How to perform Due Diligence on a tech startup?

Asian tech startup ecosystem is itself in its early stage. And as a result, we do not have enough investment and compliance professionals who are familiar with the most appropriate and efficient Due Diligence process. Venture Capitalists and Angels end up ignoring certain areas due to lack of specific knowledge (particularly Corporate laws) while Compliance professionals from CPA firms end up overdoing certain checks because they look at startups from listed company point of view. I recently came across a startup that was reviewed by a BIG4 accounting firm in a way they would audit a listed utility company. Felt like someone is cutting tomatoes with a sword.

In my view, Due Diligence effort is most productive when it is tailored to the stage of investment.

Seed Stage Due Diligence

This is most relevant for Angels and/or Early stage VCs. At this stage, the company would at most be a few founders and a prototype. The most important things for an investor at this stage to do are as follows:

1.  Jobs to be done (JTBD): Is there a real market need? Speak to potential customers.
2. Team capability: Does the team have necessary skill sets to execute and the temperament to sail through the ups and downs? Meet up with Team members individually and do reference checks on key founders.
3. Competitive landscape: Prepare a summary of local and global players in the same/similar area and collect as much information as possible.
4.  Exit potential: Prepare a list of potential acquirers and document why they would acquire a company like this.
5. Founder’s pre-nuptial: Ask founders to document the terms of their co-working arrangements. Verbal agreements or inappropriate drafting of these arrangements can cause lot of disturbance for the company. If possible, also need to get founders to sign a non-disclosure and non-compete in case of a break-up.
6. Employee contracts: Ask for employment, non disclosure and non-compete agreements duly signed by all part-time as well as full time employees. If there are non-local employees, look out for their legal employment status. 
7. Pre-existing liabilities: Ask founders to disclose all pre-existing liabilities including options granted and/or notes issued to third parties. Get them to sign an undertaking.
8.  Licensing agreements: If the entire technology of a part of that technology is licensed from an external party, the terms and conditions of usage of technology should be properly documented.
9. Record keeping: Select some transactions from the financials (if any available) and look for supporting documents.
10. Co-investors: Meet up and get comfortable with key co-investors particularly those who are close to founders.

Growth Stage Due Diligence

This is a stage when there is lesser ambiguity than seed stage. The company would likely have more data points and records to ensure a more detailed Due Diligence. This is a stage where involving a CPA and a lawyer makes sense. But it is still not possible to outsource all of the required Due Diligence. Partly because the professionals here are not very familiar with technology startups and partly because there are areas that CPAs and/or Lawyers would have no clue. 

In my view, at this stage, the most important items to watch for are:

Value Proposition:

1. Look out for the "unfair advantage" and verify that by speaking to at least one or two industry professionals. It can be the technology, business model or a combination of both.
2. Obtain a competitor landscape from the founders and verify that independently. Big red flag if founders have missed out on some prominent ones. 
3. Get details of Strategic alliances, Joint Ventures or other partnerships. Check if any of that might become a roadblock in future exit plans. 
4. If the company has multiple products, obtain features and pricing details for the entire product range.
5. Request for details of "Use of capital " and ensure that it makes overall sense. 

Investment history

1. Obtain a Capital structure table (Captable) and verify that with data independently obtained from government agencies (like ACRA in Singapore or ROC extracts in India) or independent data providers. Ensure all convertible notes, stock options, warrants, etc. are fully disclosed to calculate fully diluted outstanding shareholding pattern of the company.
2. Ask for a copy of previous Shareholders and Subscription agreements. Go through previous investors rights/options to participate in the current round.
3. Meet up with at least all the investor representatives on the board of directors. It is important to establish that the future board is going to be functional.

Legal and Secretarial

1. Get a copy of Memorandum and Articles of association to ensure that they are upto date and reflect all the changes made during the previous investment rounds. 
2. Obtain minutes of all previous board and shareholders meetings.
3. Ask founders to provide details of all existing/previous/threatened legal disputes, litigation, arbitration or judgement/s. A declaration/undertaking from the founders that information provided is complete to the best of their knowledge is also desirable.
4. Ask for details of all Patent, trademark, copyright applications (in-progress and/or granted).
5. Go through all licensing  and other agreements. 

Financial performance and projections

1. Get a copy of latest board approved budget, management accounts and audited financials (if available). Compare revenue and expenses between budget and actual accounts to identify and explore deviations. This can also be used to analyse future projections.
2. Review gross margins and net margins for each product line and assess if direct expenses have been pushed below the line as overheads. 
3. Analyse working capital items (debtors, creditors and inventory). Ageing list can be very helpful. 
4. Ensure that amounts due to technology and other service providers are accrued and recorded in accordance with agreements as liability even though they are not paid out. 
5. Obtain details of bank mandates and signatory limits.
6. Obtain copy of bank statements for all the accounts held in company's name. Match bank balances with the latest audited/unaudited financials provided.
7. Ensure that the company has filed all its tax and annual returns with relevant authorities. Get copies of tax assessment notices. 
8. Carefully look for related party transactions and ensure that they were conducted at arms length. 
9. Go through the list of fixed assets and verify material items. If there are huge intangible assets capitalised in the balance sheet, make sure that they are valued realistically.

Human Resources

1. Get a copy of company's organisational chart and list of employees with their roles. 
2. Verify employment contracts, non-disclosure and non-compete agreements (where applicable).
3. Look for historical attrition rates to identify unusually high staff turnover.
4. Ensure that all the employees have the right to work in the country they are based in. Also, verify that the company has been promptly paying the employer's contributions in accordance with local laws. 

Technical (Depends a lot on the sector whether it is software, hardware, biotech, cleantech, etc. but there are some common themes)

1. Capability of the technology: To ensure it does what it promises, schedule a demo. Prepare a walk through of various use cases. For software, go through the functionality from both front and admin ends and document screen shots. For biotech, look for data coming out of independent trials. 
2. Stability and scalability: This is relevant primarily for software startups where architecture, algorithms and databases need to be assessed for stability and scalability. Obtain a list of infrastructure monitoring tools used by the company. Get a description of redundancies built into the hosting platform and hardware.
3. Usage data: Obtain monthly traffic reports like site visitors, unique visitors, registered users, returning users, etc.
4. Third party tools: Obtain a list of third party tools and/or content utilised by or embedded within company's products. Ensure that licenses are in place. 
5. Development roadmap: Review company's plans and "Use of capital sheet" to assess if significant pivot in product direction are anticipated in coming years. 
6. Ownership: Evaluate academic affiliations of Founder/s and/or CTO to assess competing claims on the technology. If the technology is licensed from a research institute, assess the impact in an exit scenario. 

Hope this is useful not just to investors in their assessment but also to founders in preparing well in advance for a smooth and efficient due diligence. Do please let me know if I have missed out on any other important item.