Due Diligence for startups

Blog post by Espen Bordvik, COO of SocialBoards

Founding is hip

Being a founder and running a startup now seems to be one of the coolest things to do. The challenges are numerous, and thousands of startups are constantly hunting for growth and for financial support. Who has the momentum or power to succeed on this battlefield? It’s no longer David against Goliath. It’s 10 Davids against Goliath. And in this story, some Goliaths are smart enough to join forces with a couple of the Davids. If 9 out of 10 fails, it is often the one that enters smart alliances that wins.

While the business idea and the promise of success are the key motivational factors for many founders, the CEO must also pay attention to investors, both existing and potential new ones.

Exiting a startup

For this is how the story often goes. A startup that gains traction and growth from more users or increased revenue could speed up the growth through investment rounds. Eventually, the founder cedes control of the business to others, and for many founders, the end game is a buyout backed by Venture Capital, an IPO or an industrial acquisition where the startup is integrated into a larger corporation.

Preparing for exit

Preparing for the exit is key, both the exit, but also in respect of the fundraising series from the seed rounds onwards. Investing in startups binds up the investor’s capital for years, and early phase startups are very high risk. The likelihood of getting any return from a startup is very low, and if the investment pays off at all, it could take ten years.

"Founders should realize that any experienced investor will search to mitigate their losses and for a reasonable exit within some years. Therefore, the growth strategy and potential exits should be visible in the pitch deck".

A due diligence is an investigation of the target company. The first funding rounds for a startup are often supported by private individuals called angel investors, rather than venture capital or large corporations. Angel investors often invest on their own account, and view risk differently than venture capitalists.

Venture capitalists must perform a full due diligence of the operating business, whereas angel investors should undertake soft due diligence to see if the business project and the team match their investment-risk comfort level. Contrary to investing in asset heavy industries, the asset in startups will often be a synthesis of the ceo, team, idea, customers and traction. It’s indeed fragile!

Typical checks points for the soft diligence would be:

• Team – Get to know the team and the CEO, their ability and their commitment!
• Market size – Who are competitors, and what edge is needed to succeed in the market?
•  IP rights – Do they have full control over IP, code, logos and relevant domains?
• Code review – Is the code well written, and is the platform scalable?
• Budget and forecasts – Check if they are in control of the financials!
• Traction – Investigate actual revenue growth, user growth, retention, churn etc.
• Online profile – What image do they convey – e.g. do they attract followers in social media?
• Contracts – Check the essential key customer/employee/vendor contracts!

Due diligence upon exit

Fund raising is always on the agenda for many startups, and fund raisings are often made with an exit thesis. In preparing for an exit, the due diligence may vary, depending on the market, geographical location and the potential buyer. Chinese buyers, for example, prefer to build trust spending more time with key employees, than in the Virtual Data Room.

Industrial buyers looking to integrate the business will focus their due diligence on controlling and supporting the business case, whereas Private Equity and Venture Capital management will be investing against a pre-defined mandate, and must investigate the target in accordance with their fund-management liabilities.

Success is for the prepared

Regardless of the scope and style of the due diligence, the key to success is to be well-prepared. When an investor or acquirer considers committing a lot of money to a startup, they will check if the fundamentals align with their expectations.

If key contracts are not in place and verifiable, or a key element of the project is at risk, or if the financials and activity reports are not trustworthy, it could topple the investment or transaction might crumble. What motivates the performance of due diligence is risk assessment. And if the risk is too high, the investment that could power a new joint venture will be gone with the wind.

One final piece of advice; investors are often impatient. Any opportunity that comes along could be a one off. You must respond fast. And that’s why my advice is: always be prepared!