Importance of Conducting Due Diligence before Investing in a Startup: Lawyers Advice
In the world of startup investing and the private investments, the role of due diligence has become very significant. If any investor wants to involve in a successful investing, then he is required to comprehensively evaluate the sustainability of the investments. This can be done by proper research and study of the particular startup they are planning to make investment in. In startup investing, the investors has to suffer the problem of the less available information about the startup in the market. If the proper information is not available, then it would be difficult for the investors to carry on proper due diligence about the particular startup.
Before making any investment there are numerous reasons to be taken into consideration like the business model, the amount of finance involved, efficiency of yielding appropriate returns, suitable exit opportunities etc. All these things should be taken into due consideration at the time of conducting the diligence, otherwise the investors might suffer losses.
There are various reasons why it is compulsory for the investors to do proper due diligence before making the proper investments in the startup. Although nobody enjoys undergoing the rigorous procedure of due diligence, neither the investor nor the entrepreneur. However, the process of due diligence makes it easier for the investors to make a proper informed decision about investing any startups. When the investors involve themselves in conducting due diligence they have to go through the entire life of the startup right from its establishment to its potential future, as far as the same can be predicted. Going through the entire history of the startup always gives a better idea to the investors about the potential of the startup to give the valuable returns.
Most of the investing companies have certain investment criteria, which is taken into consideration by them before making any investments in the startups. Not all the investment companies have the adequate finances to take the risks. Therefore to save themselves from any type of losses, it is significant to conduct a proper due diligence and to check whether the startup in which they are planning to invest satisfy their investment portfolio. Some of the criteria set by the firms are openly stated and apparent where they only make their investments in particular industries or segments, or certain geographies, at certain investment levels. Other criteria may be less obvious and are not to be shared with the entrepreneur.
The importance of conducting due diligence gets more and more critical when the startups have the minimal sales and their cash flows are modest. In that case it is really necessary to conduct the due diligence for finding out the valuation of the business and also determine the value of the assets. While investing in the large and established startups, it will be not be necessary for the investors to conduct a rigorous due diligence as their market value will also be more and they will not have any hesitation in investing their funds but with the new startups, they need to be more cautious. Growth rates must be deliberated in the setting of the stated growth drivers as well. When looking at the reasons driving projected growth rate figures, investors should ask themselves whether such drivers can reasonably apply to the company they are evaluating.
Another important aspect of conducting the due diligence is to find out the material defects if any. When the investors is well aware about at any defects in the start-up business, either he will prevent to take such risks or he will develop a plan for the purpose of mitigating the risks. It’s really significant to take a thorough look at all the defects, and then only go ahead for the investment purposes. Any choice of investing in the startups by the investor should not prove fatal to him and that’s why it is important to conduct a diligence.
Precautions to be taken by Investors before Investing in a Startup
There are certain precaution which are required to be taken by the investors before investing their valuable money.
• First of all the investors are required to invest in the domain which they are aware about. It is really significant to understand the market where the startups are operating. They have to be cautious that the particular startup have a scalable model of business, where you can get back the returns.
• Whenever an investor is conducting the due diligence, he is required to significant precaution of employing the people with right expertise for conducting the process of due diligence and giving out favourable outputs.
• The investor is required to look into consideration certain legal documents. They need to look into the articles of association, term sheets etc. It is significant for the investors to get well- versed with the structure of the start-up company. They need to know about the other investors, directors, members. This will enable the investors to know about the percentage of the ownership they will receive in the company for the amount of money they are investing into the company.
• The investors are also required to know why and how the startups want to spend the money which has been invested by them. The precaution is required to be taken about the planning and strategy they have in mind for the purpose of spending money. The investors need to see how much money, the salary, the founder of the startup wants to pay himself.
Therefore it is really necessary for the investors to indulge themselves in the process of due diligence before spending money into any starups. The startups are generally on their initial stages when they require huge funds from the investors. So, if the investors are willing to take less risks, they need to make sure that they are investing in the well-established organizations only. If the investors conducting the due diligence finds that the investment will not be beneficial for them, they should move forward. It is significant to save money on incompetent investments rather than losing the valuable money.
Authored By: Adv. Anant Sharma & Bheeni Goyal