This article is written by Rithi Mukherjee, a graduate of Delhi University, currently a fraud investigation professional
Starting a business is not for the faint of heart. But if you are ready to turn your idea into reality, entrepreneurship is an exciting journey that will forever change your life. From overcoming challenges to landing your first client and actively managing risk.Starting a business and becoming an entrepreneur is exciting — it is also terrifying. After you leave your full-time job, you will face several common challenges that all entrepreneurs face–chief among them instability, stress, and solitude.One of the most important lessons a successful entrepreneur has learned is the ability to manage risk. The ability to manage risk is what sets an entrepreneur with an idea apart from one that actually builds a business from it. The greatest risk any startup could run into is running out of cash or available credit. Entrepreneurs should relentlessly concentrate on controlling costs and managing this risk.
For the elite startups and entrepreneurs who manage to attract the investor they dream of and survive the term sheet negotiation, there is still one more hurdle before the money is in the bank. This is the mysterious and dreaded due diligence process, which can kill the whole deal. In reality, it is nothing more than a final integrity check on all aspects of the business and the team.
First of all, what is due diligence?
“Due diligence” is just the fancy name given to the research process that is carried out prior to making an investment. It usually involves an investigation into a person or people, a business, or a marketplace.
Some entrepreneurs do very little to prepare for due diligence, assuming all the talking has already been done, and the business plan and results to date tell the right story. Others schedule exhaustive training sessions for the team.If there are conflicts within the team, differing views of the strategy, or evidence of missing processes and tools, the investment process will likely be terminated.The key theme for a successful due diligence is full disclosure and no surprises before or after the commitment.
Startup-equity investments imply a long-term business relationship, lasting an average of five years. During that period, it is very difficult for either party to get out of the deal, since there is no public market for the stock, and business divorces normally mean bankruptcy. It’s worth your time to do a little extra work here, and make this phase a win-win one for both sides.
Why does it need to be done?
As an investor, you want to know that the money you put into a business will be used in order to deliver whatever plan has been set out in the company’s business plan, investor presentation, etc.Sometimes, start up, early stage, and even some established business fail for reasons outside of the business owners’s control. These things, unfortunate as they are, are usually the result of a sector crash or more general economic downturn.
This is why due diligence is carried out. So that , the investor, can gather all the facts and information you need in order to decide whether or not the product, service, or venture you invest into is right before you part with your money.
Although investing online through an equity crowdfunding platform is still a relatively new process, investors of all types, from the new business angel to experienced angels, and those in networks, have found ways of utilising the web in order to conduct their own due diligence
Online Due Diligence?
In a number of different ways. Just as finance is crowd-sourced on an equity crowdfunding platform, so too is due diligence.
Director checks Prior to listing the owners of the business looking to raise equity finance, are required to undertake a director check. This is a background check into the people themselves, rather than the business. The main reason for this is that in a lot of the cases we see that the company either isn’t running yet or if it is, it hasn’t been operational for very long.
Then you can have the overview of the business: meet the team, and download resources such as their business plan, investor presentation, and financial forecast.
You can check business owners out via their social media channels (both professional and personal. Use Twitter, Facebook, LinkedIn, Google+, and Pinterest, etc to see how they interact with their audience. You can often get a fair sense of who a person is and what they’re like by looking at their social media activity.
Do it face-to-face Contact with the business owner or arrange a Skype or telephone call, or enter into an email exchange with the business owner. If you’re making a larger investment, you may like to arrange a real face-to-face meeting.
Key elements of due diligence process
For reference, here is a quick summary of key elements that most investors include in their due diligence process:
- Competitive landscape: They prepare a summary of local and global players in the same/similar area and collect as much information as possible.
- Exit potential: There is also a list of potential acquirers and document why they would acquire a company like this.
- Founder’s pre-nuptial: Co-working arrangements terms should be documented by the founders. Verbal agreements or inappropriate drafting of these arrangements can cause lot of disturbance for the company. If possible, also need to get founders to sign a non-disclosure and non-compete in case of a break-up.
- Employee contracts: Employment, non disclosure and non-compete agreements duly signed by all part-time as well as full time If there are non-local employees, their legal employment status should be duly signed.
- Pre-existing liabilities: Founders should disclose all pre-existing liabilities including options granted and/or notes issued to third parties. Get them to sign an undertaking.
- Licensing agreements: If the entire technology of a part of that technology is licensed from an external party, the terms and conditions of usage of technology should be properly documented.
Legal and Secretarial
- Memorandum and Articles of association should be up to date to ensure that they reflect all the changes made during the previous investment rounds.
- Minutes of all previous board and shareholders meetings should be up to date.
- Details of all existing/previous/threatened legal disputes, litigation, arbitration or judgement/s should be present (certified copy). A declaration/undertaking from the founders that information provided is complete to the best of their knowledge is also desirable.
- Details of all Patent, trademark, copyright applications (in-progress and/or granted).
- Copy of latest board approved budget, management accounts and audited financials (if available). Compare revenue and expenses between budget and actual accounts to identify and explore deviations. This can also be used to analyse future projections.
- Review gross margins and net margins for each product line and assess if direct expenses have been pushed below the line as overheads.
- Analyse working capital items (debtors, creditors and inventory). Ageing list can be very helpful.
- Ensure that amounts due to technology and other service providers are accrued and recorded in accordance with agreements as liability even though they are not paid out.
- Details of bank mandates and signatory limits.
- Copy of bank statements for all the accounts held in company’s name. Match bank balances with the latest audited/unaudited financials provided.
- Ensure that the company has filed all its tax and annual returns with relevant authorities. Get copies of tax assessment notices.
- Carefully look for related party transactions and ensure that they were conducted at arms
- Go through the list of fixed assets and verify material items. If there are huge intangible assets capitalized in the balance sheet, make sure that they are valued realistically.