Financial Due Diligence to Ensure Startup Funding Success

According to studies, more than 50 percent of all deal failures involve due diligence issues.

From hidden financial problems to high perceived risk to legal and operational liabilities to poor overall management, investors may discover several problems that give them pause during the due diligence process. This underscores the importance of being prepared and properly addressing any potential issues before your startup begins its fundraising round.

The good news is that issues are largely fixable when they’re caught early — but they have to be identified to be fixed, making due diligence preparation very important for your startup to ensure fundraising success.

Revenue Recognition Issues in Investor Due Diligence (and How to Correct Them)

Issues with revenue recognition are one of the major problems that can give investors pause during due diligence.

Such issues are especially common with SaaS and subscription-based startups and include recognizing revenue too early, failing to properly identify performance obligations in bundled services, inaccurately allocating pricing and improperly managing subscription modifications (i.e., upgrades and downgrades).

Premature revenue recognition can artificially inflate valuations and create an illusion of higher revenue and stronger growth. Yet, such a valuation is not sustainable when the problems are identified and corrected.

It’s best practice for startups to follow ASC 606 guidelines, which can help build investor confidence and provide a clear and consistent picture of your startup’s revenue. This includes transparent contract disclosures, accurate accounting for multi-element arrangements, clear handling of contract costs and detailed disclosures in financial statements.

Avoiding Burn Rate and Runway Mistakes

Burn rate and cash runway mistakes can also lead to problems during due diligence, indicating poor financial management and an overall lack of transparency. Issues with burn rate and cash runway can lead investors to question your startup’s overall reliability and its future potential.

The true burn rate should be calculated and presented to investors. This includes all hidden costs and commitments and provides a realistic picture. Some statuses only present the gross burn rate, which doesn’t account for revenue. Other burn rate mistakes include using a single-month burn rate, neglecting one-time costs and underestimating costs for scaling.

In terms of runway, startups should aim to follow the 18-month runway rule. This rule ensures startups secure enough cash to fund their operations for at least 18 months following a fundraising round. This allows startups to hit growth milestones before having to divert resources toward the next round of capital.

Hidden Burn Rate Accelerators

Startups often must manage several overlooked expenses that can cause them to burn through capital faster than initially projected. These may include new hires, greater investment in sales and marketing, acquisitions and expansion, more operational expenses and other macroeconomic factors. Other factors, such as deferred compensation to employees, invested equity and phantom costs, can also contribute to the burn rate.

As channels saturate, it’s also common for customer acquisition cost (CAC) to increase due to increased competition and the added expense of having to reach new customers. This can also eat into the burn rate.

Ensure Realistic Growth Efficiency Assumptions

There’s also the issue of being overly optimistic about your startup’s financial projections. Experienced investors can quickly spot overly optimistic — and often unrealistic — assumptions, which thereby imply issues with a startup’s ability to scale.

For instance, the cost of acquiring a new customer is often heavily underestimated in overly optimistic projections. There’s no guarantee that CAC payback periods improve over time. In fact, in many cases, it becomes more expensive to attract new customers as channels become saturated with competitors.

Some common benchmarks to shoot for include:

• 5-7 percent annual churn rate
• 100 percent net revenue retention
• 12 months or less CAC payback
• 2:1 to 4:1 LTV:CAC ratio

Cap Table and Equity Structure Due Diligence Failures

Complicated ownership structures and poorly managed equity can create immediate concerns for investors during the financial due diligence process. The more complicated things get, the more they introduce legal, financial and strategic risk, which can be a turn-off for investors. VCs want to see clear cap tables that detail who owns what and how much of it they own.

Messy cap tables create confusion over ownership and value. Mismanaged convertible notes and SAFEs can lead to further problems during equity rounds, including unfavorable conversion terms, future dilution risks and maturity date concerns. Startups should also ensure that intellectual property ownership is clearly documented and assigned to the company rather than to individual founders or contractors, as unclear IP rights can raise major issues during due diligence checks.

It’s best practice to perform an ownership audit before approaching investors to gather information and properly manage cap tables to maintain a clear record of all transactions. Additionally, consider consolidating and simplifying share classes, addressing dead equity and aggregating smaller shareholders to minimize any complexities.

Financial Controls Gaps in Your Startup Due Diligence Checklist

If your startup doesn’t have a robust financial infrastructure, it signals operational immaturity and can increase the investment risk during financial due diligence. Investors expect startups to have different levels of financial infrastructure at various stages in their lifecycle. For instance, it’s common for startups to have minimal and simplistic financial systems in place in pre-seed funding and more structured systems during seed funding. At Series A funding, investors look for more robust systems and professional financial oversight. At Series B and beyond, investors usually expect startups to have a dedicated financial team that can withstand the scrutiny of operational due diligence as well as financial review.

Bottom line: If you’re still doing spreadsheet-based accounting beyond the seed stage, it’s not going to be viewed favorably by investors. Not only is spreadsheet-based accounting best suited for early-stage startups, but it’s also prone to human errors. As your startup evolves, it should have a plan in place to improve its financial systems and controls.

Avoid Missing or Delayed Financial Reporting

Spreadsheet-based reporting or a poor financial infrastructure can result in a variety of problems for more mature startups, which may indicate deeper financial problems in the eyes of investors. Startups should strive to conduct a monthly closing process within 5 to 10 business days after the month-end and report out to internal teams and investors accordingly.

To implement reliable reporting processes and avoid missing or delayed incidents, consider implementing a data governance framework to ensure consistent, accurate and trustworthy reports.

