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Finance readiness for startups and SMEs
Due diligence is one of the scariest word that you’ll hear after agreeing on a term sheet with a potential investor. Weak finance organization, poor documentation and uncertainty in the best way forward — these are just a few things that’s gonna bring all your pitching efforts to a wack.
There’s unlikely one best way of preparing a business for a deal to be struck without experiencing the pain of being audited in various facets — from administrative documentation to financial records to operational compliance. All companies that seek significant amounts of investor monies will likely have to endure with a varying level of pain and stress across the organization just to pull through the closure of a transaction.
So let’s begin by understanding what it means to undergo a due diligence…
Due diligence almost always happens after a term sheet is agreed in principle. Not all investments really go through a due diligence process because of a lot of factors, such as:
- The business is still at a very early stage where the investment is not directly tied to the business itself
- The investment size is small enough that the cost of conducting a due diligence will exceed 5% of the transaction
Contrary to popular belief, a due diligence is not a witch hunt meant to bring down the transaction price. Instead, a due diligence is meant to provide the investor (or investors), a certain degree of comfort on the veracity of facts presented, soundness of projections and valuations, and probability of litigation / non-litigation risks that will affect the exit strategy of the investor.
The real risk here is this — it is more likely than not that skeletons in the closet will be found. Prolly around 90% of the tales that you’ve been hearing about the pains of undergoing a due diligence procedure are mostly due to the fact that experienced due diligence professionals can really bring out the worst secrets that you failed to disclose before the term sheet was agreed.
So, what happens in a due diligence? Most transactions would have a two-fold due diligence conducted — financial and operational due diligence.
Financial due diligence again can be split into two: (1) HFI — historical financial information; and (2) PFI — prospective financial information.
The HFIs provide insight into the soundness of the PFIs and can potentially flag issues related to poor financial reporting practices and weak internal control.
PFIs can be a bit complex for startups since HFIs doesn’t really provide much useful information for projection purposes. However, model integrity, conservatism and narrative alignment will likely be more scrutinized in the context of an early stage startup.
Being ready to dot all the i’s and cross all the t’s in HFI through supporting schedules, contract lists and actual documents while ensuring each assumption used in the PFIs are substantiated and stress-tested for potential variations during the due diligence process are critical.
It is easier said than done though…
Everyone who’ve gone through a due diligence will tell you how stressful it was to comply with all the documentary requirements for the transaction. Unless you’ve went through a standard financial audit process from a reputable audit firm (i.e., big four auditing firms) who conducts actual audit procedures, most of the information requested would sound Greek to you.
Throughout the due diligence process, the finance department is likely to be the key point person for every piece of information required by the auditor (unless legal documents are with an admin department). With most startups and SMEs in a tight belt situation, financing the finance department is likely the least of priority when execution is king. This leaves most middle-market companies in a disadvantageous position for an optimal deal closure.
Without a properly functioning finance function within a company, preparing and negotiating for an optimal capital structure will be difficult without the right level of expertise. After closing a funding round, the ongoing reportorial requirements and investor relations will likely cause a significant strain to the company’s human resources (if not relationship between management and staff).
I mentioned earlier that there’s no one best way to prepare for a due diligence. From our experience in helping companies raise funding, there are three factors affecting finance readiness for startups and SMEs — Availability, Capability and Timeframe (‘ACT’):
Availability
Ensuring that all documents are available and key database are kept is a massive challenge especially for companies that don’t have good documentation practices or where finance functions are outsourced. Understanding the state of document and database availability is crucial in creating the best way forward to prepare for the due diligence.
Other than the availability of documents is the scarcity of resources— from human to technological. Having the necessary resources available to support the pre-due diligence process is critical for a smoother deal closing.
Capability
Determining how good the financial records have been kept is a good starting point. However, with the growing complexities in business model of companies (especially those seeking to raise funds), some transactions might require specialist knowledge to digest and document the right approach in transactional accounting. Preparing for the due diligence will include a review of the capability of the finance department in providing financial reports that explain or comply with applicable financial reporting standards.
Other than financial reporting is the compliance capability of the company’s personnel. With the pace of change in global tax laws and regulations, failure to comply with the right situs and treatment of taxation is likely to cause a critical red flag depending on the amount of non-litigation risks involved.
Timeframe
Depending on the foregoing, fitting all the available resources into the limited time available will almost always never be possible. This is where experience comes into play — balancing all the requirements vs the resources matched with a good appreciation of priorities.
Finance readiness is a term that measures the robustness of a company’s finance organization to meet the pre- and post-deal requirements. From providing all the necessary documentation to ensuring that ongoing reportorial requirements are met without unnecessary delay — building a stronger finance organization is starting to have more business sense for companies that seeks to raise monies.
Maybe it’s time to ACT…
Finance readiness requires massive investment in the right leadership, a competent team and a scalable workflow. With capital raising become more and more common these days, either going for a private funding round or taking it to a next level with a public offering — it’s never too early to start working on assessing the company’s ACTs.
In the end, it’s all worth it.
About UpSmart
UpSmart is the premier financial consultancy firm in the startup, SME, and social enterprise industry. UpSmart specializes in strategic finance (e.g., structuring and restructuring of legal entities, valuing and modelling companies, serving as chief financial officer of companies) and operational finance (e.g., optimizing business processes and controls, accounting and bookkeeping support, financial reporting and analysis).
About Filbert
Filbert is the co-founder and managing director of UpSmart. He leads the consulting practice of UpSmart and is currently the CFO of 9 companies in the Philippines. He was previously a consulting manager at Ernst & Young in the UK. He writes for Tech in Asia, Business Mirror and serves as a mentor at The Final Pitch on CNN.
