The importance of due diligence for start-ups and scale-ups in the fundraising process

Opportunity and outlook

Despite continuing headwinds for private equity firms globally, funds look set to continue investing during 2023, driven by the amount of capital the industry must deploy. Committed but undeployed capital, or ‘dry powder’, is close to a record high, sitting at $1.24 trillion globally at the start of 2023.

At the end of what was a turbulent year, both politically and economically, the UK finished 2022 amidst a cost-of-living crisis and with business confidence at its lowest level since the pandemic. However, inflation started to fall from the 40-year-high and unemployment rates dropped, giving hope for the year ahead.

Outlook for UK business in 2023 may be uncertain, but if inflation begins to dip in the first half of 2023, this could open the door for a period of stability in the second half of the year. Increased stability would have a positive impact on the flow of funding into businesses, therefore there is room for optimism over the next 12 months.

These factors combined mean that there is opportunity for start-ups and scale-ups to secure venture capital funding. The current environment may be more competitive and selective, and so due diligence will form an integral part of the fundraising process.

Due diligence can sound scary

Due diligence is defined as: “the investigation or exercise of care that a reasonable business or person is normally expected to take before entering into an agreement or contract with another party or an act with a certain standard of care”.

The due diligence process usually begins after your pitch once the broad plan for the investment is agreed via a term sheet. Venture capital firms will each have their own processes and requirements to confirm the viability (or otherwise) of the proposed investment, but there are steps you can take to ensure the process runs as smoothly as possible:

• Early planning puts the fundraiser in a strong position. Having detailed information and supporting documentation for the past two years will increase confidence from prospective investors.
• Think like an outsider. Identify the key risk areas and honestly assess how your business could be perceived by external parties.
• Be clear on your sales forecasts. A detailed understanding of your pipeline, conversion rates and customer contracts will be important to investors.
• Ensure statutory registers, company and accounting records are up to date and Investors will appreciate and value good housekeeping.
• Resolve legal disputes including regulatory, employee issues, taxation, etc. Investors will want to ensure the business is legally compliant and that there are no claims that may arise.

Be aware also that both sides can benefit from due diligence – you as the founders and business owners are already the biggest investors in the business in terms of both cash and time/effort and identifying any risks or areas that need work at a pre-funding stage can be extremely valuable. Addressing these in advance could even lead you to an improved valuation.

Getting to know each other is key

This allows both sides to consider whether they have a future together, and what that relationship might look like. Due diligence is part of this process.

Investors are looking at the business as well as the individuals or team behind it and will be interested in your history as well as your future. So, if there are any skeletons in your closet now is the time to reveal them.

You might also want to track down founders of other portfolio companies the fund has invested in to gather their feedback, both on how the due diligence process worked as well as what their relationship with the investors looks like post-investment. This information will form part of your decision-making process when ultimately you must decide if this investment is going to be the right fit for you and your business.

“By failing to prepare you are preparing to fail”

This is especially relevant when raising funds for your start-up. You can be prepared by having information collated and ready to share, covering your finances and business to date as well as detailed plans and projections. Also consider whether you have given enough thought to some of the less glamorous aspects of running your business. Legal contracts with customers and suppliers, licences and regulations, compliance with GDPR, robust employment contracts and payrolls, IP licences, and registrations are all potential stumbling blocks which could scupper your investment progress, so ensure you get the documentation and procedures in place as soon as you can.

So long as you have honestly presented both yourself and your business during the investment pitch, due diligence does not need to be a stressful process, instead it can become one of the most rewarding and enlightening periods of your company’s journey to date.

How we can help

Blick Rothenberg has extensive experience in supporting our clients through the due diligence fundraising process. We can provide support at all stages along your fundraising journey; advising how to structure your company to secure access to tax reliefs for your investors via the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS), providing you as founders with the best structure for your own longer-term goals, preparing your business plans and forecasts, and ensuring you are compliant with all ongoing tax and reporting requirements.

We can also support you through the due diligence process itself, liaising with your own legal advisers as well as those of your potential investors to provide them with timely and accurate responses to their enquiries and ensure a smooth due diligence process and positive outcome.

Would you like to know more?

If you would like to discuss any of the above in more detail, please contact Tom Utley using the form below.