Fundraising rounds are exciting times for startups. They are also busy times, requiring a plethora of documentation to be prepared, reconciled, and properly organized.
The most important strategy when preparing for investor due diligence is to start early. Allowing plenty of time to build and fill your data room makes the preparation process less stressful.
Taking the time to create thorough, organized data rooms can shorten the due diligence process, signal your startup is prepared and mature, and increase investor confidence. Let’s take a look at what due diligence encompasses, how to vet potential investors, and what documents are an absolute must to best position your company ahead of fundraising rounds.
What is Startup Due Diligence?
Due diligence is the process during which investors audit startups to determine whether or not the company has any liabilities before investing capital. Founders who are able to produce thorough documentation ensure investors and venture capitalists that there are no shortcomings. This also signals increased success potential.
When Does Due Diligence Begin?
Startup due diligence begins with the initial investor engagement. Even casual conversations regarding goals and potential can signal the beginning of a potential deal. From the very beginning, founders must be transparent, honest, and upfront, as missing or misleading information can kill the deal. A signed term sheet begins the official process.
How Should Founders Vet Potential Investors?
As investors are working to vet the startup, founders should likewise vet potential investors. Reverse due diligence is the process of ensuring potential investors are the right fit. Founders should learn about investment history, frequency, and expectations, ensuring goals and cultures are aligned.
How Should Founders Vet Potential Investors?
As investors are working to vet the startup, founders should likewise vet potential investors. Reverse due diligence is the process of ensuring potential investors are the right fit. Founders should learn about investment history, frequency, and expectations, ensuring goals and cultures are aligned.
What Will Investors Ask?
Short answer: everything. Investors performing due diligence will want to learn everything there is to know about the founding team, the product, market viability, equity structure, cap tables, and more. They will likely look at board minutes, search for any prior lawsuits, and evaluate churn rates. This is why preparing a thorough and organized data room is critical to this process.
How Long Should Founders Expect Due Diligence to Last?
Seed stage rounds move more quickly, and the farther along the funding round, the longer the process can take. While each investor deal is unique, due diligence periods typically take anywhere from two to six weeks for Seed or Series A, though Series B, Series C, and up could take longer due to auditing requirements. Having a startup attorney perform a pre-diligence review can ensure every document is in place and no information gaps exist, which can speed up the process and prevent mid-deal lag.
Startups that prepare organized and thorough data rooms during the first round are better prepared for subsequent funding rounds. It’s easier to keep documents updated along the startup journey than to restructure data rooms after major milestones.
What Should Be Included in a Data Room?
A data room is a singular, virtual, secure location from which startups can share information with potential investors. Data rooms should tell the entire startup story with a clear company record and have the ability to illustrate future company potential. These documents should be up-to-date, transparent, and organized for easy review, leaving few, if any, openings for investor questions. Here’s what should be included:
What Financials Should Data Rooms Include?
Income and cash flow statements, previous capital infusions, and P&L and current balance sheets demonstrate financial history. Sales pipelines can demonstrate market demand. Future financial models should predict cash flows at least two years in advance, but some investors may prefer to see projections covering the next three to five years. Large or later-stage deals or subsequent funding rounds may require financials to be audited.
What Legal Documents Should Data Rooms Include?
Formation documents including articles of incorporation, bylaws, and operational agreements are the startup’s foundation. Licensing, permits, or regulatory correspondence indicates legal compliance. Cap tables, equity distribution, and stock option plans demonstrate company structure and provide a dilution roadmap while outlining investor rights.
What Product Information Should Data Rooms Include?
Product demos or mockups demonstrate functionality and value. Patents, trademarks, and copyrights should be included, as well as IP assignments. If the product is digital, data training provenance for AI products provides background history. Planned developments or enhancements further outline product value.
What Business Metrics Should Data Rooms Include?
High-performing KPIs underscore future projections. Revenue growth, churn or burn rates, and customer acquisition costs demonstrate previous wins and potential growth. Presenting high LTV:CAC ratios present attractive economic potential to investors.
What Other Documents Should Be Included?
- Vendor Agreements
- Employee/Contractor Agreements
- Board and Shareholder Meeting Minutes
- Letters of Intent
- Rolling FAQs
- Testimonials
- Pitch Deck
Have An Attorney Protect Your Interests
We know startups, and we know investors, too. During the investor due diligence period, specialized attorneys like those at HJF Law work to protect the interests of your startup. We help founders prepare founders for investor scrutiny by gathering and updating documents, ensuring regulatory compliance, and preventing legal errors during funding rounds.
Properly organizing your data room ahead of investor conversations conveys professionalism and maturity. It can shorten the due diligence process, and increase the likelihood of fundraising success.
It’s never too early to hire a lawyer! Let HJF help your startup prepare for investor due diligence by reaching out to us at (917) 726-8184 or contacting us here.