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View: The importance of due diligence in the promising world of startups

View: The importance of due diligence in the promising world of startups

View: The importance of due diligence in the promising world of startups
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By CNBCTV18.com Contributor Feb 25, 2022 7:47:55 PM IST (Updated)

Due diligence shouldn't have to be a stressful or challenging process, writes Chetan Khandhadia of RBSA Advisors.

India is an up-and-coming global innovation hub, boasting the world’s third largest startup ecosystem. Startups have leveraged the fast-tracked digital adoption perceived amongst businesses and individuals alike to build newer business models. These business models are driving investor interest in a big way.

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Startups received record funding of late. Investments into startups totalled $10.9 billion across 347 deals in Q3 of 2021 – crossing the $10 billion mark in a quarter for the first time, up 41 percent sequentially, according to a PwC India report.
However, investing in a startup is inherently a risky business; therefore, it is advisable that a potential investor has thorough understanding of a startup. That’s where due diligence comes of use. Due diligence helps investors and companies understand the nature of the transaction, the risks involved, and whether the transaction fits the investment strategy.
2021 was recognised as the year of unicorns, with the addition of 40 startups. According to Venture Intelligence, in the first three quarters of 2021, around 371 new companies achieved the unicorn status in India, and the global decacorn list became more than 40-strong with increased funding activity and valuation. Most of these companies were from the US, China and Hong Kong. Only two companies, BYJU’s and Paytm, are in the decacorn list from India.
The Department for Promotion of Industry and Internal Trade (DPIIT) has identified more than 61,000 startups representing 55 industries. These startups, spread across 633 districts, have created over six lakh jobs since 2016.
Adequate capital, courage and connecting with people are essential for excelling in the startup space. Sometimes, early-stage startups may not have a robust business plan, or have too ambitious burn-rate and cash flow plans. At this stage, due diligence can draw attention to the types of issues and uncover unexpected risks or product misalignments that an investor or a company might not have been aware of previously.
The significance of due diligence
Around 44 per cent of the startups registered in India are from Tier 2 and Tier 3 cities. The government is taking all necessary steps to make India’s startup ecosystem robust. The Government e-Marketplace (GEM) has been linked to the Startup India portal so that startups can sell their products to Government of India directly. Moreover, startups have been given income tax exemption for three years, and six labour laws and three environmental laws have been changed so that young entrepreneurs need to provide only self-certification. The government has also started a one-stop digital platform, Startup India Hub, where all information regarding startups and their ecosystem is available for entrepreneurs.
Due diligence is not only essential for investors but also should be undertaken by every startup.
Here is a non-exhaustive summary of the practical financial, commercial, technical and legal aspects of the necessary due diligences on startups.
Assuming that a startup accurately represented itself during the investment pitch, due diligence shouldn't have to be a stressful or challenging process. The startup will be asked to produce a massive number of documents and may have many meetings with potential investors, but if everything checks out, it could be looking at a bright and exciting new phase in its growth trajectory.
The process
The initial screening identifies companies fall within the potential investors’ areas of focus. In first stage, it is determined whether the proposal is consistent with the potential investor’s investment philosophy. The investment philosophy may include the funding stage of the startup, as well as its industry and geographic spread. After the initial screening, a meeting is arranged with the teams behind the companies that look promising, and potential cases are evaluated by the investors. A key part of this stage is to assess mutual interest and to get to know the team behind the startup.
A few promising cases advance to the next step.
An in-depth analysis is conducted to evaluate the investment cases in detail before deciding on whether to submit an investment proposal should be made. Generally, the investors conduct four kinds of due diligences:
  • Commercial
  • Technical
  • Financial (including tax)
  • Legal
  • In the world of startups, the term ‘due diligence’ refers to an audit of a company that has been performed in order to discover possible business liabilities or deficiencies in light of a planned business transaction, such as an acquisition or an investment.
    The due diligence procedure reduces the risk of making an unacquainted decision.
    In this process, all the adequate information is provided by the company or target, the entity to be funded or acquired, to do a thorough analysis. In the due diligence process, the analysis or review is conducted to make sure that all facts come out before entering into a financial transaction or agreement with another party. Due diligence can be an exhausting and time-consuming process, which is why founders must be well prepared, and able to dedicate adequate time and resources to ensure that the process is smooth, as a failed due diligence process can significantly devalue a startup.
    --Chetan Khandhadia is Managing Director and Head-Transaction Services at RBSA Advisors. The views expressed in this article are his own.
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