Introduction

Financial due diligence for early venture rounds is typically conducted by the investors themselves, but may also involve the appointment of an external consultant or firm to review the company’s finances depending on complexity of the business and size of the raise.

You should ask potential investors what their process entails and their specific approach to financial due diligence in order that you can prepare in advance.

What is financial due diligence?

Financial due diligence (also referred to as FDD) is the diligence stream that focuses on the company’s trading, balance sheet and forecasts. It's an important area of diligence for new investors as it covers how their money will be spent, the extent to which it is at risk and the return it is expected to generate.

What does a typical FDD process entail?

FDD usually begins after the first meeting when the investor asks for a business plan / financial model and a copy of the company’s latest accounts.

A more detailed review will usually take place once the term sheet has been agreed. Where there are multiple investors, the lead investor will take the lead on undertaking due diligence.

The investor may:

The scope of financial due diligence

Exactly what is included within an FDD scope will vary between investors; however, there are certain core items that crop up regularly.

Forecast cash flow

Investors will seek to ensure that their funding is sufficient and that you have enough cash headroom to deliver the business plan while keeping the business going.

Many companies at the venture stage are loss-making – in this case, the cash burn rate is of particular interest. Investors will assess the rate of depletion and ensure there is sufficient time and headroom before the business breaks even or raises the next round of funding.

We recommend including a forecast cash flow within your business plan / financial forecast model.

Balance sheet

Investors will assess the strength of the company’s balance sheet. Specifically, they will want to ensure that the value of assets is fair and not misrepresented, as well as understand how successfully the business converts work, orders and turnover into cash. In doing this, they will review your cash balance, aged debtors and work in progress ("WIP").

An "aged debtor" analysis illustrates how young or old the debtor balances are - if they are old, then that may be an indication that the business is slow to collect cash after invoices have been issued.
An "aged WIP" analysis does the same thing, but for work in progress, i.e. work that has not yet been invoiced. A high proportion of old WIP balances can indicate issues in getting invoices out to customers.

Investors may also review the value of tangible and intangible assets to ensure these are booked appropriately. For example, the value of stock and when the last stock take was undertaken.

On the liabilities side of the balance sheet, investors will be interested in creditor balance, i.e. how promptly the business pays suppliers.

They will also want to understand the details and terms of any debt items on the balance sheet, including overdrafts, term loans and shareholder loans.

Financial forecast or business plan

The financial forecast sets out what you expect to achieve with the new funding and provides a forward vision of what the business might look like at the point of exit, thus helping investors to estimated their potential returns.

We recommend preparing a short written document to accompany the Excel file, that sets out the key driving assumptions.

The following items are typically of interest to investors:

A note on revenue recognition

Many small businesses book turnover when cash is received or an order is placed. The more usual accounting practice is for turnover to be booked as and when services are delivered, for example:

A software business charges customers their annual subscription fee in advance

It is important to recognise turnover in line with the delivery of products and services in order to provide a reliable estimate of turnover growth, run rate turnover and profitability. Investors use these metrics for valuation analyses. If customers are charged in advance in a growing business, and turnover is booked at the time of cash receipt, this will overstate the company’s turnover and may result in difficult discussions when this emerges during due diligence.

Investors may also apply sensitivities to the assumptions within the business plan in order to understand how profit, cash and their anticipated return are impacted if things don’t go according to plan. It therefore makes sense to have a model that is built in Excel, integrated and can be flexed relatively easily.

To assess the feasibility of forecasted turnover, investors may ask to see a pipeline analysis, setting out discussions and progress with current and potential customers.

Historic trading

How the business has performed historically is one indicator for how realistic the forecasts are. Recent historic trading should ideally be included within the financial forecast model so that the forecasts can be sense-checked easily.

Investors may also ask for the company’s performance relative to budget in prior years, if sufficiently established to have set budgets historically. This is a mechanism for them to test the company’s ability to budget and perform in line with expectations.

Finance function

Investors may enquire about the finance systems used and their robustness, as well as who in the company runs the numbers. They may suggest additional resource or investment as a result of this assessment.

