Due diligence means a lot of things to different businesses. And across every sector, the sentiment around due diligence is the same; fulfilling legal and regulatory compliance obligations as and when due is a recurrent and highly thorough process that should only be handled by experts.
For startups, what does due diligence mean?
Due diligence refers to the process of investigating a business opportunity to identify any risks, issues or problems before fully committing resources or moving forward with an investment, acquisition or strategic partnership.
Why is Due Diligence so Important?
Due diligence is important to startups for several reasons:
- Risk mitigation – Startups tend to operate with limited resources and a high-risk profile. Conducting proper due diligence helps founders uncover potential risks, compliance issues, or problems that the company may not have been aware of. Identifying these risks early allows the startup to mitigate them before they become major problems.
- Avoid costly mistakes – Overlooking important issues during the due diligence process can lead to costly mistakes for startups, whether it’s legal trouble, financial losses, or operational inefficiencies. Thorough due diligence reduces the chances of expensive errors.
- Increase investor confidence – Investors and potential partners will expect a startup to conduct proper due diligence before raising funds, entering partnerships or acquiring another company. Demonstrating a rigorous diligence process increases investor confidence in the startup’s leadership and ability to manage risks.
- Establish a baseline – Documenting the findings from due diligence establishes an important baseline for a startup to refer back to as it scales. It can highlight areas that need to be monitored and improved over time.
Common Due Diligence Mistakes Founders Make
Startups are often in a hurry to grow, raise funds, and achieve product-market fit as quickly as possible in their race for success. This focus on speed and rapid progress can cause startups to overlook or skimp on important due diligence steps such as:
- Missing legal issues: In their haste, startups may fail to thoroughly review contracts, IP rights, licensing and compliance with relevant laws and regulations. This can leave them exposed to legal risks and problems down the road.
- Superficial financial diligence: Startups in growth mode may conduct only a cursory review of financial statements and accounting practices. Over time, this can mask deeper financial issues that more robust diligence could have uncovered.
- Inadequate product testing: The pressure to launch and generate revenue quickly can cause startups to rush products to market without conducting sufficient testing, quality assurance and customer validation. This often leads to issues that more rigorous diligence could have identified.
- A limited review of operations: Eager to execute their vision and scale up, startups may conduct only a high-level review of business operations related to areas like sourcing, vendor management, and compliance. Over time, inefficiencies and risks can emerge that more thorough operations diligence could have caught.
- Neglecting due diligence checklists (like this one): Many checklists and frameworks exist to guide due diligence for startups, but in their haste, founders may neglect to follow a systematic process that covers all critical areas. This can leave gaps in their diligence.
The breakneck speed and “move fast and break things” mentality of many startups can cause them to shortchange important due diligence steps across legal, financial, product and operations. While urgency is important, so is laying a solid foundation through rigorous diligence to minimize risks and avoid issues that hinder future growth.
Due Diligence Checklist for Founders
1. Legal due diligence
Startups must thoroughly review all contracts, agreements, IP licenses and permits to identify issues like:
- Incomplete or unclear contract terms
- IP infringement or ownership risks
- Compliance gaps with relevant laws and regulations
- They should also validate the legitimacy and authority of counterparties. Founders often miss issues that thorough legal reviews could uncover.
2. Financial due diligence
Startups must examine financial statements, accounting practices, tax filings and credit histories of acquisition targets or investment opportunities to identify:
- Inaccurate or misleading financial reporting
- Undisclosed liabilities, debts or contingent obligations
- Non-compliance with accounting standards and tax laws
- Even startups raising funds should scrutinize their own financial health and projections.
3. Operations due diligence
This entails evaluating how a target company or partner actually runs its business to identify:
- Inefficiencies in sourcing, production and vendor management
- Risks to continuity of supply, distribution and customer service
- Gaps in data security, HR processes and compliance controls
- Startups expanding into new markets or products need thorough ops diligence to mitigate risks.
Tips on How Startups Can Approach Due Diligence
- Focus on high-priority areas first: legal, financial, and product.
- For early-stage startups, legal and financial diligence should take precedence to identify any major risks or liabilities. Product diligence to identify issues or gaps is also critical.
- Leverage outside help where needed from advisors, accountants, and lawyers.
- Startups typically lack in-house expertise to conduct thorough diligence, so bringing in outside advisors can be invaluable. Consultants, accountants and lawyers can identify issues the founders may miss.
- Be thorough but don’t get bogged down in exhaustive reviews
- Startups need to be diligent without becoming paralyzed. Conducting reviews of key areas in appropriate depth is more important than trying to cover everything.
- Document diligence findings to refer back to later
- Startups should make notes, create checklists and compile reports on diligence findings to establish a baseline and identify areas for ongoing monitoring and improvement over time.
Other tips:
- Use proven diligence frameworks and checklists as a guide
- Set timelines and milestones to keep the process structured and avoid delays
- Focus on remediating high priority issues before moving on to lower risk areas
- Repeat diligence periodically as the startup scales and expands
Final Thoughts
Startups need to be strategic and targeted in their due diligence, prioritizing the most critical areas and gathering enough information to make informed decisions. Outsourcing, leveraging frameworks and managing the process well are also keys to success.
Due diligence is one of the most effective risk management tools at a startup’s disposal. When done properly, it can surface issues early before they become major problems that derail growth plans.
A thorough diligence process gives startups the information they need to make well-informed decisions with their eyes wide open. Rather than moving blindly forward, startups that conduct diligence can proceed with confidence, aware of potential pitfalls and how to mitigate them.
Many startup failures can be traced back to issues that could have been uncovered through diligence but were overlooked in the rush to execute. With diligence, startups have a chance to avoid costly mistakes that sap time, money and morale.
Once a proper diligence routine is established, startups can scale more confidently, knowing they have a process in place to identify new risks as they emerge. Periodic diligence allows startups to stay on top of problems and improve over time rather than being blindsided later.
And finally, kindly fill out the form below to get a free customizable due diligence checklist template.
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