Due Diligence For Startups & Investors
Before deciding to buy something valuable like a laptop or a television or a property we try to analyze whether it will be worth the money invested and how it will benefit us, the future valuation, the risks and obligations involved, and numerous other perspectives. So before buying or taking over a company(acquisition) or merging with another company or before making a potential investment in a company that involves financial transactions in millions, a thorough investigation is required. This thorough investigation of facts is well known in the market by the name of “Due-diligence”.
MEANING OF DUE DILIGENCE
In today’s magnanimously growing corporate world, Mergers and Acquisitions are the need and greed of the hour. Mergers and Acquisition is actually the consolidation of two companies. The first question that comes into our mind is how does it benefit the company? This process lowers the overall cost of the capital and other expenses and increases the productivity, creates a wider customer base and increases the market share, it reduces competition and helps in overall growth maximizing the profit. Startups today are blooming, boosting innovation and economic growth throughout the world. After the Letter of Intent is signed, the audit begins. It not only highlights the benefits but more importantly it exposes the potential risks, the obligations and liabilities, debts and penalties if any of the target company in front of the investors.. It gives the acquiring company or investor confidence that the transaction will be worth the investment. This analysis and inspection of the company’s business and operation is Due-Diligence and this helps to minimise the risk of loss and failure, assess the valuation of a business and the risks.
TYPE OF DUE DILIGENCE FOR STARTUPS
Due diligence can be (but are not limited to) of the following types:
Legal due diligence for startups is the formal investigation of all the essential legal documents of the target company/startup that includes (but are not limited to) any pending and potential lawsuits, ownership issues, employee actions, professional licenses, employment contracts, support contracts, co-founders agreements, license agreements,company-by-laws, limited liability agreements, stockholder agreements, voting agreements insurance claims, articles of association, intellectual properties, operating contracts, leases and any other similar documents that can give rise to a contractual obligation. It also includes the methods of dispute resolution, jurisdiction, representations and warranties, property and tax liabilities. This helps the investors recognise the problems and take an informed decision of investing accordingly and avoid future lawsuits after investing or acquiring the company. Also it helps the startups evaluate their market value during such due-diligence and this is beneficial in cases when there are more than one investors or acquirers
The financial due diligence involves the audit and assessment of the financial records and financial health/position of the company. It includes due diligence reports on assets bought and sold, the debts or loans if any to avoid future jeopardy. It helps the acquirer or investor assess the true market value of the company. The financial due diligence helps to detect and kind of tax evasions as well which can later cause a liability.
3. Tax(direct and indirect)
Tax due diligence involves the thorough assessment of a company’s tax liability, authenticating the tax returns, tax audit details, any agreements with tax agencies and the jurisdiction that governs it and also look for any tax evasions.
4. Intellectual property
Intellectual property assets are intangible assets which increase the market value of the company and sets the brand apart from its competitors so it is very significant that the target company has sole and exclusive ownership of the trademarks, patents and copyrights involved and the assessment of how well these are protected(if they are registered or not) is also important. So IP Due-diligence assesses the quality of these intangible assets and also checks whether or not there are any disputes pending involving the target company’s IP assets.
Operational due diligence helps to assess the future of the target company by identifying the benefits and flaws of the current business plans, internal operational processes of the company, investments made by the company and reveals the true economic position of the business, creating a better value creation plan and also unveil any operational risk. In the case of M&A, Operational due diligence for startups answers the question of what will the buying company do with the target company once it is theirs and thus helps in smoothing the process.
6. Information technology
IT due diligence helps to survey the IT infrastructure of the company and how the sensitive data is being protected and if the softwares used are up to date. It helps to assess the annual expenditure of the company on IT maintenance and assess the disaster recovery plan.
7. Human Resources
Employment contracts, salaries, bonuses,es and other allowances and benefits enjoyed by the companies are assessed in the human resources due diligence report.
8. Commercial/Market due diligence
Market due diligence helps to assess the commercial or market value of the brand by evaluating the market size and market share, customer base, potential competitors, and future prospects. It analyses the overall company performance and its market position.
The business due diligence involves probing into the various business and marketing strategies and action plans, sales, franchise agreements, agency agreements, etc and this helps in operating the business once the merger and acquisition take place and also make the investors acquainted with how the business is going to run and so make the transaction profitable.
There are certain rules and environmental standards according to which a company should operate. The Environmental Protection Agency (EPA) sets forth the standards for conducting environmental due diligence. This can include assessing the properties in connection with any kind of potential risk of environmental contamination, proper removal of hazardous waste products, any past oil spills or fire incidences, whether the required environmental permits are in place
The regulatory due diligence for startups involves the review of the company’s regulatory compliance status and understanding regulatory obligations and attentate regulatory risks.
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Frequently Asked Questions for Due-diligence For Startups
Why is due diligence important?
Due diligence is important because it helps the investors to take an informed decision by verifying sensitive information and performing audits. It not only helps to realise the worth of the investment and scrutinize projections for future performance. The future prospects but also assess and reduce exposure to short term and long term potential risks and defects. If investment is the final exam the due diligence is the revision. Startups/Target companies need to maintain complete transparency during the procedure.
Who does due diligence?
Due diligence is conducted before the binding contract is signed between the parties once the term sheet is agreed upon. It can take weeks and even months to complete depending on the complexity of the organization. Chartered Accountants, Lawyers, Investment Bankers, accountants and other consulting people conduct the due diligence to ensure a transparent deal.