How to Prepare for a Due-Diligence by Investors

Learn about how and what to prepare for a due diligence by potential investors.

Prior to investing in a business, investors have to fulfil the responsibility of carrying out the necessary ‘checks on their investment to ensure that they get maximum return from it. The process of investigating the prospects of investment by potential investors is termed as ‘due diligence’. 

Fundraising terms that all entrepreneurs should know

What is due diligence?

Due diligence is a comprehensive investigation conducted in the form of research by one party before it enters into a contract or an agreement with another party. The basic purpose of this investigation is to answer all sorts of financial, operational, cultural and legal queries related to the target company’s history, background, prospects, business plan, and goals early on. It is also conducted to ensure whether the information and materials provided regarding sales and other financial aspects by the target business to the investor are factual or not.

Why is due diligence important?

The level of risk associated with each investment greatly depends upon the investors, investing scenarios, the size and structure of the firm.  For instance, high risks are associated with investments made on startups as compared to medium-sized businesses, so due diligence of a broader capacity needs to be done by angel investors or venture capitalists. The greater the time dedicated to due diligence, the clearer the forecast of the returns expected on the investment made. Investors want to mitigate the risks through the process of due diligence early on and identify any red flags that may prove to be a threat to their investment later down the line.

A Thorough due diligence provides investors with a chance to get a better understanding of their target investment after preliminary negotiations have been made with the business owner. The investor may seek to renegotiate the prior terms agreed or in some cases may even refuse to carry on with the investment, if due diligence raises concerns and doubts. Similarly, due diligence may result in additional negotiations and more comprehensive terms and conditions when closing the final deal with the business owner.

What are the types of due diligence investors carry out?

As due diligence requires the investors to analyze every aspect of the business, the process of due diligence varies according to the maturity and stage of the business in the funding cycle,  which may also be called as the ‘investing scenario’. 

However, no matter how much the investing scenarios differ, typical due diligence by investors will include:

1. Commercial due diligence
2. Financial due diligence
3. Legal due diligence
4. Tax due diligence

How do investors do due diligence?

The method of due diligence requires investors to thoroughly examine the target company’s financial and legal records. Financial statements, audit reports, and annual or quarterly tax returns are the key documents usually inspected by most investors. Due diligence requires the investors to inspect every minute detail of the financial aspects of the target company, this may assist in the assessment of the current financial progress of the company and may provide a rough estimate of potential future profits, costs and other liabilities. Having a specialist accountant, accounting firm or an accounting specialist such as a CFO or FD can greatly help with assessing the financial picture.

Investors can ensure future profitability and successful achievement of their goals by paying site visits at the target business to assess the company’s real estate and physical infrastructure. They can check whether the company’s physical infrastructure offers adequate security against their investment and is capable of providing the services up to the required scale, as has been promised. 

Due diligence also forces investors to take a look at the human resource policies of the company. Training agendas and employee handbooks are reviewed by investors to help them understand the potential employee retention issues and the overall corporate culture of the company.

Along with financial due diligence, legal due diligence is also considered essential to check whether the company has been compliant with the state’s laws and regulations in the past and to check the target company’s agreements and any ongoing lawsuits and their potential liability. It is also done to investigate whether the company has been regularly filing its liable taxes and to check whether there are any tax liabilities resulting from errors and failure to stay compliant with the tax regulations. If you are a target company, make sure you get an internal audit done by a specialist chartered accountant or a service tax accountant, and a lawyer to make sure that your contracts, agreements and compliance arrangements are in order before initiating due diligence.

Why is the target company’s cooperation with the investors necessary while doing due diligence?

The main purpose behind due diligence done by investors is to gather and check the authenticity of the information that is provided by the target business, to examine the prospects of the investment opportunity. From the investee’s side, the business reveals the information to the investor to substantiate the claims made about the prospects of the investment, during the early stages of the negotiation. Therefore, mutual cooperation between the investors and the investees is required to conduct successful due diligence. 

The cooperation from the investee side requires the ability of the target business to provide all of the information required for due diligence and their willingness to provide relevant and truthful information. The investor’s part in the whole process is somewhat more complicated than the investees, especially when a large-sized firm decides to invest in a small business. This may be due to the fact that a small business owner is more focused on the growth and development of the business rather than on reporting and preparing for investors inquiry. The investors have to analyze the opportunity with all the details at hand, so their information requirement may be more comprehensive and sophisticated as compared to the information available with the business.

Challenges may arise when the investees mitigate their risk, by putting limitations on the information they will provide to the investors for the purpose of due diligence, as by disclosing too much internal information about the business, business owners risk leaking sensitive data and company secrets to the outside market. By providing a large amount of internal information, the investees increase their vulnerability, especially if the potential investor belongs to the same industry. As a result of this, the availability of limited information increases the investor’s risk and may ultimately lead to an unsuccessful transaction.

Hence, mutual cooperation of trust and transparency between the investors and the target business needs to be in place, in order to ensure successful due diligence. Non-disclosures and non-compete agreements might have to be put in place.

What are the essential documents usually requested by the investors when conducting due diligence?

Investors may dedicate a lot of time to fact-checking while doing due diligence, and as a result, investors may demand financial reports to confirm the details provided by the target company. They usually want to examine the sales data, market data, and employee data, so there is a lengthy list of documents that may be requested by investors. The wisest approach is to keep these documents in order before your potential investors request them for examination. Following are some of the essential documents requested:

• Business plan
• Agreements between customers and suppliers
• Organizational charts
• Financial management reports
• Past financial and tax reports (balance sheet, income statements or tax returns)
• Business partnership agreements
• Articles of association
• Shareholder arrangements
• Government authorizations
• Employee breakdown document
• Previous Investments
• Employee Contracts
• Audit Reports

Other than these standard documents, there are other documents requested that are more customized and have to be prepared specifically according to the needs of the due diligence process.

Key metrics spreadsheet: These may include details about your revenues, your company’s lifetime value, the firm’s burn rate and other important metrics that you have been keeping track of.

Cash Burn Rate: Managing Your Startup’s Finances

Your projections for the coming years: These documents hold significant weight in the due diligence process and help investors understand the business’s capacity to scale and identify any red flags in the business plan early on.

Case studies of your important customers: This assists in understanding the customer acquisition costs and also helps the investors know about the customer base that the business plans to target for the purpose of sales.

How can you prepare yourself for due diligence by potential investors?

Clear House Accountants are Accounting specialist in London who have been working with businesses and investors helping them create data rooms, prepare and review financial due-diligence and improving financials to appear more impressive to potential investors. Contact us to learn more.