Cash controls

Investors will want to ensure that there are adequate cash controls in place so that the new investment is secure. These include permissions around who can set up, approve and make payments from the company’s accounts. Make sure these are set up appropriately with your bank ahead of the fundraise.

Checklist of items to prepare for financial due diligence
Introduction

Commercial due diligence for venture rounds is typically conducted as a joint effort between the investors themselves and individuals from their network. Some funds have specific advisory boards or networks dedicated to this purpose – comprised of individuals with specific, sector expertise that they can call upon.

Occasionally, funds may also wish to formally appoint a consultant, possibly an individual or a firm, to conduct a more formal exercise. This may be applicable in the case of larger rounds, more complex businesses or a novel market.

What is commercial due diligence?

Commercial due diligence (also referred to as CDD) is the diligence stream that focuses on the commercial elements surrounding a company, in particular – the market in which it operates, it’s positioning within that market, for example, in relation to competitors, the strength of the product or service and the customers it currently serves.

The objective for investors is to verify the legitimacy, strength and potential of the product or service and thus bring confidence in the future growth prospects and value generation of the business.

What is the process?

Investors will begin assessing the commerciality of the product or service from the initial meeting. Unlike financial and legal due diligence, the scope of commercial due diligence is more variable and tailored to each individual business. It is not usually organised into a specific scope and may comprise a number of different activities and workstreams.

In practice, it may comprise:

Common scope areas

Market outlook

Areas of interest:

A large addressable market that is growing is an important feature for venture investors.

Positioning within the market and competition

Areas of interest:

There is arguably some fatigue among investors of the top-right-quadrant graph, which plots competitors on two axes and features the company in the top right. It is difficult to be explicit about the nuance of how the business is differentiated through a graph such as this. This could be used to set the scene, while a table that lists the more detailed features of competitor’s offerings, alongside your own, may be more helpful in answering the question of why and how you are different.

How compelling the company’s product or service is

This is assessed through a trial or demo of the product, and usually discussions with certain customers.

Areas of interest:

Quality of the business model

There is some overlap here with financial due diligence, but the objective is to understand the legitimacy of the business model, either in generating a profit or equity value. From a commercial perspective, areas of interest are as follows:

Checklist of items to prepare for commercial due diligence
Introduction

Legal due diligence for venture rounds is typically conducted by the investor’s legal advisors, i.e. the firm that is also preparing the investment documentation.

Depending on the complexity and extent of the scope, you may choose to answer the questions yourself, or you may ask your legal advisors to do this on your behalf.

What is legal due diligence?

Legal due diligence (also referred to as LDD) is the diligence stream that focuses on your contracts and agreements. Investors are keen to ensure that your business is operating with the appropriate agreements, protections and processes in place.

What is the process?

The investor’s appointed law firm will typically issue a questionnaire with a series of information requests and questions. You and your appointed law firm (if applicable) will then provide the answers and supporting information and there may be some discussion back and forth to clarify certain items.
This exercise will usually result in the investor’s lawyers preparing a short legal due diligence report, summarising the responses, their views on them, any key risks or matters that should be dealt with prior to completion of the transaction.

You may be asked to provide a warranty over the accuracy of the contents of the legal due diligence report.

The scope of legal due diligence

Exactly what is included within an LDD scope will vary between investors; however, there are a number of core areas that most investors will review.

Corporate

This involves confirming the current ownership of the company’s equity and corporate structure. The investor’s law firm will run a search of Companies House for each corporate entity (limited company or otherwise) and review the latest annual returns to confirm the accuracy of the share cap table.

It is worth ensuring the company’s annual return is up to date and any subsequent changes in the equity capital have been documented in the company’s statutory book as appropriate.

Employment

This entails confirmation of the employment status of key members of the team (and in some instances, all members of the team).

Investors or their appointed law firm will ask for copies of service agreements (also referred to as service contracts or employment contracts) so that they can review the terms and check their suitability. Areas of interest include:

If you do not have a service agreement, you will need to put one in place as part of the transaction. Before having this drafted, you may want to ask your investor if they have a template that they prefer to use.

