What exactly is due diligence?

Acquiring or investing in a business is a serious matter.

As such, most investors will conduct a detailed examination of the target business’s legal, financial, and operating condition. This examination process is called “due diligence,” and it sheds light on the risks and rewards of the deal.

It can also expose liabilities, impact the valuation, or uncover deal-breaking factors in the worst-case scenario.

But, in a non-technical sense, due diligence is like dating.

This is where the investor and the business owner get to know each other before completing the deal. The investor wants to get to know you, and just like dating, how you present yourself is just as important as what you present.

Also, remember that this is your opportunity to get to know the investor. Especially for small, early-stage companies, this is very important – just like a marriage, you will be working closely with your investors for a long time. So, be sure there is a fit.

Due diligence can be time-consuming and stressful. Fortunately, proper preparation makes the whole process easier and inspires confidence in the value of your business.

Also, if you are well prepared, you can spend your time in the process looking into the investor rather than running around trying to cobble together reports. If you prepare continually, it doesn’t have to be painful and can be enlightening.

What does due diligence include?

The exact scope and nature of due diligence will vary. However, any comprehensive investigation of your company is likely to include business and financial documentation and data, legal analyses, and personal interviews.

You should expect queries about your accounting practices, liabilities, shareholder dividends, and liquidity. A thorough process may also study your commercial viability. This could include researching your innovation, scalability, and unique selling proposition.

At a minimum, a clean set of books in QuickBooks (or other accounting software) is essential. You will also need copies of all legal agreements that you have ever entered into. Investors may also want to review strategies and any supporting commercial information. This will help them understand the opportunity that exists within your business.

Ultimately due diligence will be as detailed and broad as the investor deems appropriate. However, you can influence the type and qualify of due diligence. The information that the investor needs is the same information you need to run your business. Often, if you are prepared, you will be able to steer the process toward the available information.

What is the due diligence process?

Due diligence breaks down into three basic phases: preparation, investigation, and results.

During preparation, the buyer or investor will establish goals, priorities, and areas of focus for the process. On the company side, you should make sure that you have all of your documents well organized and ready for the inquiry. You can influence the preparation stage by engaging with the investor and educating them on how your business works.

During the investigation, you can expect to receive requests for information and documentation. This will involve the exchange of documents and, likely, face-to-face conversations. In this phase, you want to be as open and responsive as you can be.

Finally, in the third phase of the process, an analysis of findings and results will inform a final decision about the potential deal.

This can be a lengthy process. Often, though, when due diligence drags on, it is because the seller is slow in providing information. That means it is within your power to facilitate a faster, more efficient due diligence. This comes down to preparation.

How to prepare for due diligence

Preparing for due diligence means keeping everything a buyer or investor might want to see accurate, up-to-date, and organized.

Managing your side of the process is critically important, so here are some tips to get you started.

Create your own due diligence checklist

Put yourself in the buyer or investor’s position. If you were examining a company like yours, what would you want to know? Some investors will provide you with a due diligence checklist, but it’s a good idea to start creating your own in advance and use it to organize your books and your records.

Make sure your checklist includes these categories:

  • Corporate records
  • General financial information
  • Cash flow and investment statements and cash equivalents balances
  • Accounts receivable
  • Accounts payable and accrued liabilities
  • Revenue (total and sources)
  • Product expenses and other operating expenses
  • Taxes
  • Intellectual property
  • Material agreements
  • Personnel and employee benefits
  • Rights, permits, and other regulatory matters
  • Litigation, investigations, and other disputes
  • Property and equipment
  • Purchased and developed software
  • Strategies and future plans.

Determine how much sensitive information you will share

This is a tricky one: you want to be as open as possible, but you also have to protect yourself in case the deal doesn’t go through. Again, this is like dating – as you go through the process, you will be more open.

It may seem counter-intuitive, but there will be some sensitive information you should not share. This could include, for example, personal customer data, intellectual property, or unpublished patent applications.

Due diligence is all about transparency. Still, sharing certain information could violate data protection laws, NDAs, or regulations, breach a contract, or reveal confidential information to competitors. Be attentive to any details you may need to anonymize or entirely withhold.

Furthermore, you should ask all parties involved in the due diligence to sign Non-Disclosure Agreements or NDAs, as well. This will not only help protect your sensitive information—it will also demonstrate to future buyers or investors that the information is secure.

Note, though, that not all investors will sign NDAs.

Early-stage investors, especially angel investors, likely won’t sign an NDA.  This is not because they will reveal your information but rather because they see so many companies and engage in so many transactions that tracking these agreements would be impossible.

You will need to balance the investor’s need for information with your need for confidentiality and any legal constraints you must respect. There are no hard and fast rules here, so you will have to feel your way through.

Address unresolved exposures

Before your company goes under the microscope, you should get it in the best possible shape.

That means addressing liabilities and exposures. Ongoing or potential lawsuits, disputes, or threats of litigation will be major red flags during due diligence. So you should try to resolve them before a buyer or investor even shows interest.

There may be litigation exposures that you aren’t even aware of but which would surface during due diligence. Review any possible disputes related to:

  • Ex-employees;
  • past or present customers;
  • vendors;
  • intellectual-property issues;
  • company practices (even ones that are no longer in use).

Finally, if you cannot resolve an exposure or liability, be honest and open about it. Communicate the issue, and demonstrate the mitigation measures you are taking.

The reddest of red flags is a meaningful exposure or liability that you never disclosed. The second reddest is an obvious issue that you ignore. Hiding or just neglecting an issue can be a sign of incompetence that is much worse than a liability.

Make it as easy as possible for the buyer or investor

Remember, facilitating a smooth process is in your best interest. Organization is key to this objective.

It is a good idea to set up a virtual data room, or “deal room.” This is an online space that allows you to present information in a controlled way. A good virtual data room should include folder and sub-folder organization, with tables of contents and overview documents. Be consistent with naming and numbering. Use hyperlinks to make accessing related documents easy, and keep everything up-to-date.

Organization and clarity are key here: your data room can be a well-organized Google Drive or a folder on DropBox. It doesn’t have to be fancy, but it does have to be easy to work with.

In the process of due diligence, stay on top of all communications, and respond promptly to any requests for additional information. By being organized, professional, and courteous, you will show your company to be credible, capable, and valuable.

Start now, not later

Getting ready for due diligence is time-consuming and complex. Beginning to do so only upon attracting interest from a buyer or investor will not give you adequate time. What’s more, being unprepared will reflect poorly on your company and is likely to impact the success or failure of the deal.

So no matter where you are in your company’s growth, there will not be a better time than now to review your readiness.

It’s never too early to prepare for due diligence.

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