Published by Rich Kershaw on August 24th, 2020

Lessons for tech startups: What is due diligence?

This is an article in my series "Lessons for tech startups", about ways startups can prepare themselves for the many ways they’ll be scrutinised in their path to funding.

If you’re a first-time entrepreneur, "due diligence" is a phrase you’ll probably have heard in a legal context, and maybe even then only on TV. It sounds quite technical on first hearing but it's actually really simple. Diligence as you might expect refers to taking care due diligence refers to taking adequate care and in a commercial situation it refers to 2 things. Exercising due diligence refers to one of your obligations as an officer of the company, where it's your responsibility to make sound and sensible business decisions to protect the company and its shareholders. The second and more formal context is the specific process of examining a situation company investor or partner to make sure that the relationship that you're entering into is prudent, and that they're not really misrepresenting anything about themselves or the deal.

I'm focusing on investment due diligence, but you should regularly check-in and make sure you're exercising due diligence with any relationships you're building as your company grows. Investment due diligence will normally cover a number of steps.

Initial validation simply makes sure that you're doing what you say you will. That includes making sure that you have the client contracts you've said you do, that the product you're selling exists, and that you're trading solvently. You'll probably be negotiating over a valuation around this time too, so this will naturally include some review of finances and projections, making a professional judgement as to whether your company is commercially viable.

In the run-up to agreement on the heads of terms – the valuation and rough breakdown of how the investment will work – more in-depth due diligence will take place. That's where people like me come in. I have 20 years experience in the tech sector and, much like my counterparts on the commercial and financial side, I use that to examine the technology, stability, team, and technical partners, to sanity check your plans and flag up any potential future issues.

The due diligence team, if they're professional, should be friendly and helpful, but they work for the investor or investors. Our job is to make sure that the investors have their eyes wide open, aware of the challenges that might come up in the years to come as well as the potential for returns.

What can we do to prepare?

You need to take off your "founder" hat and think like a critical outsider. How will the third-party with no loyalty to you and your team view what you're doing? Have you made decisions that, in retrospect, may need some course correction? Make sure that the due diligence team are aware of it and they're clear that you have a plan to deal with it that is realistic and pragmatic. What is the marketplace you're operating in look like? What are your key differentiators, and how hard would a competitor have to work to match them? Are you using technology that’s right for your kind of business, and are there recruitment challenges involved in growing your team to manage that technology? If you're operating in an industry where there's regulation or compliance audits, how do you deal with that, what's the overhead, and is there any risk attached to failing that compliance or cost associated with meeting it?

Don’t forget about intellectual property, either - if it’s a key part of your company’s value, the DD team will be examining how you’ve protected it. Do you have any unique IP, have you protected it with patent or escrow arrangements, and how do you plan to exploit it in the future?

It's a lot to consider. A useful way to think about it is imagining the due diligence team as a combination of all of your fussiest clients and ambitious competitors sitting around a conference room table. The due diligence team won't just look at your business critically. They’ll try to anticipate what a future client, acquirer, regulator, or late stage investor might be thinking when they are invited to get involved.

On top of that, because investors are looking for a return on their investment, they'll be thinking about all of that in the context of possible exit plans. On top of looking at how you plan to spend any investment funds (which I’ll cover in a future article), they'll be thinking more broadly than your clients will about the size of the market. Where will the industries that you're targeting go, how much scope there is for growth, and where there may be hidden expense within your business that could be reduced in order to increase profitability?

There's a silver lining to all of this. The good news is that the same skills and bank of knowledge that you assemble to prepare for due diligence will be your textbook for your other business relationships, too! Start preparing your DD content early, and using it for decision-making, client pitches and forward planning. Future-you will thank past-you when the time comes and you need to move fast!

I've grown and guided technology platforms to scale and investment for over 15 years. If your team needs guidance on preparing for investment due diligence, platform scaling or customer experience optimisation, get in touch for and find out how I can help!
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