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Due diligence refers to the caution and prudence that one would show in managing one’s own money or the money of someone else. In order to make an informed judgment about a potential investment, the investor would need to carry out extensive research and analysis to identify the potential risks and plan for means to mitigate them. This entails comprehensive investigation and analysis of the qualitative and quantitative aspects of the business proposal, i.e. the funding requirements and the future performance, profit projections etc.

Before initiating the due diligence process, the investor quickly scans through the opportunities to ensure they meet the investment criteria. This is done by asking the venture’s entrepreneurs to submit an executive summary based on a pre-specified format the investor provides. The information provided in the summary is a prerequisite for any due diligence and hence should be well organized, concise and clear.

The summary should include the following elements:
* Description of the business
* Stage of development
* Key goals of management
* Details of product/service, whether proprietary, patented, etc.
* Details of company’s founder/CEO
* Target market size
* Growth rate
* Competition
* Financial results
* Current financing status, level of active/passive investment sought, investor appeal
* Exit strategy for returning investors’ capital

The summary allows for a preliminary evaluation of the venture. Once the investor is satisfied with this evaluation, a business plan and documentation package is proposed. But before reviewing the business plan, the investor investigates the entrepreneur and the management team. This is done through a soft evaluation through face-to-face meetings as well as a formal background check by engaging a professional corporate investigation firm to check on court proceedings, litigations and criminal records, if any. Credit and debt checks, education and credential checks are also carried out by these firms.

Financial due diligence
Business plan diligence is followed by analysis of historical financial statements and review of past operating data. This helps gain confidence on existing and projected financials. Review of cash budgets helps the investor assess the company’s credit and debt collection policies, other financing activities, including identifying when cash would be required to avert a potential liquidity crisis. Tax-related matters are also highlighted in the financial due diligence. For a company in business, investors are guided by past financial data; for a startup, they go by industry standards.

Legal due diligence
This is performed to ensure legal matters have been correctly and completely addressed. The investors request a comprehensive list of documents to understand the legal standing of the venture. The checklist of legal documents includes the following: Key contracts, employment agreements, minutes and consents of the board of directors and shareholders, confidentiality and invention assignment agreements with employees, corporate charter and bylaws and intellectual property-related documents.

Past financing agreements and shareholder agreements
Due diligence typically take 4-6 weeks to be completed. But it is essential because once disbursement is made, the capital is tied up for a long time and there is a possibility that the projections are not met and that more capital would need to be invested at a later stage to keep the operation running.

Moreover, due diligence provides a complete insight into risk assessment, risk mitigation and residual risk when evaluated against the kind of assets that justify the venture.

VED PRAKASH ARYA is MD and  CEO,  Milestone Capital.
©Entrepreneur February 2011

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