Raising funds is a crucial part of the startup lifecycle. Although it is possible to bootstrap and run a startup on a shoestring budget, it’s not a very practical approach for most tech verticals nowadays. To be able to scale quickly, bring in the needed talent and outdo the competition in the market, getting investments from angel and venture capital investors is a step most startups will need to pass through successfully.
The process of securing investments begins from the preliminary discussions and moves into the presentation of a term sheet (read our article on how to understand a term sheet here), negotiations, and then the preparation and execution of the investment agreements. Before the last stage, however, the investor will carry out what is referred to as Due Diligence (“DD”) on the startup. This is the process of gathering, understanding, and evaluating relevant information about the company’s operations to understand the legal and financial risks inherent in the investment.
The scope of the due diligence varies depending on a variety of circumstances such as the location and industry in which the startup operates but generally, investors will focus on the corporate status of the company, the financial situation of the company, and compliance by the company with relevant laws and regulations.
It is important that startups prepare well in advance for the due diligence process because if investors find too many red flags, it might sour them off the deal and even stop the deal from going forward in some cases. To that end, here are our tips for startups to go through the process successfully:
1. Review your Team Profile
Investors will likely want to get extensive information about the company’s early employees. More often than not, angel investors invest in teams, not in individuals. They’ll want to do their due diligence on the team to ensure that it has the talent necessary to execute and deliver high-quality products and services, but also the integrity necessary to manage the company’s finances (including the investors’ money) properly. Before writing a check, an investor may wish to speak with individual key team members to get their business perspective.
It’s important for startup founders to be transparent with one other about their employment and entrepreneurial history, to be sure that no team member has any red flags in their background that might give investors pause. Where any issues exist, attempting to hide them from the investors can result in legal liability depending on the language of the warranties contained in the investment agreements.
2. Regularize Your Corporate Status
The corporate status of a startup is typically the first port of call for investors. They would want to be certain that the company has been incorporated properly and is operating without any defects that could hamper its ability to continue operating. In many countries, interested persons can find basic corporate information about a company simply by paying a fee and conducting a search on the company registry’s website. Many potential investors might do this and simply lose interest in pursuing a deal if they find too many red flags.
One common flaw most early-stage companies have is a failure to keep the statutory books that companies are required by law to keep such as minutes book, membership register, etc. Also, there’s often a backlog of filings and returns which have not been made at the companies registry. These are easy fixes that can and should be done well in advance of the investor’s due diligence process since it will likely be the starting point of most investors’ investigations.
3.Regulatory Compliance
Once it is established that your company is properly registered, the next thing investors will likely focus on is whether you have all the licenses and permits necessary to operate in your chosen industry. This is important because many industries, like financial services or health, have very strict requirements, and failure to secure the requisite licenses before commencing operations could lead to severe regulatory penalties, including fines or a ban of the products/services.
To put potential investors’ minds at rest, startups must work with their legal counsel to conduct a thorough review of their regulatory environment and ascertain the licenses required to operate their business model. In our work advising startups in various industries, we have found that most startups initially overlook some permits which might have been established by state laws or minor regulatory agencies. Missing any licenses or permits puts startups at risk of disruptions, and savvy investors will spot them.
4. Finances and Revenue Streams
As part of the due diligence process, expect investors to dive deeper into your key revenue streams. If you sell a subscription service, they’ll want to know various metrics like your churn rate and your cost per acquisition. Investors will want to know that the revenue streams will continue to grow in the future. For startups in the proof-of-concept stage, investors conducting due diligence will want to see financial models that predict the potential revenue in the short, medium, and long terms.
To facilitate this, you will need to share sensitive financial information with the investors. Although the instinct, understandably, might be to make the numbers look as good as possible to ensure the investment scales through, startups that fudge figures will be at severe risk of legal liability if the investor sues for breach of contract. In some instances, the founders may also be personally liable for fraud.
5. Corporate Governance and Policies
Corporate governance refers to the internal systems and processes by which a company is run, including the powers and duties assigned to each officer and the agreed-upon actions to be taken in the event of specified occurrences. One crucial example of this, from the perspective of a potential investor, is how funds are used by the company. Who makes requests? Who approves them? Who can withdraw funds from the company accounts? Who keeps the records?
Investors want to have this information to understand the degree of control the founders have, and the kind of accountability they might expect from them. Startups should consider drafting the relevant policies such as financial policy, accounting policy, anti-sexual harassment policy as quickly as possible with the help of their legal counsel. Apart from showing investors a high level of organization, they will also help to clarify the company’s internal processes and prevent avoidable abuses by founders or employees.
6. Having an Organized Legal Data Room
The last crucial step startups must take to go through investor due diligence processes smoothly is to have all the necessary documents prepared and organized in advance. This is not difficult, as much of the documentation which angel investors and venture capital investment firms will require for their due diligence is similar and will largely be repeated over the course of multiple deals.
The essential documents include previous investment agreements, the company’s cap table, and key agreements. It’s important to ensure that all documents are properly executed, to assure the investors that the contents are valid and legally binding. Startups must also endeavor to keep the data room updated by adding and removing documents when necessary as the company evolves.