How to Do Due Diligence on a Startup

Why is Due Diligence Important When Investing in Startups?

Verifying information: Due diligence allows you to fact-check the startup's claims about its financials, market potential, and competitive advantage. This independent verification is essential to avoid falling for exaggerated or misleading pitches.

Identifying red flags: Through due diligence, you can uncover potential issues that may not be apparent at first glance. This could include legal disputes, regulatory non-compliance, or undisclosed liabilities. Spotting these red flags early can save you from costly mistakes.

Assessing the management team: The success of a startup largely depends on the quality of its management team. Due diligence gives you the opportunity to evaluate the founders' and key executives' experience, track record, and ability to execute the business plan. This assessment helps you gauge the team's capability to lead the company to success.

Understanding the market and competition: Due diligence involves analyzing the startup's target market, growth potential, and competitive landscape. This analysis helps you determine if the startup has a viable market opportunity and a sustainable competitive advantage. It also allows you to assess the startup's ability to adapt to market changes and fend off competitors.

Valuing the company: Due diligence provides the information you need to properly value the startup. By reviewing financial statements, projections, and comparable companies, you can determine if the startup's valuation is reasonable and if the investment offers a fair potential return.

Negotiating terms: The insights gained from due diligence can strengthen your position when negotiating investment terms. If you uncover significant risks or weaknesses, you may be able to negotiate more favorable terms, such as a lower valuation or additional investor protections.

Key Areas to Focus on During Startup Due Diligence

1. Financial Health and Projections

2. Management Team Experience and Track Record

3. Market Opportunity and Competitive Landscape

4. Legal Compliance and Intellectual Property

How to Do Due Diligence on a Startup

Due diligence on a startup means thoroughly investigating a company before investing.  You evaluate the startup's financials, operations, management team, market potential, and legal standing to assess viability and potential risks.Here's a step-by-step guide to performing due diligence on a startup:

Review Financial Documents
Assess the Management Team
Evaluate the Market and Competition
Conduct Legal Due Diligence
Validate Technology and Intellectual Property
Analyze Customer Traction and Feedback
Perform Reference Checks
Engage Professional Advisors

1. Review Financial Documents

First, request and carefully examine the startup's financial statements, including the balance sheet, income statement, and cash flow statement. The balance sheet shows the company's assets, liabilities, and equity at a specific point in time. The income statement reveals the startup's revenue, expenses, and profitabilityover a set period. The cash flow statement tracks the inflows and outflows of cash.Analyze these documents to assess the startup's financial health and sustainability. Look for any inconsistencies or discrepancies that may raise red flags.  High levels of debt or burn rates could indicate financial strain. Compare the startup's financials to industry benchmarks to get more context. Also,review the startup's financial projections and assumptions. Evaluate the reasonableness of the projected growth rates, revenue targets, and profitability timeline. Overly aggressive or unrealistic projections may be a cause for concern.Pay attention to key metrics such as gross margins, customer acquisition costs, and customer lifetime value. These metrics provide insights into the startup's efficiency and potential for scalability. If the startup has raised previous rounds of funding,review the terms and conditions of those investments. Understand the liquidation preferences, voting rights, and any special provisions that could impact your investment.

2. Assess the Management Team

The startup's success depends heavily on its leadership.Take time to thoroughly evaluate the founders and key management personnel. Start by reviewing their resumes and professional backgrounds. Look for relevant industry experience, previous startup successes, and a track record of leadership roles. Assess their skills and expertise to determine if they have the necessary knowledge to execute the business plan effectively.As one expert noted,"A manager’s ability to get their team through the bureaucracy of due diligence sends a signal to investors that they’re investing in the right people"​ Next,consider the management team's ability to navigate challenges and adapt to change.Startups often face unexpected obstacles, so having a resilient and agile leadership team is crucial. Look for evidence of problem-solving skills, adaptability, and a willingness to pivot when necessary. Evaluate the team dynamics and culture.  A cohesive and complementary management team can be a strong asset for a startup. Observe how the team interacts and communicates with each other. Assess if there are any potential conflicts or red flags that could hinder the startup's progress.Consider the management team's vision and long-term goals for the startup. 

Do they have a clear and compelling strategy for growth?
Are they able to articulate their vision effectively and rally others behind it?

A strong and visionary leadership team can be a key driver of the startup's success. Finally,assess the management team's integrity and ethical standards.Conduct background checks and reference checks to ensure there are no past issues or red flags.  Investing in a startup with a trustworthy and ethical leadership team provides peace of mind and reduce the risk of future legal or reputational issues.

3. Evaluate the Market and Competition

Start by assessing the size of the market the startup aims to serve.Use market research reports, industry publications, and government data to estimate the total addressable market (TAM), serviceable available market (SAM), and serviceable obtainable market (SOM).Consider the market's growth rateand future projections.  A rapidly growing market offers more opportunities for the startup to scale and capture market share.  However,also evaluate the stability and sustainability of the market.  Is it subject to cyclical fluctuations or regulatory changes that could impact the startup's success? Next,examine the startup's unique value propositionand competitive advantages.

