What belongs on your startup fundraising due diligence checklist?

You made your pitch. You hooked an investor and you signed a term sheet agreeing to their intended investment. It’s almost a done deal. The only thing standing between you and the investor’s money is the due diligence process. What is due diligence, and how can your business successfully navigate it to close your funding round? Here’s a due diligence checklist to help.

What is due diligence?

Lawyers from LawTrades defines due diligence as “the process through which investors confirm that your company is indeed the promising investment you told them it is.”

Your pitch presented a high-level view of your business and its potential. You may have identified some risks, but you didn’t get into the nitty-gritty details of your operation. The details, both good and bad, are what due diligence is all about.

Before investors hand over their money, they want to see evidence and financial statements supporting your claims: copies of contracts confirming customer commitments, testing results that back your performance claims, market research, the list goes on.

How does your company prepare for due diligence?

You won’t satisfy your potential investors with a cursory overview of your business operations. You need to dig through every document supporting your claims, policies, and practices. Due diligence takes valuable time away from you concentrating on your business, and that’s what makes it so painful for many founders. The best way to prepare for due diligence is to get organized and/or hire a lawyer to help, which will make you stand out to investors. Decreasing friction and increasing time-to-close benefits both you and the investors working with you during the due diligence process. Luckily, our virtual data room features are available to founders that use DocSend during the fundraising process (and to anyone just signing up for DocSend). You can simply create an online data room right inside DocSend by adding the relevant confidential documents we list below in the due diligence checklist section.

Serial entrepreneur Alejandro Cremades explains:

“The due diligence process is one of those dirty little secrets of the startup world. One that almost no one ever talks about…Most [founders] would rather give birth, have to run into a burning building to save a kitten, or have all of their teeth pulled. At least the pain would be over much faster. Few want to revisit those days. Much less share with the world how it really felt. It can be traumatic.”

Due diligence can seem never-ending for founders. And producing concerning documents often results in investors asking for more information.

For example, if an investor finds that a specific contract exposes the company to unreasonable risk, the investor will demand answers. In the best-case scenario, you’ll need to provide an explanation or documentation explaining how you’ve protected against the risk. However, don’t be surprised if the investor requires you to negotiate an amended contract that lowers the risk to your business (a time-intensive exercise).

If a single contract can delay closing your funding round, imagine the potential issues that can arise when investors closely examine your entire business.

So, while due diligence is time-consuming and can be frustrating, with preparation and a solid platform supporting your business, this process can help accelerate your business toward success.

Create a due diligence checklist business plan before you begin fundraising

Due diligence is inevitable in fundraising. Don’t wait until you have a deal on the table. Instead, save yourself a lot of hassle and start gathering documents and data before you ever pitch your first investor.

Due diligence is largely a document- and data-gathering exercise. You provide evidence for the claims you made during the pitch, the operational nuances of your business, and the risk mitigation you’ve taken. Use a due diligence checklist to make sure you’re collecting the right information.

Not only will this help you quickly respond to due diligence requests, but also, the better you know your business, the stronger your pitch will be.

Set up organizational infrastructure

To keep your due diligence documents and data organized, set up a virtual data room. Using a platform like DocSend for your due diligence data room will help the process run smoothly.

Many due diligence topics require multiple documents (e.g., corporate records, policies and procedures, customer contracts), and providing these documents through a single communication streamlines the process. DocSend’s virtual data room allows you to send multiple documents with a single link.

Smart permissions management also helps control sharing through due diligence. During due diligence, your investors need access to your most sensitive and confidential business documents (e.g., intellectual property, trade secrets, employee salaries, investor information). Smart permissions allow you to grant document access only to those with a need to see the applicable information.

What does a DocSend data room look like for fundraising due diligence?

Although biotech is an outlier industry that has different traction and timelines than traditional software-based companies, we recently published a guest post on using DocSend’s virtual data room features during due diligence by Viraj Mane, Co-Founder and Chief Scientific Officer at Lactiga. Viraj explains how showing tractions can be difficult for a biotech company so he shows the six specific segments he uses in his virtual data room to convey traction to potential investors. Some of these confidential documents include patents, trademarks, regulatory agency approval, and more. These sensitive documents are critical to the due diligence process to ensure his company has what they need to protect their Intellectual Property, as well as, give confidence to potential investors that they are on the right track. Using our virtual data room features allows you to have a customized, secure, and easily usable data room to tell your startup’s story through documents. Other virtual data room providers make this cumbersome and very expensive. Your due diligence process is too important to spend more time and money setting up data room software that provides less value. Below is an example of Lactiga's DocSend hosted virtual data room that includes their documents to show traction to investors during the due diligence process.

Prepare to address material risks

Investors are often sold on the potential of your product or service. The due diligence process allows investors to evaluate risks that could prevent that potential from becoming a reality.

Material risks are those that could cause your business to fail. For example, if you’ve pitched a new search engine, the biggest risk to your company is likely the complete market dominance of Google. If your search engine is a worthy investment, how has Google not already created something similar? Can Google easily replicate your search engine? How will you market against it?

