When you’re trying to get people excited about your idea, it’s tempting to want to gild the lily. But startup founders should never put themselves in a position where they’ve overpromised only to underdeliver. It can — and almost always will — catch up to you because of a little thing called financial due diligence.
This is the process potential investors use to vet your startup. It can also come into play if you ever explore a merger or acquisition. Plus, it can be a tool you use to vet vendors and certain types of customers, too.
So what is it, actually? In short, financial due diligence is the process that dredges up all of the details about your startup or another company/person to make sure everything adds up.
Because of this, every startup founder should have at least a grasp on financial due diligence. To help you get a handle on what it means in the startup world, let’s look at it in three specific use cases: with investors, during M&As, and internally.
Financial due diligence for investors
Before an investor will cut your company a check, they want to be sure they have a clear idea of your current value and likely growth. As a result, they’re willing to invest time and resources into due diligence.
Every angel investor and VC firm has a specific process they use here, which means due diligence might look different for each different investor. That doesn’t mean you can’t prepare, though.
So you’re ready for any investor to perform financial due diligence, make sure these things are accurate, organized, and ready to hand over:
- Financial documents and reports: Since we’re looking at financial due diligence here, this probably comes as no surprise. Generally, during due diligence, investors will want to see your company’s:
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- Balance sheet
- Income statement
- Cash flow statement
- Revenue stream, including analytics on your customer acquisition cost (CAC), churn rate, etc.
- Growth forecasts and revenue projections
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- The details of your business structure: This will generally include your capitalization table, articles of incorporation, and information about your founders and key employees. Some investors may want to talk to members of your team, so have their contact info ready.
- Critical business components: While the above two components tell an investor a lot about where your business is at, angels and VCs still want to make sure your model is sustainable and capable of growing. For that, they may want information about your key customers and vendor relationships.
Again, different investors have different processes here. The main thing is to be responsive. You may want to clear availability for yourself and certain members of your team so you can gather up and organize any requested documentation.
It can be tempting to fill in the gaps in areas where you’re not sure or pick and choose data to make your company look better. Don’t. Most investors have contracts that will give them legal recourse if you knowingly misrepresent your startup. Be transparent during due diligence so you don’t run into problems down the road.
Due diligence for M&As
At a certain point, you might be approached with an acquisition offer or a merger. Both you and the potential buyer/merging company should do your due diligence.
If you eventually decide you want to buy another company, that’s doubly true.
During M&As, due diligence plays a critical role. It’s not enough to just scan a company’s books. You need to dig deeper. Bad bookkeeping practices could make them look better than the reality. The last thing you want is to find yourself tied to a company in a compromising position.
As part of the financial due diligence process during M&As, involved parties should thoroughly look over all of the other company’s key financial statements and projections. At the same time, they should evaluate risk areas, like vendor or supply chain problems or imbalanced customer concentration. Look into fixed assets and inventory, too.
Ultimately, financial due diligence requires a two-pronged approach here. You should be looking at the company’s financials, of course, but you should also be evaluating the company’s ability to maintain them accurately. Fraud, mismanagement, and countless other issues could make the merger or acquisition a bad idea for your company.
While you could potentially conduct due diligence yourself, it’s generally advisable to hire a third party to conduct financial due diligence during M&A transactions. This will deliver more detailed, accurate information without taking over your desk or other key employees’.
Due diligence to help your startup succeed
Lastly, there may be instances when your startup wants to conduct financial due diligence itself. You may benefit from going through this process when you’re hiring a new vendor or considering bringing a new partner on board, for example. If your startup will be reliant on a person or entity, financial due diligence can protect you from a serious headache — or much worse.
Some startups also perform some level of financial due diligence with particularly large clients. If a sizable portion of your revenue stream will hinge on accounts receivable from any single client, it may make sense to ensure they don’t have a track record of missed payments or outstanding balances with other companies.
As a startup founder, entering into a financial due diligence process can feel stressful. But it’s a key part of landing investors, especially if they’ll be giving you a sizable sum of money. Similarly, it’s critical in any M&A transaction. It could save you from hitching your horse to a wagon with problems. And some startups even use it to protect themselves before entering into relationships with important vendors, partners, or customers.
In other words, due diligence will always be a fair bit of work. But it can be an extremely useful tool once you learn how to wield it.
If you want help preparing for financial due diligence or pinning down the key areas to look into during your own due diligence process, talk with us. Our expert accountants work exclusively in the startup world, which means we can help you navigate these waters. Get in touch today.