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What Is Due Diligence? A Quick Guide

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What is Due Diligence

The question of what is due diligence will have a number of answers depending on the context. When it comes to SaaS (Software as a Service) startups, due diligence refers to the comprehensive investigation and assessment process that potential investors, acquirers, or partners undertake to evaluate the viability, value, and risks associated with the company. This thorough examination typically combs through a range of factors, including financial performance, technology infrastructure, intellectual property, customer base, competitive landscape, and legal compliance.

Due diligence helps stakeholders gain a deeper understanding of the startup’s business model, market positioning, growth potential, and any potential red flags, allowing them to make informed decisions about whether to invest, acquire, or collaborate with the SaaS company. It’s a step in the decision-making process that is very draining for startups but it helps mitigate risks and ensures that both parties enter into a partnership with a clear understanding of what to expect.

What Are The Areas Of Due Diligence?

As mentioned above there are a number of areas of due diligence that a startup company will need to hurdle before they can close a round of funding. Each area helps the investor understand what they are buying into better and de-risks them. Let’s have a look at each.

Financial Due Diligence For A Startup

Financial due diligence for a tech startup involves a deep dive of the company’s financial records, statements, and financial management practices. The goal is to assess the startup’s financial health, whether or not the founders of the company are telling the truth about growth (it happens) and to identify any potential financial risks or issues. Here’s what you should prepare for financial due diligence:

1. Financial Statements:

  • Have your financial statements ready, including income statements, balance sheets, and cash flow statements. These documents provide an overview of your financial performance and position.

2. Historical Financial Data:

  • Provide several years of historical financial data to demonstrate trends and growth patterns. This can help investors or acquirers assess your financial history.

3. Budgets and Projections:

  • Share your financial projections and budgets. These should be based on realistic assumptions and provide insights into your expected future performance.

4. Revenue Model:

  • Be prepared to explain your revenue model in detail. This includes how you generate income, pricing strategies, and customer acquisition and retention metrics.

5. Cost Structure:

  • Detail your cost structure, including operating expenses, cost of goods sold, and any fixed or variable costs. Identify areas where cost optimization is possible.

6. Cash Flow Analysis:

  • Provide a cash flow analysis to demonstrate your ability to manage cash effectively. Highlight any working capital requirements. One of the core ones here is cashburn and number of months before cash out.

7. Debt and Equity Information:

  • Share information about any outstanding loans, debt agreements, or equity ownership. This includes terms, interest rates, and covenants or liens that are in place.

8. Customer Contracts:

  • Summarize your customer contracts and subscription agreements, including their terms, duration, and renewal rates.

9. Key Performance Indicators (KPIs):

10. Tax Compliance:

  • Ensure that you are compliant with all tax regulations. This includes tax returns for all of the entities of your business.

11. Cap Table:

12. Use of Funds:

  • Be prepared to explain how you intend to use the funds you’re seeking or what the acquirer plans to do with the company.

13. Management Team:

  • Showcase the experience and qualifications of your management team, as their expertise can impact financial stability.

14. Financial Controls:

  • Describe your financial controls and processes to ensure accurate and reliable financial reporting.
  • Financial due diligence is one of the largest parts of the process for due diligence. And for good reason. It’s important for building trust with investors, partners, or potential acquirers. It helps them assess the startup’s financial situation, risks, and potential for growth. By preparing the above documents and information, and staying raise ready you demonstrate transparency and stable from a business perspective. It’s advisable to work with financial professionals and legal advisors to ensure your due diligence process is well-prepared and thorough.
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Legal Due Diligence For A Startup

Legal due diligence for a tech startup involves what some would call a comprehensive review of the company’s legal affairs and documentation. In reality it’s more of a dim lit interrogation room and can be quite stressful. The purpose is to identify any legal risks, compliance issues, or potential liabilities that could impact the business. The key is that although there are a lot of things that may be seen as red flags, most can be mitigated. Here’s what you should prepare for legal due diligence:

1. Corporate Formation Documents:

  • Provide all relevant corporate documents, such as articles of incorporation, bylaws, operating agreements (for LLCs), shareholder agreements, and board minutes. Ensure these documents are up to date and accurate.

2. Ownership and Equity Structure:

  • Maintain an updated cap table in a tool like Carta showing the ownership structure, including the names and stakes of all shareholders, and any outstanding equity grants or options.

3. Contracts and Agreements:

  • Share copies of all contracts and agreements, including customer agreements, vendor contracts, partnership agreements, and employment contracts. Highlight key terms, expiration dates, and any ongoing obligations. Using a contract management tool will help you maintain this information as you go.

4. Intellectual Property (IP):

  • Present information regarding IP assets, including patents, trademarks, copyrights, and trade secrets. Provide documentation of IP registrations, ownership, and any SaaS licensing agreements.