Investors will also ask for details of any other incentive schemes in place, such as bonus arrangements or option schemes.

Finally, they will ask if there are any outstanding or unresolved disputes with employees or former employees.

Contracts

If part of the scope, this involves a review of any key contracts, for example, customer contracts, supplier contracts and / or leases.

This helps investors to understand:

Customer, supplier and financing contracts can sometimes include “change of ownership” clauses, which require that the relevant party is notified of any change of ownership or control of the business. In some cases, this clause may also require that the other party consents to any change of ownership prior to completion. Even a minority equity investment can sometimes be considered a change of ownership and therefore it is a good idea to do a quick search of any key contracts for these clauses and notify the relevant parties before completion of the deal.

Intellectual Property

Investors will want to ensure that all IP is owned by the business and not by individuals or employees. They will also review what, if any, arrangements you have in place to protect your IP, such as patents.

Health and Safety

Among other sectors, health and safety is of particular importance to businesses operating within construction, engineering, food production, manufacturing and leisure. An investor may ask to review your health and safety policy to ensure that you take these responsibilities seriously.

Insurance

Investors may wish to review the company’s insurance policies to ensure that there is appropriate cover in place.

Anti-bribery

Investors may wish to discuss your approach to preventing and reporting bribery and may review your anti-bribery policy, if you have one.

Checklist of items to prepare for legal due diligence
Introduction

Equity investment is all about partnering with people. Understanding how you and your team operate is important to potential investors.

From your first interaction, they will be assessing you, your approach, your ability to deliver your plan, how you work with others, how well you listen and consult and where you might need extra support.
For obvious reasons, perceived weaknesses in the founders or management team is rarely given as a reason for decline; however, it is a very common reason in practice. It is therefore important to maintain a pragmatic approach throughout the deal process – highlight your strengths, be realistic, be open about your weaknesses and areas for improvement, be thoughtful and reasonable in your negotiation and be patient with the rounds of questions and diligence.

It’s also important that, throughout the deal process, you are able to assess how well you work with your potential investors so that you can be confident their investment will result in a good and workable strategic partnership.

What are investors assessing?

Investors will be seeking to gain an understanding of:

On a more serious note, they will also run basic background checks on criminal convictions, director disqualifications or PR issues. It’s best to be up front about anything that would likely cause concern.

A note on ambition – there is a lot of conflicting advice around on how “ambitious” founders should be in their approach. This is partly because investors have a varying appetite for risk. It’s helpful to possess and portray a certain level of ambition and resilience to convey the confidence you have in your product or service, but ensure that this level of ambition is credible and is backed up by realistic and achievable forecasts for the business.

How investors make their assessment

There are a variety of means for assessing individuals and the team dynamic, some more formal than others:

Spending time together

When you're trying to juggle running your business as well as a fundraise, it can be difficult to remember to spend time building this relationship. If time is tight, this can be done in part through making due diligence sessions face to face. It sounds obvious but it is fundamental and often missed - make time to invest in getting to know your investor.

Referencing

Investors may ask you to provide references – usually at least one personal and one professional.

Questionnaires

You may be asked to complete a questionnaire that covers any historic convictions, directorships, alternative income or activities etc. which you may be asked to warrant at completion.

Psychometric testing

You may be asked to complete a psychometric test.

Consultants

An investor may formally engage a specialist consultant to spend time with you and the team and provide an assessment. Alternatively, they may introduce an individual from their network or portfolio to do the same on a more informal basis.

Common areas of weakness

Below are a few of the more common areas of weakness identified by venture investors.

Lack of clarity in roles or imbalance between the founders

It can be difficult to clearly define roles in a business that is evolving very quickly, and hence this issue is common in high growth, early stage businesses.

Ways to mitigate this

Limited prior experience of growing a successful business

Investors tend to favour entrepreneurs that have done it before, i.e. successfully grown and sold a business. If this is the case then highlight it, if not, it can be helpful to demonstrate track record within a relevant industry and related successes.

