In the age old classic, The Wizard of Oz, Dorothy is advised to follow the yellow brick road through the surreal and unfamiliar world of Oz until she reaches the Emerald City. Red boots and all, she, together with her travel companions, set out on this journey, facing some unnerving scenarios along the way. Sound familiar?
Although not written with start-ups in mind, this story can easily serve as a metaphor to illustrate the fascinating world start-up entrepreneurs must navigate on the “yellow brick road” to their next “Emerald City” destination – be it funding rounds, impossible deadlines, incubator pitches or that big exit – this journey has it all. One of the most important, however, not-so-often-discussed, destinations on this “yellow brick road” are due diligence investigations. This article explains why start-ups (or investors) should always keep this often-forgotten destination, and its potential impact on future investment success in mind.
What is a due diligence investigation (commonly referred to as a “DD”)?
Startuplawyer.com defines a due diligence as “an investigatory process performed by potential investors or acquirers to assess the viability of an investment or acquisition and the accuracy of the information provided by the target corporation (or start-up)”.
As such, although a due diligence is usually done by the investors, any start-up would be well-advised to consider the due diligence implications of all their actions leading up to that point. Simply put, this starts by ensuring that internal processes are in place to accurately and continuously record, save and timeously update documentation from the get go. More specifically, documentation and official company records, items relating to internal governance procedures, stakeholders’ communications and company information (i.e. organisation information, market size, team structure), key and material agreements, financial management and annual statements, asset valuation, regulatory approvals, product development and proof of intellectual property (IP) protection are all important for the start-up to keep on record. Furthermore, saving these documents in an orderly and easily accessible folder system eases the process of any due diligence investigation, which in turn, speeds up negotiations and valuations, potentially staving off weeks on an investment timeframe.
Why is it important?
Any sensible investor likes to determine beforehand exactly what it is that they are investing into and in doing so, considers various factors, including: compliance with the potential investor’s investment model, the financial position and investment viability of the start-up, material risks related to its business model, management structure, founders’ commitment, company valuation, legal standing and regulatory compliance. In short, investors are eager to get an all-inclusive and well-rounded snapshot of the start-up to encourage them to provide the necessary funding and to see if the two parties fit. Therefore, if a start-up can provide this information accurately and timeously, it may well contribute to investment negotiations being concluded far more easily than anticipated. Both parties are advised to note that due diligences generally take longer than anticipated, but by being adequately prepared and organised many a pitfall can be avoided.
Does a due diligence benefit the start-up at all?
Yes, regardless of whether the investment proceeds, the preceding due diligence is a good trial by fire for any start-up. Usually, by way of the investor providing a due diligence report, concerns or queries are highlighted in detail, providing an objective and holistic view of all the facets contributing to the start-up’s business. This can greatly assist the start-up in determining further strengths, weaknesses, opportunities or threats. Start-ups are, however, advised to not be duped into a due diligence too easily. Especially during early stage negotiations, a commitment from investors (usually in the form of a term sheet) is important to ensure mutual benefits are derived from the due diligence investigation.
Although a due diligence is a high level and intense review of the start-up’s business, it need not be a daunting experience. It is important to remember that both the investor and the start-up should benefit from this process – the start-up showing off its true colours, and the investor justifying its investment. As such, communicating honestly to avoid any confusion, disappointment or time wastage is well advised before any due diligence and subsequent negotiations commence. Considering the above, if a start-up is aware and is pro-actively engaging this inevitable destination from the get-go, the due diligence need only be a brief stopover on your “yellow brick road” to the next Emerald City destination.