Ensure Adequate Financial Leadership

As startups evolve and approach Series A fundraising rounds, most investors want to see evidence of financial leadership. This is when it typically makes sense to bring a Fractional CFO or bookkeeper on board for professional financial oversight and leadership. Bookkeepers are ideal for managing the day-to-day of your startup, while controllers help ensure financial accuracy and internal controls. Bringing in a Fractional CFO is ideal when you need to set strategy, secure funding and guide the startup’s future financial decisions. Pre-Series A is often the perfect time for a startup to seek professional assistance.

Unrealistic Financial Projections: A Common Startup Fundraising Mistake

Unrealistic financial projections are among investors’ biggest concerns, and there’s a fine line to strike between ambitious and delusional growth forecasts. An ambitious projection is supported by market research and strategy, while a delusional one includes unsupported assumptions and overestimates a startup’s capabilities and market potential.

Startups tend to use either bottom-up or top-down forecasting. The former forecasts with granular, operational data to form a prediction, while the latter starts with a broader market overview and uses this to estimate its potential in the future. Your startup may also elect to institute a hybrid approach that combines both methods.

A sensitivity analysis can also be useful when determining accurate financial projections. This method allows startups to get an idea of how different variables or assumptions impact their financial projections and can help determine multiple realistic scenarios.

Customer Concentration and Revenue Quality in Due Diligence

Even strong top-line growth can overshadow hidden risks in revenue composition that investors can sniff out during due diligence. Revenue concentration is of particular importance, as an over-reliance on a small group of customers can give investors pause. Ideally, your startup is well-balanced and isn’t revenue-dependent on a small number of people.

Revenue quality is also important, as investors and venture capitalists want to verify that your revenue is sustainable as much as it is profitable. They often look for recurring revenue data, ensure that revenue is recognized properly and assess organic growth.

Finally, investors will also carefully assess the churn rate. The churn rate has a direct impact on potential growth, and if it is too high, investors may have concerns.

Unsustainable Customer Economics

Investors don’t just want to see product-market potential; they want to see evidence of a sustainable operation. Some examples of unsustainable unit economics include:

• High CAC: If your startup is going to be sustainable, its LTV must be higher than CAC. A healthy LTV:CAC ratio is 3:1.
• Hidden costs: These may include lost revenue from a bad experience, damage to brand reputation from negative reviews, loss of referrals and increased operational costs.

Strategies to improve unit economics include keeping variable costs low, creating programs to extend LTV and reduce CAC and increasing revenue per unit.

Retention and Churn Warning Signs

Some retention metrics that signal major problems with your startup include:

• High churn. Try to keep churn in the 5-7 percent range.
• Low LTV:CAC. Ideally, this should be at least 3:1.
• A low net promoter score. This indicates too many detractors and low brand loyalty.
• Low or negative NRR.

Tax and Compliance Issues in Venture Capital Due Diligence

Some of the common tax and compliance issues that derail deals during due diligence include:

• Unpaid payroll taxes
• Worker classification issues
• Missed tax filings
• Missed compliance deadlines

Transform Your Startup for Successful Investor Due Diligence

If you’re looking to position your startup stronger for investor due diligence, consider working with an expert financial services partner like Graphite Financial. We specialize in supporting startups with their financial needs and work proactively to ensure your startup is in good standing when it’s time to go out for fundraising rounds. Clean financials often translate to better valuation and more successful fundraising. Graphite is here to help strengthen your target company’s financial health and overall investor readiness. Contact us today for more information and to schedule a consultation.

Frequently Asked Questions

What financial documents do investors review during due diligence?

While financial and legal documents vary by startup and the specific investment stage, investors tend to be interested in income statements, balance sheets, cash flow statements, audit reports, tax returns, financial projections, cap tables and more as they conduct due diligence.

How detailed should financial projections be for Series A fundraising?

With Series A fundraising, financial projections should be detailed enough to include monthly income statements, cash flow statements and balance sheets for the first year, and annual forecasts for two to five years into the future. While investors are interested in the potential of your startup in seed funding, they tend to want to see tangible proof of growth in Series A fundraising.

What burn rate multiple do investors consider acceptable?

Investors generally favor a burn multiple at or below 1x. Anything lower indicates greater capital efficiency, while anything over 2x is concerning. While the acceptable burn rate multiple varies by growth stage, 1x is generally an ideal one to shoot for during growth stages.

When do startups need audited financials versus reviewed statements?

Audited financials tend to be required in more high-level situations, like Series C funding or during an acquisition. They are usually required at the request of investors and prove that financial statements are free from material misstatements. Other situations where audited financials may be required include mergers or partnerships, when seeking a bank loan, when your startup is preparing for a public offering or to meet regulatory requirements.

What percentage of revenue from one customer is considered too risky?

While this can vary, the most common benchmark is 10 to 20 percent. Anything above that point increases risk and is indicative of significant financial trouble if a startup were ever to lose that client.

How far back do investors look at financial history during due diligence?

It’s common for investors to assess a startup’s financial history for the past three to five years. However, investors are often particularly interested in financial forecasts and projections for young startups that lack a robust financial history.

What financial metrics matter most during venture capital due diligence?

VCs focus on the metrics to help better understand a startup’s past performance and future potential. Some of the key metrics they’ll assess include revenue growth, CAC, LTV, profit margins, cash burn, cash runway and churn.

How can startups prepare for investor due diligence efficiently?

Startups should focus on demonstrating their financial health and capital efficiency, proving market traction and customer validation — and aiming to tell a story with their financial data to best relate to investors. It can also be helpful to work with an experienced financial professional who can help your startup optimize its efforts and better tailor its preparation to what investors are looking for.