Preparing Your Startup for Due Diligence: A Financial Checklist

Building trust. Identifying and mitigating risks. A commitment to transparency.

When these are achieved with investors, your startup is much more likely to experience fundraising success. When you consider that nearly 40 percent of startups eventually fail because they run out of cash, you can’t downplay the importance of fundraising and building investor relationships. That’s a big part of what the due diligence process is designed to accomplish — and it’s a key step that investors are going to take when weighing whether to financially back your startup. If you’re prepared, your startup can showcase its financial health through accurate record-keeping while also demonstrating its growth potential in the future.

However, your startup’s financial due diligence checklist isn’t basic. It needs to be thorough and comprehensive for the best results and to increase your chances of securing funding. In this post, we’ll dig into this financial checklist and help you better understand how proper preparation can pay dividends in fundraising success in the long term.

Understanding the Due Diligence Process for Venture-Backed Startups

Due diligence isn’t your typical startup valuation. While a standard business valuation determines your startup’s monetary worth, due diligence takes things a step further by thoroughly investigating your startup’s financial records to verify information, while also identifying and addressing risk and any potential issues.

It involves a detailed examination of your startup’s financial records, legal agreements and contracts, operations and any other relevant aspects, including your intellectual property. In a sense, due diligence verifies business valuation while also working to minimize risk and identify any liabilities that could impact your startup. This comprehensive investigation is standard procedure among investors before they make a decision on whether to financially back your startup, which reinforces the importance of being prepared and getting ahead of any potential red flags that could surface. The due diligence process essentially allows investors to make more informed decisions about investing and on what terms to invest. It can help them with negotiation leverage during the fundraising process and assist with performance monitoring following any investment. This process offers a deep dive into your company’s financial health to provide investors with confidence.

Due diligence becomes especially important as startups move from seed to Series A funding. While seed funding investments are largely based on potential, Series A funding tends to be higher-risk, and investors are looking for startups with a clear business model and growth potential. The results of their due diligence findings will significantly influence their decision to invest.

Noting this, it’s important that your startup is well prepared to be thoroughly assessed. Being prepared can help streamline the fundraising timeline and improve valuation outcomes.

Essential Financial Documents Every Startup Must Have Ready

Your startup must have its financial documents in order to prepare for due diligence. Investors will carefully examine three key documents — income statements, balance sheets and cash flow statements — and also look at historical financial data. Here’s a closer look at what investors are specifically looking for in the trio of aforementioned documents and why they’re so important:

• Income statements: Income statements (i.e., profit and loss statements, statement of earnings) summarize your startup’s revenue, expenses, gains and losses over a defined period of time. Investors tend to look for specific key indicators on income statements, such as revenue growth, profitability, potential for future growth, and how well your startup is managing its costs and expenses. They’ll also often look for business model sustainability and EBITDA to help determine valuation.
• Balance sheets: A balance sheet is designed to offer a snapshot of your startup’s health by detailing what you own and what you owe, as well as the amount that’s been invested. Investors assess your startup’s balance sheet to gauge its overall financial health, particularly paying close attention to your asset quality, debt levels and liquidity. In performing due diligence, investors will also assess these factors and compare them to industry averages to further weigh your startup’s strength and overall competitiveness. This allows them to understand your company’s financial position relative to industry standards and competitors.
• Cash flow statements: Cash flow statements document the movement of cash and cash equivalents in and out of your startup and help investors assess their target company’s financial health, performance and viability. Investors are looking at your startup’s cash flow statement to get a better idea of how you’re managing cash, allocating for growth and financing your operations.

Ideally, your startup should have 12 to 18 months of financial data that’s properly organized and audited to present to investors. This tends to be enough historical data to help investors understand your startup’s performance and any trends. In addition to helping investors assess your startup’s financial health, it also helps determine a fair valuation and can help inform decision-making. Having this information prepared in advance should be a key part of your diligence checklist.

Another aspect that you’ll want to prioritize is the month-end close process. This is a fundamental procedure that your startup should use to finalize its financial records for the previous month. It helps ensure financial accuracy while helping prepare for the forthcoming accounting period. It’s particularly important for ensuring the accuracy and integrity of your financial records, ensuring compliance with industry and accounting standards, and helping inspire more sound decision-making. When done right, the month-end close process also helps boost stakeholder confidence with accurate and transparent financial reporting.

Building Investor-Ready Financial Projections and Models

A key aspect of building trust with investors is creating robust financial models that can withstand their scrutiny as they conduct due diligence on your startup. A good financial model should offer various key components to help forecast your startup’s performance, including:

• Revenue projections
• Unit economics
• Scenario analysis

Good financial models are grounded in reality and should be supported with documentation. To create a robust financial model, analyze your startup’s historical data and conduct market research to better understand your market size, competition and growth potential. Good financial models are typically integrated financial statements that consist of your profit and loss statements, balance sheets and cash flow statements, which help validate each other. These efforts help demonstrate your company’s financial performance to investors clearly and convincingly.

It’s also key to create multiple scenarios in your financial model to give your startup and investors a sense of projected performance amid various conditions. For instance, consider creating best-case, worst-case and most-likely scenarios to convey a deep understanding of your market and the various internal and external factors that could impact future performance.

Key Financial Metrics and KPIs That Investors Prioritize

Investors prioritize several key metrics when conducting financial due diligence, and the importance of various metrics also often depends on the industry your startup is operating in. Here’s a look at some of the key metrics to take note of when preparing your startup’s financial data:

• ARR: Especially important for SaaS startups, this helps measure predictable future revenue, helping investors gauge your startup’s overall health and growth potential.
• LTV and CAC: LTV and CAC (customer acquisition cost) are especially important metrics for eComm startups. Specifically, the LTV:CAC ratio compares revenue generated by the customer with the cost of acquiring them. Generally, startups should shoot for a ratio of about 3:1, which signals efficient acquisition and sustainable growth.
• Unit economics: Unit economics are important for all startups because they detail the profitability of each individual unit of your operations. They help break down your financial situation at the most basic level and help investors better understand how you’re allocating resources and whether your business is ready to scale.

