Finance Due Diligence for Startups

The diligence process intensifies at each stage to match the increasing complexity and stakes of the investment. Early stages focus on potential and basic compliance, while later stages scrutinize performance, scalability, and adherence to more complex legal and regulatory standards. Financial diligence becomes more important as the company matures.

1. Financial statement fraud: VCs may engage specialized accounting firms to conduct thorough audits, looking for any signs of manipulated financial statements. They pay close attention to revenue recognition practices, expense categorization, and any exceptional items that could distort the company’s financial picture.
2. Hidden costs and liabilities: Investors scrutinize business arrangements and contracts for any undisclosed obligations or potential future costs that could impact the company’s valuation or performance.
3. Corruption and unethical practices: Due diligence at later stages often includes background checks on key executives and an examination of the company’s business practices to uncover any signs of corruption or unethical behavior.
4. Volatility of earnings: VCs analyze the consistency and sources of the company’s earnings. Unexplained volatility or an overreliance on non-recurring income can be red flags.
5. Sensitivity analysis: Investors may perform detailed sensitivity analyses on financial projections to test the robustness of the company’s financial model and uncover any unrealistic assumptions.
6. Third-party verification: VCs often engage law firms and specialized due diligence providers to conduct independent verifications of key claims and metrics.

1. Maintain accurate and up-to-date financial records

Keeping your financial records organized and current is clearly important for finance due diligence - but it’s also best practice to keep your books and financial statements up-to-date and accurate. This includes:

• Income statements
• Balance sheets
• Cash flow statements
• Tax returns
• Financial projections
• Capitalization table

2. Implement robust financial controls

Establish strong internal controls to ensure the accuracy and reliability of your financial data - this includes keeping careful track of your expenses prior to fundraising. And after fundraising, it’s a very, very good idea to have a standard accounting software, bank accounts and corporate cards set up and dedicated to the business. This may include:

• Accounting software connected to bank and credit card feeds via APIs
• Expense management tools (the best cards have these built in)
• Regular reconciliations
• Segregation of duties and controls on who can approve expenses
• Documented financial policies and procedures - this is usually pretty light for early-stage companies but an outsourced accountant can help set this up

3. Engage professional advisors

Working with experienced professionals can significantly enhance your preparedness for financial due diligence. Consider engaging:

• A startup-focused accounting firm; most startups don’t have an audit, but an accounting firm that has executed many diligence requests will make the process smoother
• Legal counsel with expertise in startup law; startups with experienced law firms tend have better diligence
• Other finance advisors are optional at the earliest stages, sometimes a part-time CFO is helpful

4. Prepare a comprehensive data room

Organize all relevant financial documents in a digital data room. Most of our clients use a simple tool for their deal room like Google Drive or Box, but there are more expensive solutions on the market as well. As far as what to put into the data room, our checklist has a more through list of items to include, but at a high level, this should include:

• Financial statements (if you can go back 3 years do so)
• Tax returns
• Contracts and agreements
• Capitalization table
• Intellectual property documentation

5. Be transparent about challenges and opportunities

Transparency is key during financial due diligence. As one of our VC friends once said, don’t bet on stupid - you don’t want to hope that a VC misses or forgets to ask a question during diligence. Instead, be up front so that you can proactively address any challenging finance items. Be prepared to discuss:

• Any financial challenges or setbacks
• Growth opportunities and plans
• Market conditions and competitive landscape

1. Incomplete or inaccurate financial records

Many startups struggle with maintaining comprehensive financial records, especially in the early stages. This can lead to delays and complications during due diligence. Items like cap tables, payroll data should be kept cleanly, and, once again, in a solid accounting system.

2. Cash based books

Some founders, mainly less experienced ones, don’t keep their financial records in the accounting method that VCs expect - accrual based accounting. Instead, they record transactions as they hit the bank account, which is cash accounting. Most VC metrics are based on accrual financials, so this can cause delays in diligence. And, many very early-stage startups often operate with informal financial processes, which can raise concerns during due diligence. Implementing formal procedures early on can help address this issue.

3. Complex revenue recognition

For startups with innovative business models or subscription-based services, revenue recognition can be complex. Since so many VCs use metrics that are based off of ARR and revenue, ensure you have a clear and defensible revenue recognition policy and are correctly recording revenue.

4. Unrealistic projections

VCs expect high growth when they examine startups’ projections. However, overly optimistic financial projections - especially low expenses - can damage credibility. Be prepared to support your forecasts with solid assumptions and market data. Growing fast is good, but projecting that your startup will grow fast without increasing any expenses is usually the sign of an inexperienced founder.

5. Poor tax compliance

Neglecting to file tax returns and other compliance issues can be expensive to fix. VCs don’t want their capital going to pay for fines and late fees, especially for problems that occurred prior to their investment. Engage with tax professionals to ensure compliance and optimize your tax position.