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Due Diligence for Early Stage Startups by Acacia Lawrie and Allen Nieman

12-16-2021
Early stage start up investing requires due diligence on behalf of the investor and the founder.

Early stage startup investing is (at least) a double-sided marketplace. On the one hand, there are the entrepreneurs and their startups seeking capital to grow their companies. On the other hand, there are investors who seek opportunities to grow their capital. In the end, they seek the same outcomes, albeit from their unique sides and perspectives. Each side accomplishes a significant part of this through the process of due diligence.

David Rose, author of Angel Investing – the Gust Guide to Making Money and Having Fun Investing in Startups, defined due diligence as“the careful investigation into a company prior to making an investment.” I would offer the entrepreneur’s definition is similar: “the considered preparation and offer of information about your company to a potential investor, and your careful investigation of the investor, in an effort to secure capital.”

Entrepreneurs

There are several pieces of information that most potential investors will want to examine. By collecting this information early and keeping it up to date, you will make raising capital that much easier while you are also continuing to run your business. Significant details could be written about each of these areas, however in this brief post we’re just going to enumerate them. These areas include:

·      Corporate formation and capitalization materials

·      Founding and early-stage team and advisors' biographies, roles, and responsibilities

·      Comprehensive employment agreements with all employees, including founders

·      Pending or threatened litigation

·      Financial information. More or less detailed, depending on company stage. At a minimum, cash inflows (capital and revenue)and outflows (expenses).                     May also include your personal financial situation

·      Business model. How your company will make money for e.g. software as a service “SAAS”, hardware or consumables sales, data licensing, subscription, etc.

·      Market understanding. Detailed description, size, your unique offer and value, competition

·      Intellectual Property

·      If you have customers, information about them.Note that what investors will be interested in will be different based on your customer profile                                                     i.e. individual consumers vs. enterprise contracts

·      Any contracts, LOIs, MOUs, statements of work, etc. with any third parties

·      Details about the solution / product / service and any market validation to-date (customer surveys, waiting lists, MVP, beta, clinical trials)

·      Note the above list is not exhaustive

Finally, as an entrepreneur, when you accept capital from an investor, you are entering into a long-term relationship with that person in away that is not easily separable. You cannot fire your investors like you can abad employee hire. As such, while the investor may be investigating you, your team, and your company, a much less talked about fact is that you should also be investigating them. Can you imagine doing business with them for a decade?Do they have character traits that ingratiate them to you or repel them from you? Do they have more to offer you than their capital, such as their business network or particular skills or expertise?

Investors

As an investor in an early-stage startup, you are making along-term bet towards an uncertain outcome in which there are few guardrails.You need to believe in early-stage startups as an asset class with the certainty of high risk and the possibility of high reward. While very few investments in publicly traded companies can actually go to zero, it’s quite likely that a high percentage of investments in early stage startups will go to zero or return less than 1x. Investors should be guided by three things before investing in an early stage startup.

1. Investment thesis.  An investment thesis in the context of early stage investments is unique from other types of investment theses. According to the Founder Institute, an investment thesis is “the stage, geography and focus of investments, as well as the unique differentiation” for the investor. This is, effectively, defining your “why” for investing. What types of companies, in what stage(s), doing what kind of business, for what purposes. This will, for example, help you determine if investing in dating networks vs neural networks is right for you.

2. Understanding of key risks. A significant function of due diligence for the investor is uncovering key risks. All startups have significant risks. During due diligence an investor wants to locate any deal-killing issues such as poorly protected IP, over-burdened financial commitments such as technology licensing, or ownership issues such as poorly structured equity. Non deal-killing risks are important to uncover as well as investors will want to know that entrepreneurs understand their space and have mitigation plans.

3. Finding enough reasons to say yes. Many people look just for red flags. We think it’s important for investors to look the other way. Can enough reasons to “say yes” be found during due diligence? Is the team strong enough, with sufficient passion and perseverance to work through the tough times? Is the market large enough and the problem acute enough to make a difference? All of the diligence areas listed above can be sources of “yes” and a careful consideration of the information will yield an answer one way or another.

Resources

There are a number of excellent materials that already existto help both entrepreneurs and investors in this journey. You can find links tosome we like below.

https://nvca.org/model-legal-documents/

https://www.ycombinator.com/library

https://www.ivp.com/saas-fundraising-handbook/

https://www.youtube.com/c/hustlefund

https://www.inc.com/christopher-mirabile/10-due-diligence-survival-strategies-for-entrepreneurs.html

https://piqueventures.com/wp-content/uploads/2016/11/Integrated-Investing-Sample-Due-Diligence-Checklist-Oct-2016.pdf

https://www.crunchbase.com/home

 

 

 

 

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