The need for a finance lead or finance director

It is very common for early stage, high growth businesses to lack support in finance and reporting. With new external investment and shareholder reporting, the need for support in the finance function will increase. If you intend to appoint a head of finance or a finance director, or your investor requires that you do, either as part of the process or post completion.

Misalignment in approach or personality

This can manifest in a number of different ways and is not easy to mitigate – if there is a fundamental misalignment of approach, then the partnership is unlikely to be successful.

A strong team dynamic is the best way to overcome this, if it becomes an issue in securing investment. A particularly driven and ambitious CEO, with the capacity to listen, alongside a more prudent operations or finance lead, may present a successful combination, while one of these individuals acting alone may not be considered investable.

Introduction

The lead investor will ordinarily appoint an individual as a Non Executive Director on the Board of Directors. This individual is usually the person who led the investment from within the investment team and may be known as the Investor Director. Apart from their statutory obligations as a director, their role will be to represent the investor on the board, help to monitor performance of the investment on behalf of the fund and be a conduit such that you can benefit from the fund’s broader network and expertise.

The lead investor may also (or as an alternative) hold an observer seat – in practice this differs very little from a Non Executive Director except that the individual cannot cast a vote and may have varying rights to speak, as set out in the articles of association adopted on completion.

It is also common for the lead investor to appoint an independent Non Executive Director or Chairman, i.e. an individual that does not work within their organisation. These individuals are part of the fund’s network and usually have significant Non Executive and Chairman experience drawn from other companies. The rationale is to strengthen the board with the appropriate governance and bring relevant sector and growth credentials and experience.

How are Non Executives remunerated?

Investor Directors: individuals appointed from within the fund itself, to represent the fund and provide a conduit, are typically unpaid.

Non Executive Directors: independent individuals appointed by the fund are paid by the company in the same way that any other Non Executive Director would be. This is usually a monthly fee in return for a monthly commitment of time, say, 2-3 days.

Do companies have a say in who is appointed?

The Investor Director will be selected by the fund and the fund will have the right to appoint an alternate – this is important in case that individual ceases to work for the fund and must hand over their board positions.

The independent Non Executive Director is usually selected in partnership with the fund – it is unusual for a fund to seek to appoint a director that a company does not approve of. However, note that the fund may have the legal right to remove this individual and appoint another, which could be used if misalignment between the company and the fund were to arise in the future. We recommend speaking with your legal advisors on this point to understand the precise rights that the investors will have with regards to making changes at board level.

What is the process?

Selection of an independent Non Executive Director or Non Executive Chairman may take place before or after completion of the transaction, and typically works as follows:

All institutional investors are required to carry out KYC checks on your company, key shareholders and directors.

These apply to the following individuals:

You will be required to provide the following information for these individuals:

Alongside the adoption of the revised articles of association and signing of the shareholders agreement, there are a number of other documents required to complete the seed round. Drafting of these documents should form part of the scope of works for your legal advisors.

Share Certificates

A share certificate will be produced for each seed investor, setting out the number of shares they hold, the class of share (most likely ordinary shares for a seed round) and the nominal price per share (often a penny or a pound).

Each share certificate is signed by director of the company and witnessed.

Board Minutes

A board minute will be prepared that will approve:

The board minute should also:

The board minute is signed by the Chairman of the board.

Written Resolutions

This ordinarily takes the form of one document with two resolutions:

The document is signed by the existing shareholders of the company.

Disclosure letter

If no warranties have been provided, then a disclosure letter is not required.

If warranties have been provided, then the warrantors and the company may wish to provide a disclosure letter, which sets out information relevant to the warranties.

For example, the founder (if one of the warrantors) may have provided a warranty that there is no outstanding litigation with any former employees. If there is any outstanding litigation, then this would be disclosed in the disclosure letter and referenced to that particular warranty. This ensures that the seed investors are aware of these issues and provides legal protection to the warrantor, as the investors would not be able to make a claim against the warrantor for breach of warranty in relation to that particular litigation. If the outstanding employee case was not disclosed and were to come to light after the transaction, then the seed investors may be able to claim for breach of warranty.

