Working at PrivateCircle provided me with the opportunity to prepare ourselves for larger institutional funding.

This is a blog post summarizing my learnings on how startups should go about preparing themselves for due diligence. In this post, we will explain what data is required, how to go about this process, and other relevant information. Although it simply looks like a list and an explanation as accounting MIS teams know, there is a lot more that needs to be organized, automated, checked, and verified for all things to fall into place.

Financials

Past audited reports (past 3 years)

In terms of financials, investors typically ask for details from the last three audited financial years. They will also request provisional numbers for the current financial year and projected numbers for the next couple of years. Additionally, they may look for specific items in the financial statements and ask for more information on items that are material. 

For example, in an IT services company, investors may focus on the employee’s cost or the capitalization cost in the financial statements. Similarly, a financial services company may focus on investments or debt costs.

Detailed explanation for specific items in financial statements and recurring revenues

For example, most IT companies capitalize on the salary they pay to employees when building a product over the period of the entire project. This can cause a higher number on the depreciation side and investors may ask for details on the capitalization and overall employees. They may also ask about the number of employees who worked on the product and the operational costs.

The investors may focus on abnormal patterns in the financial statements, such as expenses/revenues that have suddenly become too high or too low. They will also analyze Annual Recurring Revenue (ARR), Monthly Recurring Revenue (MRR), Operating Profit, and Cashflow. The details about the new revenues/customers added, the churn rate, the upsells, the net retention ratios, and other financial ratios are also required. The startups generally don’t maintain these records.

So, startups should maintain revenue data at a monthly frequency level, including information on existing and new accounts, the proportion of revenue from the top five customers, and the cost to acquire a customer. All of this information should be properly maintained and tracked. They may also inquire about specific details for product lines if the startup offers multiple products or services.

Startups should avoid misclassifying expenses and creative accounting. They should be consistent with their revenue recognition policies. They should not change their revenue recognition policies to inflate revenues. To avoid accounting errors, it’s always better to have two audits, i.e. internal audit and the statutory audit if affordable.

Pipeline development

In terms of pipeline development, investors will ask about the startup’s existing pipeline, including the number of leads and deals in active conversations. They may also want to know the conversion ratio for the past three years and the cost to acquire a customer for lead generation. They may also want to see reports for each salesperson if the sales are coming from referrals or directly from a sales team.

Formal contracts

Another important aspect investors may look at is contracts or agreements with customers. They may want to see the period and renewal date for these agreements, particularly for B2B contracts. They may also want to see letters of engagement or intent for B2B contracts, as well as master service agreements and sales-related agreements for specific proposals.

In terms of expenses, they may want to check the contracts with vendors for large expenses found in the financial statements such as infrastructure cost, licenses cost etc. They may also want to check the credit terms with vendors.

Legal  and ​​Secretarial

In terms of legal and secretarial requirements, investors will want to check the documents such as a memorandum of association and articles of association, as well as an updated cap table. They may also want to know about any prior agreements between founders and third parties that may affect the company and how they are being accounted for. 

When reviewing startups, investors may also ask for all agreements from day one and may be particularly interested in agreements that are in place prior to the memorandum of association and articles of association. Additionally, suppose the investor is from a different place. In that case, they may want to see any relevant agreements or documents that comply with the laws of that region such as RBI, SEBI, etc.

Startups tend to miss out on generating share certificates or collecting counterfoils. Therefore, counterfoils should be taken and kept at the registered office. The startup needs to provide the copies of minutes of board meetings and members’ meetings. Hence, minutes books should be maintained regularly. 

In start-ups, there may not be a separate secretarial team, so they may outsource it and do it once a year, which is an informal way of doing things. Board meetings should happen at least once every quarter. In informal situations, they may prepare minutes at the end of the financial year. In the meantime, if they have passed a resolution to obtain credit from a financial institution, the company may miss out on this while preparing minutes at the end of the year. Outsourcing can really help startups on this front who are new to such responsibilities. But, it is important to check the service provider on a regular basis. 

The copies of returns filed with the MCA should be provided and verified. It is best to have a secretarial team or a company secretary on a retainer ship basis to ensure compliance with MCA requirements. Compliance related to maintaining certain registers as per the Companies Act, such as registers of members, charges, and managerial personnel, in specific formats will also be verified. If the company has granted ESOPs to employees, then documents such as copies of board resolutions granting ESOPs, allotment letters, etc are required to be submitted. 