What sets the startup apart from its competitors?
Does it have a proprietary technology, a more efficient business model, or a superior user experience?

Assess how well the startup's offerings address customer pain pointsand meet market demands. Analyze thecompetitive landscape by identifying the startup's direct and indirect competitors.  Evaluate their market share, strengths, weaknesses, and strategies. Determine if the startup has a defensible position in the market and if there are significant barriers to entry for new competitors.Consider the startup's pricing strategyand how it compares to competitors.

Is the startup able to offer competitive prices while still maintaining healthy margins? 

Assess the startup's ability to differentiate itself based on factors other than price, such as quality, customer service, or brand reputation.Lastly, evaluate the startup's go-to-market strategy and distribution channels. How does the startup plan to reach and acquire customers? Assess the effectiveness and scalability of its sales and marketing efforts. Consider the startup's partnerships, alliances, and ecosystem relationships that could provide a competitive advantage.

4. Conduct Legal Due Diligence

Start by examining the startup's legal entity structure, such as whether it is a corporation, limited liability company (LLC), or partnership.  Verify that the startup is properly registered and in good standing with the relevant state authorities.  Review the startup's organizational documents, including articles of incorporation, bylaws, and operating agreements, to ensure they are properly drafted and comply with applicable laws. Next,review the startup's contracts and agreementswith customers, suppliers, partners, and employees. Look for any terms or conditions that could expose the startup to legal risks or liabilities.  Assess the enforceability and validity of these contracts, and ensure they adequately protect the startup's interests. Intellectual property (IP) is a critical asset for many startups, especially those in technology-based industries. Review the startup's IP portfolio, including patents, trademarks, copyrights, and trade secrets. Verify that the startup has proper ownership or licensing rightsto all its IP assets. Assess the strength and enforceability of the startup's IP protection measures, such as non-disclosure agreements (NDAs) and invention assignment agreements with employees and contractors. Regulatory compliance is another key area of legal due diligence. Assess the startup's compliance with applicable laws and regulations, such as data privacy laws, industry-specific regulations, and employment laws.Review the startup's licenses, permits, and certificationsto ensure they are up-to-date and properly maintained. Identify any potential regulatory risks or challenges that could impact the startup's operations or growth.Conduct a thorough review of any past or pending legal disputes, litigation, or regulatory actions involving the startup or its management team. Assess the potential impact of these issues on the startup's reputation, finances, and operations. Consider the likelihood and potential outcomes of any ongoing legal proceedings.

5. Validate Technology and Intellectual Property

You want to ensure thatthe startup has a solid technological foundationand the necessary legal protections in place. First,assess the startup's technology stack. This includes the programming languages, frameworks, databases, and other tools used to build and run the product or service. Evaluate the scalability and reliability of the technology. 

Can it handle the expected growth and user demand?
Is it built on proven and well-supported technologies, or does it rely on outdated or obscure tools?

Next, review the startup's IP protection measures. This includes patents, trademarks, copyrights, and trade secrets. Verify that the startup has properly filed and secured the necessary IP rights. Review the patent applications and granted patentsto assess their strength and scope. Ensure that the startup has the exclusive right to use and commercialize its technology. Evaluate the startup's open-source software usage and compliance.Many startups leverage open-source components to accelerate development, but this can also introduce legal and security risks.  Ensure that the startup is properly attributing and complying with the open-source licenses. Additionally,assess the startup's data privacy and security practices.  With the increasing importance of data protection regulations like GDPR and CCPA, startups must have robust measures in place to safeguard user data. Review the startup's privacy policies, data handling procedures, and security infrastructure. Also, consider the startup's technology roadmap and future plans. 

Is the startup investing in research and development to stay ahead of the curve? 
Are there any upcoming technological advancements or industry shifts that could impact the startup's competitive position?

Remember, technology and IP are constantly evolving. Encourage the startup to stay vigilant and proactive in protecting and advancing its technological assets.

6. Analyze Customer Traction and Feedback

Customer traction and feedback are criticalindicators of a startup's potential for success.  Analyzing these aspects helps you understand how well the product or service resonates with its target market and whether the startup is on a path to sustainable growth. Here's how to analyze customer traction and feedback effectively:

Look at therate at which the startup is acquiring new customers. A steady or accelerating growth rate is a positive sign, indicating that the startup is successfully attracting its target audience.
Calculate the cost of acquiring a new customer. Compare this to the startup's revenue per customer to determine the sustainability of its growth strategy.
Examine thepercentage of customers who stop using the product or serviceover a given period. A low churn rate suggests strong customer satisfaction and loyalty, while a high churn rate could indicate issues with the product or service.
Assess how actively customers are using the product or service.High levels of engagement typically correlate with customer satisfactionand product value. Look at metrics like daily or monthly active users (DAU/MAU) to gauge this.
For startups that sell products,assess the rate at which customers make repeat purchases. High repeat purchase rates indicate strong customer satisfaction and loyalty.
Lastly,identify any recurring complaints or issuesthat customers mention in reviews or feedback. Addressing these pain points can be critical for improving customer satisfaction and retention.

