Reply To: What is the key focus in due diligence for an early stage (startup) company?

#108708

Korath Wright
Participant

Every DD is different, including from one startup to another. However in general, early in the Due Diligence process it’s important to have a strategy clearly defined. This informs the scope, materiality and risk profile required for the Due Diligence.

With startups it can be especially tricky to nail down important aspects beforehand. They can have agile management styles and be in a shifting state while finding a business model that is profitable. Even so, with a well defined strategy, a Due Diligence process can move forwards using it as a framework for what does and doesn’t work.

In keeping with agile management styles, this generally requires a higher investment in people and processes throughout, has a higher risk of losing focus, and has less predictable outcomes.

Varying greatly depending on strategy and other specifics, a few of the initial aspects to focus on early in Due Diligence for a startup stage company can include:

Legal – What liability exposures are big enough to warrant the cost, and what sort of remedies can practically be used considering counterparty risks or the requirements for continuity of day-to-day operations.

HR – High concentration of key people means they have more power to dictate negotiations and significantly impact value creation with their departure. Sellers who stay on as key people may no longer have the performance they did when they relied on their salary for income.

Governance – Less scrutiny over decision making at various levels often provides gaps in governance. In cases of overlap between owners and management, self reporting has lower levels of accountability.

Financial Statements – Less reliable financial statements and less of track record require more work to get similar quality numbers. Audits may have gaps or be non-existent. Accounting standards may not have been applied consistently.

IP – Sufficient intellectual property registration and documentation of processes may not be in place in a younger company or startup.

Tax – If companies have never made money, they may not have large risks of tax liability exposures from previous positions. However this can change, and in some high profile cases we are seeing today, companies such as Apple have to pay retroactively. Also, carrying forward tax credits from startup losses could improve a mergers business case.

Representing key risks and assumptions to be assessed, the framework developed for each DD can depend on many factors such as the startups type of industry, market factors, investor goals, risk appetites, and a variety of other factors specific to each company’s situation.

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