Due Diligence – Pre-investment audit

 

Due diligence can be defined as a process of gathering and analysing information regarding all of the essential functioning areas of a company by a potential Venture Capital or Joint Venture investor. Due diligence is supposed to help the investor in making an investment decision concerning a capital entry or to present to a financing company or creditor the investment security of a company. Due diligence is demanded by an investor after receiving the first information about a project from a business.

 

The process of due diligence usually starts after a company is presented to a potential investor by a project owner or consulting company. This takes place after a few meetings or, in some cases, even after the first. The decision belongs to the parties.

 

During such meeting, the Venture Capital investor or a financing company acquires knowledge on the topic of the undertaking, which only source is the project owner and members of his team. Therefore, even the best and most precise data about a project come from sources that are not verified by the investor and are not certain. Due diligence are actions undertaken by the investor, in order to “confirm” information received from the project owner about his project. These activities are made at the expense of the company applying for financing and at its risk. This is connected to a risk of conducting such research in an unknown to the investor field. The project owner, familiar with his own project and initial research, is confident about the certainty of the facts presented by him, not the investor.

 

Practically, a “verification” of a project by an investor takes place simultaneously with the process of getting familiar with by said investor or the consulting company.

Classical due diligence complies of a few basic examinations:

• Legal examination,

• Accounting / financial examination,

• Business examination (the company, market, team etc.),

• Technological examination,

• An examination of other areas, including those representative of a certain company 

 

 

One goal, but a different scope and form

 

Due diligence is not a process that always looks the same. The form, scope and method of conducting such examinations varies depending on:

• The phase of development of the development of the business (as for a Venture Capital the phases are: seed, start-up, early expansion),

• The requirements of certain investors or creditors,

• The market, on which the company operates or will operate,

• The technology or other solutions used by the company,

• The size of the company, the team, the complexity of the used production or sales procedures etc.,

• The size of the investment and its financial scope,

• And other factors, which are representative of a certain company.

 

Despite the elasticity depending on the form, scope and method of performing due diligence, the main goal of this examination does not change, which is “confirming” what has been communicated to the Venture Capital investor by the project owner or consulting company. Investors often entrust consulting companies to perform due diligence, which help implant the financial procedures in the same project, for a consulting company is more capable to familiarize with the complexity and nooks of projects, by working in the field of the project owner.

 

There is not always something to examine

 

The intensity of due diligence activities is directly proportional to the phase of development of the company or to its complexity. The younger a company, the less to research. However, the more technically complicated it is, the more there is to research. What comes with early phases of development is no data and a limited access to it.

 

In the case of a project in a seed or early start-up phase, due diligence activities are usually very limited. Here the investor may perform his own analysis of the market or technology, if it already exists. He himself analyses the project owner’s company and O&M.

 

Expenses too high

 

One of the more important reasons of limited due diligence activities in early stages of development is the will to limit the expenses of such research. That is why investors and project owners often entrust consulting firms to perform such examination, in order to cheapen the expenses.

 

For it is not anything unusual when the estimated costs of performing full due diligence are a large part of the entire amount intended for a capital entry into a young company. In extreme cases, the expenses of a hypothetical full due diligence may by higher than the amount of the investment planned by the Venture Capital investor.

 

A lack of information does not signify incorrect information

 

Very often the Venture Capital investor is not able to acquire market information, on which he could perform an evaluation of a given project. In these situations some investors depart from the execution of a project because of the inability to estimate the risk. Other investors accept the risk and perform a capital entry (which may be linked to a decrease in the evaluation of a company or project).

 

Only what is important is truly researched

 

Because of a lack of market information investors limit themselves to conducting only the basic examinations. The scope of these activities depends on the specific situation of a project of company. However, most frequently Venture Capital investors concentrate on performing due diligence of the technology and the market environment of the company, as well as an exact verification of the project owner and his team (O&M).

 

The financial information of a small company in the form of financial reports is regarded as insignificant.

 

Formal due diligence in a late start-up

 

The general rule is that along with shifting the phase of development of a company, the due diligence process becomes more formal and more complicated. In the case of investing into a company being in an early expansion phase, the due diligence process may be very formalized. That process in then intricately planned and implemented by numerous external advisors.