Due diligence is the rigorous process of verification that occurs before a business deal is finalized. In the startup world, this usually happens after a term sheet has been signed but before the money is wired to the bank account.
It is effectively an audit. The investor has bought into your vision and your pitch deck. Now, they need to verify that everything you told them is actually true. They are looking for liabilities, legal holes, and financial discrepancies.
For a founder, this period can be intrusive and exhausting. It requires opening up every aspect of your business to outside scrutiny. It is the moment where the “handshake deal” is tested against the cold hard facts of your operations. If you pass, you get funded. If you fail, the deal falls apart.
The Three Pillars of Investigation
#While every firm operates differently, due diligence typically focuses on three main areas. You should expect deep questions in each category.
Financial Diligence: This is a check of your numbers. Investors will ask for bank statements, tax returns, and profit and loss statements. They want to ensure that the revenue you claimed in your pitch matches the cash that actually hit your bank account. They will look at your burn rate and your projections.
Legal Diligence: This is often the most tedious part. Lawyers will review your corporate structure. They need to know if the company actually owns its intellectual property. They will check your employment contracts to ensure everyone has signed IP assignment agreements. They will look for any pending lawsuits or threatened litigation.
Commercial Diligence: This validates the market. Investors might call your top customers to ask why they love the product. They might talk to industry experts to verify your market size estimates. They are checking the viability of the business model itself.
The Data Room
#To manage this process, startups use a “Data Room.” This is a secure, cloud-based folder where all these documents are stored.
Founders often scramble to build this after receiving a term sheet. This is a mistake. It slows down the deal momentum. A prepared founder keeps a running data room from day one.
Your data room should include:
- Articles of Incorporation
- Cap table
- Board meeting minutes
- Employee agreements
- Customer contracts
- Historical financial statements
If your data room is messy or missing key documents, it signals to the investor that your operations are sloppy. Organization here builds trust.
Reverse Diligence
#Most founders view due diligence as a one-way street. The investor checks the startup. However, you are entering into a long-term partnership. You must perform “reverse diligence” on the investor.
You need to know who you are letting onto your cap table. Call the founders of other companies they have invested in. Ask the hard questions.
- How do they act when things go wrong?
- Are they helpful or do they micromanage?
- Do they have the capital reserves they claim to have?
If an investor refuses to let you speak to their portfolio CEOs, that is a massive red flag. You are hiring a business partner. You need to vet them just as hard as they vet you.