What is Due Diligence? 

You're the founder of a promising startup and have attracted the interest of potential investors? Congratulations! You've reached an important milestone on the road to growth and success. But before you venture into the world of corporate finance and begin selling shares in your startup, it's crucial to prepare for a significant step: Due Diligence.

Within this blog article, we provide you with a comprehensive insight into due diligence and the key considerations you need to take into account. Additionally, we give you an example checklist that you can use to ensure you've covered all aspects during your due diligence process.

Definition of Due Diligence

The term "Due Diligence" essentially means "careful examination." This translation accurately captures the essence of what due diligence entails. Due diligence involves a comprehensive analysis of your company, wherein information about your company is disclosed, examined, and evaluated by external parties.

When is Due Diligence Conducted?

Due diligence is typically conducted when buying or selling company shares. Its purpose is to assess the condition of your company, and it plays a key role in securing an investment. Discovering significant deficiencies during due diligence can lead to the termination of the buying or selling process.

Who Conducts Due Diligence?

Due diligence is typically commissioned by potential investors who have a strong interest in investing in your startup. Through due diligence, investors aim to assess the risks of their investment. While in theory investors can carry out due diligence themselves if they have sufficient expertise, in practice, external service providers specializing in company audits are often employed.

As the founder, you also play a pivotal role in due diligence. You must ensure that all necessary information is disclosed and accurate. Moreover, you shoulder the responsibility of representing your company to the best of your ability to secure a favorable investment.

Stages of Due Diligence

The process of due diligence can vary widely depending on the requirements and the nature of your company. Broadly, the process can be divided into the following stages:

Preparation

During The preparation phase, the founder and the investor discuss the framework for the due diligence. Questions to be addressed include: What aspects will be examined and to what extent? Who bears responsibility for specific tasks? What data and information will be required? How will the data and information be provided? Once these questions are answered, it is advisable to draw up a non-disclosure agreement (NDA). This agreement protects the founder, as sensitive company data will be scrutinized during due diligence. It's also a good idea to agree on a Letter of Intent (LOI). This document commits investors to buying shares in your company following a successful due diligence process. In return, founders often commit to not negotiate with other investors during this period. Penalties for terminating due diligence prematurely may also be included to cover incurred costs.

Information Exchange

Once the framework has been established, the necessary information and data must be provided. This entails substantial effort for both founders and the evaluating party, involving the preparation of a large amount of data. Relevant data may include financial data, business plans, contracts, legal documents, and personnel records. The technology stack of the company is often also requested to gain an overview of the technologies, software products, frameworks, and programming languages used.

Due Diligence

The most time-consuming phase, the due diligence itself, begins. All the information and data provided must be organized, verified, and assessed. Depending on the size and complexity of the company, this process can take several months. To streamline and organize the due diligence process, subcategories are usually established. Details of these subcategories and their focus can be found in the section below titled "What is examined during due diligence?”.

This stage presents a number of challenges, as disagreements and conflicts can arise. To avoid this, a structured approach and effective teamwork between the founder, investors and valuers is essential. Ensure that your team is cohesive before entering this phase.

Risk Assessment

After completing the due diligence, the findings are consolidated, and a risk assessment is created. This evaluation influences the negotiation terms and investment conditions.

Negotiation

With all facts laid out and the risk assessment of investing in your company in hand, the goal is to negotiate a favorable deal with the potential investors and define the investment conditions. If you're interested in tips on how to negotiate successfully to secure an attractive cap table, check out our blog post dedicated to the subject of cap tables.

Contract Signing

The ultimate aim of due diligence is the signing of the contract. Once all parties are satisfied with the due diligence results and have reached a consensus on the negotiated investment conditions, the investment contract is signed, thereby formalizing the investment process.

What is Examined During Due Diligence?

As previously mentioned, due diligence is often divided into subcategories focusing on specific areas of your company. Please note that the following subcategories are examples only and by no means universally applicable or comprehensive.

Legal Due Diligence

In this type of due diligence, all legal aspects concerning your company are examined. This can encompass labor law matters, shareholder agreements, regulatory affairs, or ongoing legal disputes. Legal due diligence also covers patents, intellectual property rights, inventions, and trademark registrations.

Financial Due Diligence

Financial due diligence revolves around your company's financial figures. This includes a meticulous examination of the capital structure, profit and loss statements, accounts receivable, liabilities, liquidity, and assets. Clear and transparent reporting is crucial for this aspect to facilitate assessment.

Tax Due Diligence

This category involves a comprehensive analysis of all tax-related information pertaining to your company, including tax payments, tax risks, or other tax implications.

Market Due Diligence

Market Due Diligence examines your market position and business opportunity. It assesses the current state and development of the target market, as well as the strategic direction for successfully entering the market.

Management Due Diligence

This is where you, as the founder, take center stage. Management Due Diligence evaluates the competence of your start-up's management team. It identifies strengths and potential areas where expertise may be lacking to effectively run the business.

Technology Due Diligence

Technology Due Diligence entails a comprehensive evaluation process that meticulously analyzes your organization's technology infrastructure, software architecture, and innovations. It ensures that your organization's software initiatives are founded on a solid foundation capable of supporting future growth.

Exit Due Diligence

This type of due diligence is particularly significant for venture capital funds. VCs are driven by exits, which means they exit your company after a specific period. Hence, exit due diligence evaluates available exit options and explores the conditions under which an exit could occur in the future.

Conclusion

In summary, due diligence stands as an indispensable and demanding phase within the corporate financing process. It enables a thorough assessment of potential risks and opportunities for a startup prior to investors acquiring shares. Successful due diligence requires close collaboration between founders and evaluators to transparently and accurately provide all relevant information. The structured examination across various categories, including legal, financial, tax, market, technology, management, and exit strategy, provides a comprehensive foundation for well-informed investment decisions. If all parties are content with the results and agree on the conditions, due diligence can culminate in a successful investment agreement, paving the way for a promising future for your startup.

To ensure your due diligence success, we've compiled a checklist for you to review necessary steps. 

Important note: This is an example and by no means universally applicable or comprehensive. The checklist must be tailored to your startup’s specific circumstances and only serves as inspirational guidance in this example.

Example of a Checklist for Your Due Diligence

Financial Documents:

• Annual financial statements from the previous years
• Profit and Loss statements 
• Balance sheets
• Revenue and cost projections
• Liquidity status and cash flow analyses

Business Plan and Strategy:

• Current business plan and future strategies
• Market positioning and competitive analysis
• Potential risks and challenges

Legal Documents:

• Incorporation documents and bylaws
• Contracts with customers, suppliers, and partners
• Legal disputes and ongoing court proceedings
• Intellectual property (patents, trademarks, copyrights)

Personnel and Management:

• Organizational chart and responsibilities
• Resumes and qualifications of executives, and potentially the entire team
• Employment contracts and salary structures
• Open positions and workforce planning

Customers and Suppliers:

• List of major customers and their revenue contributions
• Customer retention strategies and contracts
• List of major suppliers and dependencies

Technology and IT Infrastructure:

• Overview of utilized/developed technology
• Software licenses and technical support
• IT security and data protection measures

Tax Aspects:

• Tax returns from the past years
• Outstanding tax liabilities
• Special regulations or tax incentives

Real Estate and Assets:

• List of company assets
• Property ownership and lease agreements
• Condition of machinery and equipment

Insurance:

• Existing insurance contracts
• Liability coverage and policies

Compliance and Regulation:

• Adherence to industry laws and regulations
• Environmental and occupational safety regulations
• Licensing and certifications

Customer References:

• References from existing customers or partners