Know your risks and be prepared to discuss them before you begin due diligence. Have a document prepared outlining how your business will mitigate or overcome material risks. Don’t sit back and hope your investors won’t question any material risks. These will likely be their biggest concerns through due diligence.

There’s a lot to keep in your head when preparing for due diligence. How do you do it? Don’t rely on your memory or plan to respond to investor requests as they come. Lean on a due diligence checklist instead.

Due diligence checklist

Angel investors and venture capitalists have unique approaches to picking investments. As different as those visions might be, they’re all generally looking for the same types of documents from your business through the process. Use this due diligence checklist to prepare:

Due diligence item: References

Investors are interested in your business, but they’re also interested in you and your team. They may ask for both customer and personal references to vet your product, service, and people.

Due diligence item: Corporate records and documents

This includes anything related to the legal and organizational structures of your company, including:

• Organizational documents (articles of incorporation, articles of organization, bylaws, operating agreement, etc.)

• Shareholder meeting minutes, board of director meeting minutes, etc.

• Company organizational chart

• Same documentation for any affiliate companies

Due diligence item: Business plans and financials

In your pitch, you presented a high-level overview of your historical performance, forecast, runway, and other performance metrics. In due diligence, you must provide the data that supports these presentations:

• Formal business plan

• Forecasts: Sales, purchasing, margin, customer growth, marketing spend, etc.

• Balance sheets (from founding to present)

• Income statements (from founding to present)

• Tax returns (from founding to present)

Due diligence item: Market research

To position yourself in the market, you pitched your potential in the existing market. Be prepared to show how you came to your conclusions with research, data, and surveys to back your positions:

• Industry trends

• Total addressable market (TAM)

• Customer acquisition cost

• Retention rate

• Price, cost, and margin analysis

• Prospective customer research

• Trial results

• Competitive landscape

• Focus groups, interviews, surveys, etc.

• Other research

Due diligence item: Intellectual Property

If your products are protectable under intellectual property (IP) laws, expect your investors to spend significant time here. If you haven’t taken the time to protect your product, you had better have a good explanation. If you have protected your IP, they’ll take plenty of time to make sure you did it correctly. They’ll expect to see:

• All existing and/or applied for patents, trademarks, copyrights, and domain names

• If you haven’t applied for protectable assets, an explanation (preferably a formal legal opinion) describing the decision not to file for IP protection

• Any IP assignments that were made to you from another company or inventor and associated recordation documents

Due diligence item: Shareholder information and agreements

As interested as your investors are in your business, they are most interested in a return on their investment. They need to know exactly how much of your business they’ll own in exchange for their investment and how that ownership interest compares with your other owners:

• List of owners and percentage ownership interest

• All existing stock and options and their value at issuance

• Any agreements related to stock, options, grants, and other issuances

• Vesting schedules related to any issuances of stock or options

• Agreements related to voting rights of shareholders

• Any regulatory or legal documentation related to shares and shareholders

Due diligence item: Material agreements

Material agreements will vary from company to company based on the nature of your business. Any agreement that could significantly impact the business as you presented it to the investors in your pitch should be included in material agreements. Common examples include:

• Standard terms of service or use between your business and customers

• Any agreements or understandings between your company and others with obligations exceeding $25,000

• Property leases (real estate and personal property)

• Loans, mortgages, liens, or encumbrances against your company

• Loans provided by your company

• Insurance policies

• Licenses of any company intellectual property to third parties

• Licenses of third-party intellectual property by your company

• Any standard form used by the company in the ordinary course of business (NDAs, purchase agreements, terms of use, etc.)

• Any agreements outside the ordinary course of business that could have a material impact on the business

• Consulting agreements

• Agreements with officers and directors

Due diligence item: Risks and potential litigation

If your business is currently in a legal dispute or you have reason to believe you might become involved in any, you’ll need to list that. Here are some examples of what you may need to provide:

• Correspondence and documents related to any existing or threatened lawsuit, proceeding, or investigation

• Correspondence and documents related to any existing or potential regulatory investigations or compliance concerns

Due diligence item: Employee relations and benefits

If your business scales, employees will inevitably become your biggest cost and liability. Any policy, procedure, benefit, or agreement related to employees goes here. This might include:

• List of company employees including title, salary, bonus potential, commissions, exempt or non-exempt status, and contact information

• Standard offer letter and/or any employee contracts

• Agreements between the company and any employee and/or director

• List any documentation related to any employee benefit (401(k), insurance, medical, stock option, etc.)

• Severance plans

• Company handbook and any other company policy

Due diligence item: Equity grants

It’s not uncommon to offer equity (ownership interest) to early employees, or even customers or consultants, in your early days. These grants impact your investors’ ownership interest, and they will need to see the equity you’ve already promised others.

Stay organized and ahead of the game with DocSend

In summary, preparing your business to respond to investor requests during due diligence is largely a document-gathering and organizing exercise. This due diligence checklist is just the start — DocSend Spaces provides ideal features to facilitate a smooth document gathering and sharing experience. Leveraging a powerful document platform will help founders and investors alike stay organized through the due diligence process.