Product and Services

Investors pay particular importance to understand the cost and revenue for each product and calculating the economics of development and commercialization. The code should be clean and in a sellable form in case the company wants to integrate with another party or do a business unit sale or acquisition.

If the packaging is not up to par and the code is unclean, it can become a problem during due diligence. Not every investor asks for such a detailed level of product information, specifications, and transferability. But they will definitely have a demo of the product, and code review is usually done by their team at the next level. They may not ask about it at the initial conversation stages, but once the first level is cleared, they may ask for a code review.

If the company has any patents, copyrights, or other intellectual property details, they need to provide that information. This falls under legal needs as well.

Taxes and Compliance

The Companies need to provide information on taxes, both income tax and indirect tax such as GST. A minimum of the last three years’ returns copies including monthly returns. Data should also be provided on purchasers and input taxes mainly for input tax credit. They will do their own analysis to check for restricted inputs and potential liabilities.

Startups also need to provide all past notice histories from the day they started, including notices received and closed from the income tax department and GST. Additionally, labor laws and statutory compliance should be properly complied with, as this is often neglected by startups and other companies. Laws related to Provident Fund, Employees’ State Insurance, gratuity, bonus, minimum wages, CLRA licenses, etc. should be complied with. There are many records and registers to be maintained by the companies under various state and central labor laws. 

People usually only focus on income tax and GST, but labor laws are just as important. However, there is often a lack of awareness in this area. 

There are also industry-specific legal requirements that startups may need to disclose their compliance. 

Human Resources

On human resources, investors will need a list of all employees, past and present, and all the necessary documents such as offer letters, appointment letters, agreements, etc. Startups tend to miss this, they will appoint employees but fail to provide offer letters and maintain proper records. Additionally, the companies need to provide their HR policies, such as office timings, leave policy, code of conduct, etc.

The investors may also ask for information on employee turnover rate and the top five highest paid employees. 

Financial	Past audited reports (past 3 years) Provisional and Projected Financials Detailed explanation for specific items in financial statements ARR Upsell, New, and Churn revenues (at least for the past 3 years) Existing Pipeline Past success rates- Pipeline achievements Specific details Product wise Contracts with and Purchase Orders from the Customers Details about capitalization Details large expenses and contracts with vendors Details of debtors and creditorsFixed Asset registers
Secretarial/Legal	MOA & AOA CapTable- diluted holdings Shareholder Agreements and other contracts entered into by Investors Share Certificate copies Board meeting and General meeting details- minutes books Agreements with the Founders/Directors All the Forms filed with MCA Compliance related to Annual Returns Registers and documents required to be maintained as per Companies Act- like Register of Members, Register of Directors and Key Managerial Personnel, Register of Charges etc ESOP documents
Product and Services	Cost related to each product Code review, Patents, Copyrights, and Intellectual Property Rights
Taxes	Income Tax and GST Returns for the past 3 years (Monthly/Annual) For GST- more data to be provided related to Input Tax Credit, Reverse Charge Mechanisms Details of all past notices received and existing pending notices
Labour Law and other Statutory Compliances	Various Labour Laws and statutory returns filed for the past 3 years Licenses, and registrations obtained under multiple labour laws Notices and litigations details- past and present Industry-specific registrations and licenses
Human Resources	List of all employees (past and present) Employment agreement copies Offer Letters/Appointment Letters HR Policy Employees turnover
Company Policies and other General Information	BCP Other company policies such as ITMS, Data Protection, Code of Conduct etc

Other information needs:

The company should also have general policies in place such as business continuity, risk management, data storage standards, privacy, code of conduct, and ethics. They will also need to provide information on the company structure and workflow.

However, the main concern is ensuring that all statutory compliance is met. Non-compliance with statutory requirements are the formal invitations to the authorities to inspect. 

Proper maintenance of MIS is crucial. It is important for the company to maintain proper records and master data systems from the beginning, including sales information, revenue, customer names, product and service lines, etc. At what stage should a startup begin to focus on serious MIS reporting? If not from the inception, at least from when the first revenue was clocked. This allows for easier generation of reports for investors and other stakeholders.

Most people focus on revenue or growth alone, but it is important to have all aspects covered.

Overall, the due diligence process can be intense and time-consuming, but by being prepared and having all of the necessary information on hand, you can make the process go more smoothly.