This is the fifth and last installment of our 2020 First Time Founders Series. Let’s talk about formalities and why it pays (literally) to be organized.
What is Due Diligence?
“Due Diligence” is the review of your startup in preparation for a business transaction. That transaction can be a venture capital investment, a bank loan, a business partnership, or an acquisition. Experienced executives may also diligence your startup prior to joining your team.
Your potential business partners are looking under the hood to make sure you know what you’re doing, confirm the actual business matches your claims about the business, and avoid surprises.
Not all diligence reviews are created equal, and every aspect of your business can be subject to a diligence review. Folks may want to review your legal structure, financial records, intellectual property portfolio, HR practices, etc. Some partners will turn over every stone, some will take a quick peek.
The cost of disorganization.
You may have done everything right: a robust IP portfolio, amazing commercial traction, solid financials, best-in-class HR practices. But, if you’re disorganized and your partners cannot quickly confirm you’re amazing, your deals will slow down, and the value of those deals may take a hit.
Here’s the truth: if you’re disorganized, your partners will assume you’ve cut corners and ignored formalities. They will assume there are hidden risks, or at least increased costs to fix mistakes. A bank may turn you down for that loan. A VC may lower their valuation. An acquirer may reduce their price.
The flip side: if you’re organized, your partners will assume you know what you’re doing. They’ll often ask fewer questions or reduce the scope of their due diligence review. Your deal will get done faster.
It is therefore important not only to mind business formalities but also to be organized.
The best way to get organized is to start organizing. If you expect to take VC investments, get a sample VC due diligence request list, and set up a virtual data room that is organized to match that list on day one. Settle on a naming convention for your documents and stick with it. When you finalize a document, make sure it is final – one copy signed by all parties, with all dates and final terms filled in. Do not rely on multiple copies or email attachments to re-create final documents after-the-fact.
This level of organization also helps you catch issues before they become problems. You can quickly spot that your critical commercial contract was never signed – there it is, still sitting in draft form, not a dated PDF with all signatures attached. You will notice that your new engineering hire never returned her signed confidentiality and invention assignment agreement. You will see the missing board approvals.
Take ownership of records. Keep them organized. And then, when that life-changing term sheet is followed by a due diligence request, you can say, “no problem, here is our pre-existing data room.”
Always those formalities.
Organization can help you catch risks, but it cannot eliminate risk. Let’s go back to our prior discussion about employees and contractors. It is fantastic that you have final, signed, and dated consulting agreements from all your independent contractors. Outstanding that they are sitting in your virtual data room just waiting to be reviewed by your partners. Not so great that all of these independent contractors were misclassified, and a quick review of those well-organized agreements reveals that your contractors should be full-time employees, entitled to W-2 wages and benefits. An acquirer may still buy your startup, but your payout will likely be lower because of this issue. Organization alone is not enough.
Your startup is a real business, subject to real laws. To maximize the value of your startup, you must mind those formalities. Talk to your advisors, seek out experts within your network. Ask questions. Re-review our prior installments in this series – each time touching on important formalities and next steps.
Our goal in this series was not to give you a checklist of issues or pitfalls to avoid. It was to get you asking questions, with the right vocabulary to get practical answers. Thanks for reading, and good luck!
This blog was originally posted at Galvazine.