’t eliminate risk entirely – unforeseen circumstances may still pop up.
• Extensive due diligence periods can cause deal fatigue for investors, leading to lost interest.
• If any red flags arise when reconciling your balance sheet, investors may walk away.

Although due diligence is par for the course when it comes to fundraising, these pros and cons should be considered to ensure the process goes as smoothly as possible.

The Takeaway

Fundraising is an exciting time for startups, but it’s important to go into this process with clarity. Yes, it takes time, but it provides a clear picture of the business’s finances for both investors and companies.

Do you need help getting your accounting in order before a fundraising round? We’re here to help. 

To learn more about our accounting services, schedule a consultation now!