Performing Due Diligence with Startups

LLC-Vs-Legal-Liability

Any time companies engage in mergers and acquisitions, they also perform due diligence. “Due diligence is an expression used to describe a process conducted to ensure that the combination of two companies makes business and financial sense. Many factors are considered, and due diligence is conducted by both parties to a merger or acquisition. Obviously, both parties have the right to decide whether a merger or acquisition is right for their company, and so they each examine the other’s finances, business practices, personnel, and corporate culture to ensure the transaction is a good fit.

With start-ups, however, due diligence is a different matter. Start-ups lack the years-long track record of financial performance. Often, top personnel have not been in their positions long enough to fully evaluate them. Many other factors normally considered in due diligence also may not be particularly susceptible to evaluation simply because there is not enough of a record to evaluate. This obviously complicates due diligence when it comes to a start-up.

How Can You Perform Due Diligence on a Start-up with a Limited Business History?

Start-ups by definition have a limited business history. It is not possible to examine how their market share has changed over time, at least not in any meaningful way. Their market share might be negligible. It’s a start-up, after all, and any merger or acquisition involving a start-up is based mostly on potential at least as much as performance.

Even though they might be limited, when engaging in a merger or acquisition with a start-up business you must look at as many traditional business metrics for which you have meaningful information. These metrics include

  • Product fit: You must evaluate what the product is, whether people use the product, whether the product is finished and ready for market or still in development, and whether the finished product has value. Has that value been established by sales or market research?
  • Market fit: Determine whether there is a market for the product, including whether anyone else sells a similar product, whether there is demand for that product, how many other market participants there are, and how big the market is.
  • Legal and intellectual property issues: You need to evaluate any contracts that are in place, including contracts with suppliers of raw materials or parts as well as with buyers of the finished product. Also, are there any patents on the product, whether filed or approved? Is this an open-source product not covered by someone else’s patent? Is it in competition with original equipment manufacturers’ products?
  • Financial issues: This is one of the less traditional evaluations of a very traditional – and vital – element of due diligence. Because you are dealing with a startup, you likely do not have years of cost and revenue data. Still, you can look at current incoming and pending revenues and how those revenues measure up to costs, including research and development, employee costs, administrative costs, and other types of financial outgo.
  • Financial structure: Start-up or not, every business has a financial structure, detailing who owns what, where the money is coming from, who owns shares, options, warrants, or other forms of equity, vested or otherwise.

If You Are Involved in a Merger or Acquisition with a Start-up in the Palo Alto Area, You Should Consult with the Attorneys of Startup Company Counsel to Make Sure You Do it Right

If you are on either end of a pending merger or acquisition in the Palo Alto area, you need to make sure you perform proper due diligence to ensure that the transaction is the right move for your company. To help you with questions about issues related to due diligence, you should consult with the business attorneys of Startup Company Counsel at 408-441-7555 or through our contact us online form

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