A Practical Guide to Due Diligence during Fundraising

Often, when founders are hustling to keep their head above water, compliance takes a backseat. Here’s what founders can do when it comes to due diligence.

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2021 was a great year for Indian start-ups, with as many as 44 unicorns born in the year alone. But, amid the glory and grandeur, as many as 12,889 companies and startups shut shop in FY21 due to lack of funds. While disruptive business ideas, market potential, and founder profiles are key to successful fund raises in the early stage, there is one aspect of the fundraising process that is often overlooked — due diligence. The outcome of a due diligence exercise determines the contours and timelines of a deal and may even see funds walking away from a promising opportunity.

In business as in life, if something is too good to be true, it might as well be. Due diligence helps a fund to check the veracity of claims made by founders and assess the risks associated with the business.

The process of due diligence has various dimensions — business, legal, financial, technical, environmental, etc. However, most aspects of business and founder due diligence are conducted prior to giving a term sheet. Funds provide the term sheet for a deal only after they gain maximum comfort on the business and founder-related aspects, whether through reference checks, customer calls or consultations with industry experts.

Once a term sheet is given, the non-disclosure clause of the term sheet enables a fund to access the company’s records and statutory filings and appoint independent consultants to conduct certain checks. Given that business and founder checks are more or less done prior to giving the term sheet, the focus at this stage is on assessing the legal and financial aspects of the company — the seemingly boring stuff like accounting records, statutory registrations, licenses, labor law compliances, corporate law filings, TDS, and GST payments, etc.

Common issues with compliance in Indian start-ups

As pre-seed and seed stage investors at Arali, we come across various lapses made by founders early on in the business. Often, when founders are hustling to keep their head above water, compliance takes a backseat. However, they pay heavily for these lapses at the deal-closing stages. Unwinding some missteps is immensely difficult: indemnities need to be given, deal timelines get prolonged by 5 to 6 months, and exits become tough as valuations are affected.

In the initial days, many founders borrow from friends and family. If this is not documented properly, they end up becoming a pain for future fund raises. Very few startups sign formal employment agreements with initial employees, the lack of which can lead to IP ownership and assignment issues. This is especially true if there has been early attrition in key roles.

Other common issues involve non-compliance with labor laws, low data privacy, inadequate security measures, and lack of documentation with key vendors and customers. More serious violations include irregularities in deposits of GST and TDS and erroneous recording of financial transactions.

Clearly, it doesn’t make sense to put in all the blood and sweat and accept a lower valuation or lose the deal altogether owing to such blind spots.

Here’s summing up our experience with founders when it comes to dos and don’ts for the due diligence phase:

A. Planning and preparation

Proper resource planning and preparation can make all the difference to your due diligence experience.

• It is important to identify one founder who will own the process for the company. Founders should align on responses to key questions.
• Set expectations with your accounting and secretarial firms so that they can organize the data at their end.
• Set up a data room (shared folder) and populate it with relevant documents.
• Identify any gaps and proactively fix them.
• Mentally, set aside 2–3 hours daily for 3–4 weeks for co-ordination while due diligence is being conducted.

B. Before commencement

• Have a discussion with the fund about any focus areas for due diligence.
• Identify contacts from external due diligence firms who will conduct the process for the fund.
• Ask for a preliminary checklist and get your doubts cleared.
• Understand and assess timelines and key targets, and prepare in advance so it does not sidetrack the fundraising process.
• Establish a process for providing information and resolving queries.

C. During the due diligence process

• Align the data room to the structure of the checklist provided by the firm.
• Organize the data as per the checklist, and put together any missing data.
• Stay connected with the due diligence firm and consultants to resolve queries.
• Work with consultants to address issues as quickly as possible, and with the VC to evaluate the importance of these issues.
• Delays may happen, but focus on minimizing them.

Recommended best practices for a compliant ecosystem

• If you have ever dreamt of getting funding from investors, you’d know that the hard work begins on day 1 — and this does not exclude maintaining the necessary paperwork and documentation.
• Ensure that compliance is part of the culture. Establish an attitude that compliance isn’t a nuisance, but a healthy foundation that will have a huge impact on funding cycles and exits.
• Always look to hire reputed and reliable accounting and secretarial experts.
• Devoting time today on finalizing templates for employment and vendor contracts will avoid conflicts and hassles later.
• File taxes as per the law of the land and respect timelines.
• If you’re borrowing or raising funding from friends and family, ensure that you have proper shareholding agreements in place.
• Employ good accounting practices for revenue recognition and recording costs in line with accepted accounting principles.
• Record and stamp important agreements .
• Finally, review compliances at regular intervals, and don’t be completely reliant on external consultants.

At Arali, we’ve seen due diligence as a make-or-break factor when it comes to deals. Ensuring that compliance is part of your day-to-day tasks right from the start will lead to direct outcomes such as lower deal timelines, better trust levels with investors, and so on. Doing things right from Day 1 can go a long way in ensuring a smooth and hiccup-free fundraising experience.

Arali Ventures is a pre-seed, seed-stage VC from India, investing in entrepreneurs building enterprise-tech solutions for the world. We help shape their journeys through product-market-fit and beyond and scale the offerings to greater heights.

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