7. Perform Reference Checks

Reference checksprovides firsthand insights into the startup's reputation, the credibility of its founders and key employees, and the quality of its partnerships.Start by contacting previous employers, colleagues, or business partners of the founders and key employees.  Ask about their work ethic, leadership style, problem-solving abilities, and how they handle challenges. Next,contact current and past customers to learn about their experience with the startup’s product or service. Ask about the quality, reliability, and customer support they received. When contacting customers:

Ask about their satisfaction with the startup's product or service
Inquire about the value they have received
Inquire about any challenges or pain points customers have faced when working with the startup.

Customers can provide valuable perspectives on the startup's ability to deliver on its promises and meet market needs. Also,reach out to current and former employeesto gauge their satisfaction with the company. Former employeesprovide a unique inside look at the startup's culture, management style, and internal operations.  Reach out to them to gather candid feedback on their experience working at the startup. Ask about the reasons for their departure and any red flags or concerns they may have about the company. When conducting reference checks, use a structured approach to ensure consistency and thoroughness:

Prepare a list of questions in advance and take detailed notes during the conversations. 
Look for patterns or common themes across multiple references to identify areas of strength or potential concerns.

Pro Tip:Maintain confidentiality throughout the reference check process. Respect the privacy of the individuals you contact and ensure that any sensitive information shared remains confidential. Use secure communication channels and data storagepractices to protect the integrity of the information gathered.

8. Engage Professional Advisors

The last step is to engage advisors. Advisors bring specialized expertise and an objective perspective that can help identify risks, uncover opportunities, and provide a more comprehensive understanding of the startup’s potential.  Here’s how to effectively engage and utilize professional advisors during startup due diligence:

Engage a lawyer or legal teamwith experience in startup law. They can review contracts, intellectual property rights, regulatory compliance, and any potential legal issues that could impact the investment.

Hire an accountant or financial expertto analyze the startup’s financial statements, tax filings, and overall financial health. They can also help you understand the startup’s valuation and the financial implications of your investment.

If thestartup operates in a technical or specialized industry, consider hiring a technical advisor or industry expert. They can evaluate the viability of the startup’s technology, product development process, and scalability.

Engage a market analyst or consultantto assess the startup’s market potential, competitive landscape, and customer demographics. They can provide insights into market trends and the startup’s position within the industry.

Ensure that your advisorswork together to integrate their findingsinto a comprehensive due diligence report.  This holistic approach provides a more complete picture of the startup’s potential risks and opportunities.

Benefits of Thorough Due Diligence

The benefits of conducting thorough due diligence include:

Helps you identify potential risks and red flags: Thorough due diligence uncovers any hidden issues that may affect the startup's viability. This includes financial discrepancies, legal challenges, and operational inefficiencies.

Enables informed investment decisions: By examining all aspects of the startup, you gain a complete picture of its strengths and weaknesses, allowing you to make well-rounded investment choices.

Increases the likelihood of successful investments: Understanding a startup's market position, competitive edge, and growth potential helps you invest in businesses with higher chances of success.

Helps build trust and alignment with startup founders: Conducting due diligence fosters transparency and trust between investors and founders, ensuring both parties are aligned in their goals and expectations.

Improved post-investment management:The insights gained from due diligence can inform your post-investment management strategy, helping you provide better support to the startup and improve its chances of success.

Final Thoughts

By meticulously examining every aspect of the startup, from financial health and market potential to the management team and customer traction, you significantly reduce the risks associated with your investment.The insights gained during this process help you make smarter decisionsbut also provide a solid foundation for negotiating better terms and supporting the startup post-investment.  In an environment whereover 90% of startups fail, thorough due diligence is your best tool for increasing the likelihood of success. If you’re seeking to streamline your financial management or need expert advice, consider using Sam’s List. Sam’s List is a curated platformdesigned to help you find and connect with highly recommended accountants, CPAs, and tax strategists. With features like endorsements and reviews, direct contact options, a personalized matching service, and comprehensive research tools, Sam’s List makes it easier for you to find a trustworthy and competent accountant tailored to your specific needs.Start your search on Sam’s List todayand ensure your financial matters are in expert hands.

How to Do Due Diligence on a Startup: Frequently Asked Questions

What are the key financial documents to review during due diligence?

Key financial documents include balance sheets, income statements, and cash flow statements. Analyzing these documents helps you understand the startup's financial health and sustainability.

How can I assess the credibility of a startup's management team?

Evaluate the experience, skills, and track record of the founders and key management personnel. Look for a history of successful ventures and industry expertise.

What are the most important legal aspects to consider during due diligence?

Review the startup's legal structure, contracts, intellectual property, and regulatory compliance. Identifying potential legal risks or liabilities is crucial.

How long does the due diligence process typically take for a startup?

The duration varies based on the complexity of the startup and the thoroughness of the review. It can take anywhere from a few weeks to several months.

What red flags should I look out for when conducting due diligence on a startup?

Watch for inconsistencies in financial statements, high debt levels, legal disputes, lack of market research, and inexperienced management teams.