An Introduction to Due Diligence

What is due diligence in financing? 

Due diligence is a detailed examination or investigation carried out by an interested party to confirm facts or details of a potential investment. It is a vetting process used to review a company’s financial records, business transactions, legal information, and any other material required to be appraised before becoming involved in a business arrangement with that company. 

Why is it necessary? 

For raising finance or funding, due diligence is necessary to understand the level of risk associated with an investment. It ensures that accurate and relevant information is gathered about the target company before proceeding with an investment or funding arrangement. 

The process is typically carried out by potential investors, lenders, or partners at a corporate and individual level, to aid in mitigating any associated risks. 

What information and documents will potential investors typically request during due diligence?

The type of due diligence conducted largely varies depending on the type of business. An IT-focused company, for example, should expect detailed questions relating to, inter alia, IT assets, systems, cybersecurity checks. However, there are also some generic information requests for all businesses dependent upon the level and type of due diligence conducted.  some general requests for information made based on the type of due diligence conducted.

Type of due diligence	Information required
Financial	Audit reports Financial statements for the past 3 years Annual or quarterly tax returns  VAT statements Financial management reports  Details of revenue, expenses, and profitability. Cash flow statements  Balance sheets, including assets, liabilities, and equity. Details of outstanding debts, loans, and credit agreements. Business partnership agreements Articles of association Shareholder arrangements Financial projections
Legal	Details of pending or historical legal disputes or litigation  Details of any regulatory licences, permits, or approvals. Compliance with relevant laws and regulations Supplier and customer contracts Insurance policies, including any claims made Joint venture and partnership agreements Settlement agreements Franchising agreements Shareholder certificate documents Business licences Occupational licence Building permits documents Tax registration documents Power of attorney documents Pension plans or schemes the company is involved in
Human resources	Training agendas  Employee handbooks Employee details, including compensation, contracts, and benefits.
Operational	Organisational structure and key personnel Background and biographies of key executives and management team. Management structure and roles/responsibilities. Supply chain and vendor relationships Manufacturing, production and distribution processes (if applicable) Inventory details and management Product/ service trials, warranties, and complaints Quotes, pricing, invoices, and profit margins
Commercial	Market analysis and industry trends. KPIs and measurements used to evaluate performance Customer profiles and segmentation. Marketing and sales strategies. Published press releases and articles (if applicable)
Technology and Intellectual Property	Details of technology assets and proprietary systems. Documents on patents, trademarks, and copyrights Inventions, innovations, and research and development efforts.
Environmental and Sustainability	Environmental impact assessments and reports. Details of environmental compliance and initiatives. Potential environmental liabilities.
Real Estate	Property ownership and lease agreements. Real estate appraisals and evaluations.

How long does it take?

The time taken to conduct due diligence largely varies depending on for example, the company size, level of investment, type of product or service offered. While it is hard to predict the exact time frame, in general, startup due diligence processes last for about 1- 2 months. However, for a startup in the pre-seed funding stage, it can take a week or two.

How to prepare for due diligence?

Steps that can be taken to aid in preparing for due diligence are set out below:

1. Archive, archive, archive! Organise your startup’s finances from day one.

2. Use software to store and update due diligence folders.

3. Correctly order all documents, reports, and analytics.

4. Be responsive and open.

5. Ask for feedback.

6. Do not hide anything important.

7. Do not share or show too much. For example, avoid showing internal documents such as those containing personal information of employees or historical records that are no longer relevant to the company's current state.

8. Do not leave any questions unanswered.

What happens after due diligence?

The next steps depend on the outcome of the due diligence findings.

Scenario 1: Successful Due Diligence, Investment Offer Accepted

The investor may proceed with making an investment offer if they are satisfied with the results of the due diligence process.

• The terms of the investment (such as equity stake, funding amount, valuation, etc.) will be negotiated and finalised between the investor and the company. 

• Legal documentation, such as investment agreements, contracts, and any necessary regulatory filings, will be prepared and signed by both parties.

• The investor may require regular updates on the company's progress, financial performance, and other key metrics as outlined in the investment agreement.

Scenario 2: Successful Due Diligence, Investment Offer Declined

Even if due diligence is successful, the investor may choose not to proceed with the investment for various reasons, such as changes in their investment strategy or financial circumstances. In this case, both parties will part ways, and the company seeking funding can explore other investment opportunities.

Scenario 3: Unsuccessful Due Diligence, Investment Offer Withdrawn

If the due diligence process reveals discrepancies or inaccuracies in the company’s information that the investor is not comfortable with, they may choose to withdraw their investment offer.

• In such cases, the company seeking funding will need to address the concerns raised during due diligence and potentially restart the process with a renewed investment proposal.

• Parties may also enter into renegotiations that might involve adjusting the investment terms, revising the valuation, or making other changes to the deal structure to better align the interests of both parties.

How can startups benefit from due diligence?

Whilst due diligence primarily aims to mitigate risks for investors, startups can gain significant advantages from this process. Successful due diligence establishes trust and validates the company's growth potential, making it an essential step towards securing investments. Additionally, comprehensive evaluations during due diligence can help startups identify areas for improvement. While discovering unforeseen errors may not be met with enthusiasm by startup founders, it does however, offer insight into areas that might have been overlooked for example,unexpected issues in business plans, product development, and financial forecasts.

Author: Shanaya Kapoor -

Author: Shanaya Kapoor -

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DISCLAIMER

This article has been written by law students for the sole purpose of providing informative insight. The information in this article is intended for educational purposes only and does not constitute legal advice, nor should the information be used for the purpose of advising clients. You should seek independent legal advice before relying on any of the information provided in this article.

Sources

James Chen: “Due Diligence”, (Investopedia, last updated 29th April 2023) <https://www.investopedia.com/terms/d/duediligence.asp> accessed 15 August 2023

Thomson Reuters, 'Due diligence for a project finance transaction: purpose and process' (Thomson Reuters Practical Law, 2023) <https://uk.practicallaw.thomsonreuters.com/w-018-8584> accessed 10 August 2023

Douglas Cumming and Simona Zambelli, ‘Due Diligence and Investee Performance’ (2016) <https://doi.org/10.1111/eufm.12100> accessed 3 August 2023