5. Litigation and Legal Disputes:

  • Disclose any ongoing or pending litigation, regulatory investigations, or legal disputes. Include information about settlements, judgments, or potential liabilities. This is an area in which it is highly recommended that you be open and honest.

6. Compliance with Regulations:

  • Ensure that your startup is compliant with all relevant industry regulations, data protection laws, and intellectual property laws. Document compliance efforts and any required permits or licenses.

7. Data Privacy and Security:

  • Highlight your data privacy and security practices, including how customer data is handled and protected. Provide evidence of compliance with data protection laws like GDPR or CCPA.

8. Employee and Labor Matters:

  • Share information about your workforce, employment contracts, and compliance with labor laws. This should include employment agreements, benefit plans, and stock option plans.

9. Real Estate and Leases:

  • If applicable, provide documentation related to office leases or any real estate holdings. Ensure lease agreements are current.

10. Insurance Policies:

  • Share details of your insurance policies, including liability, property, and professional indemnity insurance. Make sure policies are up to date.

11. Warranties and Representations:

  • Be prepared to make accurate representations and warranties about the state of your legal affairs and any potential liabilities.

12. Employee Handbook and Policies:

  • Provide copies of your employee handbook, codes of conduct, and HR policies. Ensure they are compliant with employment laws and regulations.

13. Tax Compliance:

  • Maintain accurate tax records, including tax returns, filings, and documentation of any pending or historical tax matters.
  • Legal due diligence is often the step of due diligence that early stage startups are least prepared for. Mostly because at early stages you don’t have a senior legal hire or a head of legal. This means that preparing the above documents and ensuring legal compliance demonstrates transparency, reduces risks, and enhances the trustworthiness is the responsibility of the founding team. It’s advisable to work with legal counsel to get briefed on this and how to handle questions that might come your way.

Technical Review For A Startup

Technical due diligence for a tech startup can be quite exhausting. The primary objective is to assess the technical capabilities, risks, and opportunities within the startup. At the end of the day it’s trying to answer the questions:

  • Is your platform secure?
  • Is your platform well built and scalable?
  • Do you own your codebase/how much are you relying on open source?

Here’s what you should prepare for technical due diligence:

1. Technology Stack:

  • Provide a detailed schema of the technology stack you use, including programming languages, frameworks, databases, and third-party tools. Highlight any unique or proprietary technologies as well as any open source code.

2. Software Architecture:

  • Share the architecture of your software solutions, including high-level design, system components, and how they interact. You should prep your technical team to be able to explain how the architecture supports scalability and performance.

3. Source Code:

  • Make your source code accessible for review. Making sure you have your startup NDA in place first. Ensure it is well-documented, organized, and follows best coding practices. Address any issues related to code quality or technical debt.

4. Development Team:

  • Present information about your development team, including qualifications, experience, and roles. Usually your CTO will lead this process and introduce anyone else they see needed. Describe how the team collaborates and how you ensure code quality and security.

5. Product Roadmap:

  • Outline your product development roadmap, including planned features, enhancements, and milestones. This can help assess your technical vision and planning and is often presented by the founder or CEO of the company.

6. Security Measures:

  • Detail the security measures you have in place to protect your technology and data. This includes encryption, access controls, and vulnerability assessments.

7. Data Management:

  • Explain how you handle data, including data storage, retrieval, and data protection practices. Highlight compliance with data privacy regulations.

8. Scalability and Performance:

  • Address your system’s scalability and performance capabilities. Provide information on how your technology can handle increased user loads.

9. Infrastructure and Hosting:

  • Share details about your hosting and infrastructure, whether on-premises or in the cloud. Discuss redundancy, disaster recovery, and infrastructure costs.

10. Software Development Lifecycle (SDLC):

  • Explain your SDLC processes, including how you plan, develop, test, deploy, and maintain your software. Emphasize best practices and continuous improvement as well as how often you release.

11. IP and Patents:

  • Provide information on any intellectual property and patents associated with your technology. This includes documentation of patents or patent applications.

12. Technical Documentation:

  • Offer comprehensive technical documentation, including API documentation, system diagrams, and user generated guides, you should hopefully have a lot of this in a tool like Confluence.

13. Product and Code Reviews:

  • Be ready for technical experts to perform code reviews and assessments of your technology. Address any identified vulnerabilities or areas for improvement.

14. Technical Debt:

Acknowledge and discuss any existing technical debt and plans for addressing it.

  • Once you’ve jumped through each of these hoops you’re well on your way to funding. Keep in mind that the funding process is very time consuming, not just for the founders but for the finance, legal and tech team too. Probably best to reward them with something a bit more substantial than a pizza party.

Contract Sent is not a law firm, this post and subsequent pages on this website do not constitute or contain legal advice. To understand whether or not the ideas and guidance on the Contract Sent website is applicable to your business, you should consult with a licensed attorney. The use and accessing of any resources contained within the Contract Sent site do not create an attorney-client relationship between the user and Contract Sent.

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