How can an early-stage startup prepare for due diligence?

written by Alexey Knysh, Finance PM Senior Partner, Head of Financial Advisory

What is financial due diligence?

Financial due diligence is the procedure undertaken by the potential investors to understand:

• Historical financial performance of the investee
• Key assumptions in the management’s forecast
• Core team and systems in use
• Controls, accounting policies in place

The financial due diligence aims to provide reasonable assurance to the potential investors that the given historical financial information is materially correct; the assumptions in the forecasted period are reasonable and supported by relevant evidence.

Financial due diligence is a stand-alone process. Although the analytical team can perform it independently of the other reviews (like legal DD, team DD, etc.), we do not recommend analyzing the financial DD’s scope, conclusions, and recommendations separately from other areas. Instead, investors should apply the overall approach to evaluate the potential investees.

What are the specifics of the financial due diligence for early-stage startups?

The scope and depth of financial due diligence depend on many factors, including the stage of the business. The process of review of a $100 ml revenue business and pre-seed startup with 3–5 employees will be inherently different.

So is there anything to check in a pre-seed, seed-stage business? Definitely yes.

The investors will focus on two key areas:

1. Historical financial information

Even if the startup does not have traction, there are still things important for investors, such as:

• How was spent the previous funding?
• What was the historic burn rate?
• Is there a financial discipline?
• Are there any accounts/records available?

Trust me, tidy up books and records will increase your chances of creating a positive impression on the investor.

We have gathered the common mistakes while doing finances in your early-stage startup:

• Use of personal bank accounts for business transactions and vice versa.

Sometimes the business expands faster than the legal structure. Not all startups have the legal entities to support the business bank accounts. However, it is necessary to allocate a minimal separate bank account for business and use it only for these purposes.

• Use of Excel /Google spreadsheets as the primary accounting solution.

It is ok to use spreadsheets for presenting, summarizing, and analysis of financial reporting. However, we advise using simple accounting software for day-to-day bookkeeping. It will ensure the security, reliability, and completeness of the information. There are quite a few solutions that provide free packages for bookkeeping, like Wave App, Xero — choose which one you like most.

• Preparation of only the cash flow statement.

A cash flow statement is an essential report but for sure not the only one you should prepare. If you want to use only one report for your reporting, it must be a Profit & Loss Statement. The use of this report will allow you to compare different ones to ensure you record your sales/costs as they happen and not when the money is received.

• Incorrect classification of key cost items.

Often startups classify cost items randomly, which makes the reporting challenging to analyse, review and compare to other businesses. Incorrect classification also might be a key driver not to provide funding to startup (e.g., when your R&D is small compared to G&A/S&M).

For example, the payroll costs are shown as total without allocation between R&D, G&A, and S&M, Management costs shown as a separate line without allocation to types of expenses, cost of sales is not shown at all.

As a rule of thumb, your P&L should have the following items:

• Revenue
• Cost of sales
• R&D
• S&M
• G&A

Let’s talk about them in more detail.

Revenue — a self-explanatory item of P&L that includes all the sales. If you can split it between recurring and non-recurring, it would make your financial reporting stand out as well as make potential investors’ lives much easier.

Cost of sales — this line shows how much it cost to create/support/deliver products you sold to customers.

Here’s a list of the general costs that comprise the Cost of Sales for a SaaS business and are not part of the Operating Expenses:

• Application hosting and monitoring costs.
• Customer support and account management costs.
• Data communication expense.
• Software license fees for products embedded in the application.
• Website development and support costs.
• Professional services and training personnel costs.
• Costs of subscriptions.
• Hosting expenses to deliver the actual software. Think Rackspace or AWS expense.
• Costs for third-party software that is part of the product delivered to customers. It could be a third-party expense for a reporting software application used in the company’s product and delivered to the customer.
• Personnel costs tied to the employees responsible for managing/running the servers and data center delivering the SaaS application to customers.
• Personnel costs for the professional services team responsible for getting a customer live on the product (i.e., implementation, consulting, data migration, training, etc.).
• Personnel costs for the customer support team responsible for supporting customers once customers are live on the application.

R&D — Research & Development costs are the crucial part of any tech business P&L. It demonstrates how much funds you allocate to innovation and product creation. The higher is the % of R&D in the overall P&L structure, and the more attractive the business would look. It is especially relevant for the early-stage start-up.

S&M — Sales & Marketing costs. Once you have your MVP and start getting traction, the Sales and Marketing costs should include your sales team’s salaries, marketing, advertising campaigns, etc. Usually, you should also regularly analyse metrics like CAC, LTV, ARPU, Churn Rate.

G&A — General & Administrative costs. Salary of your management and back office, office rental, utilities, etc. It is essential to have this item under control, as disproportionate spending on the G&A will likely trigger concerns during any financial due diligence for apparent reasons. No one wants to invest in management’s salary.

If one of the employees (e.g., CEO) is involved in R&D/S&M/G&A, make an assumption for allocation of his costs between all expenses items.

1. Forecast financial information

The investor would decide to invest if he has reasonable grounds to believe that the project is feasible and will deliver adequate returns. Therefore, to convince him, the start-up must have a robust financial business plan.

Understandably, not everything will go according to plan. Still, having a well-thought business model is an excellent indicator of the management’s ability to drive the business to success.

We have seen many examples when the management failed to provide an adequate business plan, failing the fundraising process. This is why we have gathered the most common mistakes when preparing and presenting the financial model for financial due diligence:

• Lack of listed hypotheses and assumptions. It makes the model hard to read to those not involved in the business.
• Not transparent format. Excel is a great tool that allows you to link all the data and build formulas. Not everyone uses its full capacities. A common situation is putting the data manually when there is no chance to understand its origin.
• Modeling for ten years+: nowadays, even three years is a very “distant” prospect.
• Overcomplicating the model: when it turns into an endless datasheet, it is simply impossible to single out key metrics. There are separate pages, a summary, a memo/instruction for using and reading the document.
• Currency: there are two common mistakes — it’s either not mentioned at all, or one uses $ when business, clients, and investors are in the Eurozone or the UK.

A mere list of mistakes won’t be enough, for sure. So here are some principles to base oneself upon while working on your financial model:

• Any good financial model lives and dies by assumption, so don’t forget to keep a record of yours and add them to your summary page for everyone reading the model to follow your logic.
• Financial model as any financial document shall be transparent, so don’t forget to use formulas, automatic updates and keep it simple.
• Everything affects everything; if your costs grow, your earnings grow proportionally. Pay attention to this.
• Always use relevant currency, the one your clients or investors use.
• Be reasonable: the CEO can get less than a developer, and has his equity shares, but he can’t get less than an analyst; this is just a matter of motivation.
• Don’t plan too far ahead: 2–2,5 years will be just fine. The industry is changing so fast that 5-year plans look too abstract.
• Ask questions, don’t forget to involve key team members as CTO knows better which specialist he will need in 6 months and how much he will be spending on servers.
• Look for industry standards; there are tons of information out there you can’t build your model in a vacuum.
• Use available templates: there is no need to reinvent a bicycle. Just find a template that you like the most and improve it.

Conclusion

If you are planning to fundraise, you cannot avoid financial due diligence. Even if your startup is at an early stage and you don’t have traction yet, you still have things to put in order and prepare your startup for the due diligence procedure:

• Have your reporting package with historic information ready, tidy, and simple.
• Have your 24–36 month forecast financial data to support your business’s required funding and valuation.

Try to keep your finances in order from the very beginning, and keep in mind these simple tips for preparing a financial model and maintaining financial reporting. Having all this will help you easily undergo due diligence and build strategically plan.