Company Due Diligence For Startups

Due diligence is a term that we hear quite popularly when we are on the subject of acquisitions, startups, venture capital funds, and the like. So, why is this term being used so frequently? What’s the reason for it being so popular and widespread?

Any financial decision that is taken bears a significant amount of risk along with it. It is only fair that the person who has invested a large sum of money gets an idea regarding the level of risk involved, what the impact of the risk will be on his investment, etc. Due diligence, in simple words, is all the proper steps taken to reduce the risk of making an uninformed decision. It is an investigation procedure that provides you with enough information to make an assessment.

A potential investor first needs to see if the acquisition fits into his overall strategic plan, and that’s where due diligence comes of use. Investing in a startup is an inherently risky venture; therefore, it is heavily advised that a potential investor does complete and thorough scrutiny of the startup that it intends to invest in.

Startups will need a hefty investment of capital in order to achieve the standard growth rate, but once that growth rate is achieved, it must also be maintained in the long run. Another point to be considered is as compared to established businesses; startups have a considerably high level of uncertainty when it comes to attaining milestones, which makes the need for due diligence all the more crucial.

Need and Impact of Due Diligence

Due diligence involves the review of a company’s finances, assets, liabilities, its structure and operations, potential and present litigation and all other relevant business activities. Before the due diligence begins, the parties sign an NDA (Non-Disclosure Agreement) because this process involves sharing of the sensitive data of the company with regard to its financials, operations, finances, legal and other regulatory information.

Types of Due Diligence

Technical and Intellectual Property Due Diligence

It is an analysis that is carried out regarding the technical aspects of a product or service and the underlying intellectual property. This becomes a critical matter for tech companies.

Experts in the technology field will conduct due diligence regarding the same to assess whether it is a viable option.
– What phase is the product currently in, research phase or development phase?
– What potential does it hold in terms of growth and scalability? – Does it infringe on any existing patented products?
– Does it provide security to users with regard to sensitive information?
– Has the company taken adequate measures to protect intellectual property?
– Has the company granted any third party exclusive rights to use the technology in any way?
– Does the company have any pending patents for any of its products?

Document Checklist:

• Schedule of all the patents, copyrights and other intangible assets.
• Patent filing documents.
• Documents pertaining to proprietary technology developed by the company.
• Technology license agreements entered into by the company. – Pending actionable or not actionable claims case by or against the Company regarding violation of intellectual property.

Tax and Financial Due Diligence

Here, the analysis is made with regard to historical data for the entire entity or possibly on specific projects, review of forecast performance and funding requirements, scrutinizing all the documents related to the tax liability, taxes of the company, finding answers to questions such as:-
– Is the current financial position a favourable one?
– Does the business have healthy cash flows?
– Is there potential in terms of scalability?
– Does the business present long term prospects?
– What is the current status of the financial ratios of the business?
– Does the business have any kind of liabilities related to taxes and other regulatory authorities?
– Has there been a steady growth in terms of profitability?

Document Checklist

• Copy of audited financial statements of the previous three financial years.
• Copy of the Income Tax Return acknowledgment of the previous three financial years.
• The latest copy of the CIBIL report and credit rating.
• Essential correspondence with the tax authorities, if any.
• Fixed and variable cost analysis.
• Financial projections.
• Schedule of the debtors and creditors.
• Schedule of assets and liabilities.
• Copy of orders, notices and intimations issued by the tax authorities.

Human Resources Due Diligence

HR due diligence involves understanding the country’s system of employment contracts, labour laws, labour relations, regulatory policies, work culture, and industry standards. The workforce that is the human side of an organization has both cost and value in monetary terms.
– What are the insurance plans in place for the employees?
– How many retirement plans does the company have for its employees?
– Are the HR policies within the boundaries of the labour laws?
– Are the employment contracts as airtight as possible?
– Does the company have a high labour turnover rate?

Document Checklist

• Employees Register with all the relevant details, demographic and otherwise.
• Payroll details.
• Schedule of ESOP.
• Employment contracts and the relevant contract clauses.
• All the HR policies in place.
• Register of complaints and grievances made.
• Grievances redressed, pending complaints, etc.
• Workplace sexual harassment cases, if any.

Legal Due Diligence

This is done to assess the company’s risks from the legal and regulatory standpoints. Legal compliance is often the trickiest and the most tedious, by far. Most of this has to do with compliances with the Ministry of Corporate Affairs.

It involves the examination of:-

• Memorandum of Association.
• Articles of Association.
• Prospectus.
• Employment agreements.
• Licensing and franchising agreements entered into by the company.
• Loan and guarantee agreements to which the company is a party.
• Documents pertaining to any financing arrangements entered into by the company.
• Copies of lawsuits, pending or previously filed against the company.
• Equipment leases entered into if any.
• Real estate agreements entered into by the company.
• Material contracts, such as joint venture agreements, partnerships and such other arrangements.
• Minutes of the Board Meetings of the previous three financial years. – All the registers are pertaining to the company.
• List of the directors and other key managerial personnel and their details.
• Tax paid receipts.
• All compliance certificates pertaining to regulatory, statutory and corporate compliances.
• Certified true copies all RoC filing.
• Details of any executed or pending Settlement Agreements entered into by the Company.
• Details of any labour litigation.
• Copies of any injunction orders issued by a competent court (if any).

Final Note

Due diligence is a very detailed and extremely crucial process. The output that is obtained has a high level of significance because it helps the investor make a well-informed decision regarding whether the company is worth investing or not. Therefore, the process has to be in an extremely thorough and detailed manner so as to arrive at the best.

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