Other key metrics include burn rate, cash runway and various capital efficiency metrics.

Finally, your startup shouldn’t overlook the importance of cohort analysis and customer retention metrics. Cohort analysis helps provide insight into customer behavior over time, thereby identifying areas for improvement. By better understanding your customers, you can help improve retention, reduce churn, optimize your marketing efforts, and better learn who your ideal customer is and what they’re looking for. Some customer retention metrics to pay specific attention to throughout this financial analysis include churn rate, retention rate, Net Promoter Score (NPS), customer lifetime value and net revenue retention, among others.

Tax Compliance and R&D Credits Documentation

Proper management of your startup’s financial situation extends beyond a robust financial model and keeping an accurate, organized history of financial data. It’s also important to ensure your startup’s tax compliance and proper tax documentation. Some of the essential tax documents that you’ll want to keep organized include your tax returns, sales tax compliance and evidence of compliance with any state-specific requirements (i.e., Delaware franchise tax filings). Accurate tax filings can help build trust and credibility with investors by demonstrating your startup’s commitment to responsible financial stewardship.

R&D tax credits can specifically help improve your startup’s valuation. Qualifying for these credits can help improve your cash flow, demonstrate further fiscal responsibility and showcase a commitment to investing in innovation to further benefit your startup.

Organizing Your Cap Table and Equity Documentation

Prioritizing real-time updates, meticulous record-keeping and regular audits are all ways your startup should be ensuring accurate cap table records and equity documentation. Cap table and equity documentation are essential for the health and success of your startup, especially if you have multiple stakeholders. Accurate records help boost investor confidence and fundraising, detail a clear ownership structure, and help fulfill compliance and legal obligations.

409A valuations are also crucial for startups. They help establish the fair market value of common stock and can influence employee stock options. Investors scrutinize 409A valuations to assess the value and fairness of equity compensation and potential risks that could come from the transaction.

Setting Up a Professional Data Room

You might consider creating a data room to organize your key documents when preparing for due diligence. These rooms must be well-organized, include thorough documentation and also restrict access to anyone who shouldn’t be able to use the room. It’s key to structure folders smartly and know where all relevant documents are stored for fast, convenient access. The big value of these spaces is that they represent a secure, centralized location for sharing and reviewing sensitive information.

When creating a data room, make sure you clearly define your objectives and scope, develop a folder structure and create a robust document index. Folder structures are best organized in logical categories (e.g., Financials, Legal, etc.), and the document index should list all the documents and their locations.

Common Due Diligence Red Flags and How to Avoid Them

Readying for investor due diligence is very labor-intensive, and there are many ways things can go awry. Some of the red flags that you’ll want to catch early and remedy include:

• Revenue recognition issues
• Cash flow problems
• Inconsistent or incomplete reporting
• Lack of clean financial records
• Compliance issues

If your financial reporting has problems, it’s typically best to address them with investors and explain how you’re going about resolving them, essentially taking a negative and spinning it into a positive. Proactively managing these concerns shows strong diligence, financial responsibility and transparency.

Working with Financial Professionals During Due Diligence

Need help readying for investor due diligence? A fractional CFO or outsourced accounting professional could be the answer for your startup. Fractional CFOs are experienced accounting professionals who work independently of your startup. One key benefit of working with an external accounting partner is that they bring an outsider’s perspective to your startup and can help provide unbiased insight. They also ensure their services are performed according to regulatory and compliance standards— a key advantage during the financial due diligence process.

Ready to Ace Your Next Fundraising Round?

Do you need help preparing for your next fundraising round? Consider working with Graphite Financial for due diligence preparation. With years of experience supporting venture-backed startups for investor due diligence, we’ll become a true extension of your startup and put you in the best position to succeed with your next fundraising round. Contact us today for more information and to schedule a consultation.

FAQs

How long does the due diligence process typically take for venture-backed startups?

This depends on various factors. It may take as little as a few weeks to as long as several months.

What financial documents are most critical during Series A due diligence?

Critical documents, especially for venture capitalists, include income statements, balance sheets and cash flow statements.

How can startups avoid common financial red flags during due diligence?

Avoiding issues during due diligence all starts with being organized and working transparently. Arranging a data room can also help keep documents in order.

What role does a fractional CFO play in due diligence preparation?

Fractional CFOs are experienced accounting professionals who know what investors are looking for and can help organize documents in a way that meets regulatory and compliance standards, while positioning your startup for fundraising success.

How should startups organize their financial projections for investor review?

It’s typically best to begin with a high-level overview, move into the assumptions and metrics driving your financial model, and then back up your presentation with historical financial data and key metrics.

What are the most important financial metrics investors focus on during due diligence?

Investors are interested in revenue growth, profitability, cash flow, ARR, LTV:CAC ratio and unit economics.

How can proper R&D tax credit documentation impact startup valuation?

Qualifying for R&D tax credits can help improve your startup’s cash flow, demonstrate fiscal responsibility and showcase a commitment to investing in innovation, which can further benefit your startup.

What are the key differences between seed and Series A due diligence requirements?

Seed due diligence is largely based on potential, while Series A due diligence involves a deeper dive into financial data and operational sustainability. Series A is much more comprehensive and thereby involves more meticulous planning and preparation.