Why due diligence is important for entrepreneurs
Due diligence is a vital tool with which investors gauge the effectiveness of corporate governance and make up their mind on M&A.
In today’s complex business and financial environment that has witnessed several companies, including some of the most trusted names in the business, compromise on integrity and getting caught under the net for fudged accounts, with the intent to siphon off money and evade even the best scrutiny, it is increasingly important for investors and buyers to insist on a thorough due diligence before making the final move.
It is critical for a buyer or investor to know about the financial or legal health of the company they are planning to buy or invest in. Due diligence is a vital tool, based on which investors/buyers gauge the effectiveness of corporate governance and make up their mind on merger or acquisition, after validating whether the assumptions and assertions made by the company are true and fair.
This critical step is what enables the interested parties (buyers or investors) take that leap of faith. It is through due diligence that they can check for any unknown issues, which should have been brought to their notice earlier and evaluate the growth prospects of the company. These important inputs help decide whether the investment or acquisition will be worthwhile or not.
In several cases, where issues are uncovered during the due diligence process, companies are told to put them right before any further moves are made by the investors.
What do investors look for in the due diligence process?
First and foremost, investors need to know beforehand about the company's current and projected financial details, organisation information, market size, team structure and level of competence, potential to compete in the market and future growth prospects.
These are the key areas of interests for Venture Capitalists. They also want a perusal of all stockholder communications, customer and supplier agreements, credit agreements and loan/debt obligations, partnership and joint venture agreements. From a legal perspective, it is important for them to know the structure of the company, staff headcount and cost, further requirements in staff to grow the business, and liabilities and lawsuits if any.
Any conflicting claims already made, hidden or unresolved problem areas cropping up during the review will put a halt to any further progress with the investor. Any missing or incomplete information, missing signatures on contracts or facts that arise, which are inconsistent with previous claims or discussions, undisclosed debts and liabilities, will raise all the red flags with an investor and put a halt to further movement in the process unless resolved and clarified.
That is why it is important to ensure that all these necessary documents are well organised and ready to produce as and when required during the process.
Moreover, the company must have detailed presentations together (factually correct and on time) prepared by various teams, giving a detailed overview of that respective function or department to ensure that the right information is shared with the investors and any queries or doubts addressed. Also, the business should keep all lines of communication open with the investors and immediately act on clarifications sought with factual explanations.
Importance of a legal advice
A good legal team can prove to be immensely useful to manage the due diligence and securities offerings and in making the right pitches to the investors.
After the basic information sharing, assimilation of facts and verification of the same is over; the investors will rectify the problem areas, if any. While some problems can be addressed and corrected, others may be beyond the control of business, hence difficult to resolve.
In such case, investors might insist on making changes to the transaction documents, they might adjust the bidding price for the business, the shareholding structure, or investor rights and responsibilities.
It is only when these issues are settled, the due diligence process will be completed to the investor’s satisfaction, which in turn will help the transaction follow through to the signing stage.
Thus, due diligence help investors to get an accurate view on what the company has done so far and how it might fit into a broad portfolio or investment strategy. For an investor, this research helps them from missing something that could be vital to their decision-making process. What was once a short and rather perfunctory process has now grown into a highly detailed and quantitative process offering insight into the future prospects of business.
Though there is no one formula for this process, businesses that understand the criticality of this process and its components are certainly at an advantage, when it comes to attracting investments. They can leverage it as a stepping stone to a bigger and brighter future.
I highly recommend that companies keep this in mind, even as they are just starting up. With good legal advice, keep the records clean right from the beginning. This will save any problems at a later stage and also the aftermath of cleaning up process.
For Investors Due Diligence to be a cakewalk, the entrepreneurs need to have self-discipline in maintaining the records of the venture, such as daily operations documents and details. It is always good to split the responsibilities amongst the Co-founders for recordkeeping and timely reviews. This not only helps the entrepreneur to keep the due diligence outcome positive, but also ensures that they have daily data on their fingertips.
To sum up, the top 10 priority tasks every entrepreneur should religiously follow, irrespective of the stage of the venture, in order to ensure complete compliance for Investors Due Diligence:
1) Do Indexing of all the signed documents and official records
2) Keep the records at one safe place
3) Label your files with color codes and time stamping
4) Do regular and frequent board meetings
5) Review all the pre-decided agenda one by one and check if the documents are in place
6) Entrepreneurs should know the financials and record them
7) Interact with your Legal Advisor/CA or the financial consultant on regular intervals
8) As early stage Entrepreneurs, you might not be perfect in processes, but be honest in your data and remain transparent
9) Never ever hide or fudge your data from your investor, because you think it’s not worth sharing.
10) Last but not the least; never be ‘Penny Wise Pound Foolish.’
The writer of this article is Vikram Upadhyaya. He is the Chief Mentor and Accelerator Evangelist at GHV Accelerator. He is also the Founding Board Member of the Indian Angel Network Incubator and an advisor to projects being undertaken through the Telecom Centres of Excellence (TCOE). The views expressed here are personal.