The disclosure letter is signed by the warrantors and the seed investors, to confirm receipt.

Supporting agreed form documents

If there are any documents that are defined or referred to in the shareholders agreement, in particular, those referred to in the warranties, then these must be provided at completion, for example, a copy of the business plan, the investor presentation, the management accounts or any due diligence reports.

Alongside the adoption of the revised articles of association, signing of the shareholders agreement, there are a number of other documents and actions required to complete the round. Drafting of these documents will normally form part of the scope of works for the law firm representing the investor, who is also taking the lead on the investment documentation. It may be part of your law firm’s scope to review these documents and actions.

Share Certificates

A share certificate will be produced for each investor in the round, setting out the number of shares they hold, the class of share and the nominal price per share (often a penny or a pound).

Each share certificate is signed by director of the company and witnessed.

Board Minutes

A board minute will be prepared that will approve:

The board minute should also:

The board minute is signed by the Chairman of the board.

Written Resolutions

This ordinarily takes the form of one document with two resolutions:

The document is signed by the existing shareholders of the company.

Disclosure letter

A disclosure letter is usually drafted in response to certain individuals and the company agreeing to provide warranties.

The letter sets out any information that relates to the warranties.

For example, the CEO may have provided a warranty that there is no outstanding litigation with any former employees. If there is any outstanding litigation, then this would be disclosed in the disclosure letter and referenced to that particular warranty. This ensures that the new investors are aware of these matters and provides legal protection to the warrantor, as the investors would not be able to make a claim against the warrantor for breach of warranty in relation to that particular litigation. If the outstanding employee case was not disclosed and were to come to light after the transaction, then the new investors may be able to claim for breach of warranty.

The disclosure letter is signed by the warrantors and the new investor(s), to confirm receipt.

Supporting agreed form documents

Any documents that are defined or referred to in the shareholders agreement, in particular, those referred to in the warranties, must be provided at completion, for example, a copy of the business plan, the investor presentation, the management accounts or any due diligence reports.

Pre completion searches

The investor’s legal counsel will carry out a number of specific pre-completion searches:

Pitfalls to avoid

Make sure that you obtain power of attorney for any key individuals that are unable to attend the completion meeting and are unable to sign remotely. It is surprising how often completions are held up by availability.

If the company has restructured as part of the investment, ensure that a bank account has been set up for the entity that will receive the proceeds. It can take time to put a bank account in place and this can delay completion.

Once the fundraise is complete, you will need to:

Pitfalls to avoid

Shares won’t qualify for SEIS or EIS relief if they aren’t paid for at the time of issue. Make sure you have a bank account set up so you are ready to take payment.

SEIS3 and EIS3 forms, which enable investors to claim tax relief, can only be issued to investors once the business has been trading for at least 4 months.

If an investor develops a connection with the company during the hold period (3 years for SEIS and EIS), then they will lose their tax relief.

If your company ceases to qualify for the scheme during the hold period (3 years for SEIS and EIS), then your investors will lose their tax relief.

A cap table (capitalisation table) summarises the ownership of a business pre and post a fundraise, demonstrating the full breakdown of the Enterprise Value, including shareholders, debt and cash.

It is an essential tool that enables you to see the mechanics of your individual fundraise and to calculate specific figures for the legal documents, for example:

We have built an easy-to-use cap table template specifically for seed rounds.

All you will need to complete the template is:

Step by step instructions are included within the template, which is built using basic Excel formulae and thus can be tailored to fit your business and fundraise.

There are also a number of built-in checks in the model below the cap table. If any of these show an error, you'll need to check your inputs:

Copyright Capitalex Limited 2024, a limited company registered in England and Wales No. 08990469. All rights reserved.
Capitalex does not provide legal, financial or tax advice of any kind. If you have any questions with respect to legal, financial or tax matters relevant to your interactions with Capitalex, you should consult a professional adviser. Capitalex does not make investment recommendations to you. No communications from Capitalex, through this website or any other medium, should be construed as an investment recommendation. Further, nothing on this website shall be considered an offer to sell, or a solicitation of an offer to buy, any security to any person.