What happens in due diligence

By Abha Lohia · Startup Decoded

Due diligence is the investigation an investor carries out on a startup after agreeing a term sheet and before sending money. It checks that what the founders said is true and finds risks that change the price or the terms.

What is due diligence?

Due diligence, often shortened to DD, is the process of checking a company's claims before an investment is final. A term sheet sets out the main deal terms but is mostly not binding, so the investor uses this stage to confirm the facts behind the price: the numbers, the legal position, the product and the people.

The word comes from the idea of taking due care. Investors do it to avoid surprises. Founders should see it as normal, not as a sign of distrust. A clean diligence speeds up the deal. Problems found late can reduce the valuation, delay closing or end the deal altogether.

At pre-seed and seed, diligence is light: a check of the cap table, the founders' background, a few customer calls and basic legal papers. Cheques are small and the investor is betting mainly on the team. At Series A and later, the review widens to audited financial statements, detailed contracts, tax and a full legal report, since the money at risk is larger and the company has more history.

What is checked in financial due diligence?

The investor, or an accountant hired by the investor, looks at the financial statements, bank statements, revenue records and how revenue is recognised. They check that the reported sales match invoices and cash received. They look at the cost structure, the burn rate, the cash balance and any debts or guarantees.

They also test the key metrics in the pitch, such as customer acquisition cost, retention and gross margin. If the deck said monthly revenue was ₹1 crore, they will check bank credits and tax filings for the same months. Gaps between what was said and what the records show are the most common cause of trouble.

What is checked in legal due diligence?

Lawyers review the company's incorporation documents, board and shareholder resolutions, the share register, past funding agreements, and the cap table. They check that every share was issued correctly and that filings with the Registrar of Companies are up to date. They look at contracts with customers, vendors and key partners, and at any court cases or notices.

They check that the company owns its intellectual property, including its software, brand and domain name, and that employees and contractors have signed agreements assigning their work to the company. For a company with foreign investors, they check compliance with foreign exchange rules, including reporting to the RBI.

What is checked in tax and compliance?

Tax review covers income tax returns, GST registration and returns, tax deducted at source on salaries and payments, and any notices or demands. The investor wants to know about any unpaid liability that will become theirs when they buy into the company.

Compliance covers licences and sector rules. A fintech must hold the right approvals from the RBI. A health company must follow rules for medical data and devices. A company that collects personal data must handle it as the Digital Personal Data Protection Act, 2023, requires, subject to the rules as they come into force. The investor also checks labour law compliance, such as provident fund and gratuity.

What is checked in technology and people?

For a software company the investor may review the code base, security practices, cloud costs, and dependence on open-source or outside tools. They may ask how data is stored and who has access. For others the review covers the supply chain or manufacturing quality.

Investors also speak to customers, former employees and past partners to check the founders' account. Reference checks on founders are common. They want to know that the team can work together, that key staff are tied in with stock options, and that the company has no hidden disputes between co-founders.

What is a data room and how long does it take?

A data room is an organised online folder where the company puts all the documents the investor asks for: contracts, financial statements, tax papers, the cap table and policies. A tidy data room with a clear index shows professionalism and saves time.

Diligence for a venture round usually takes a few weeks, and sometimes longer when many issues arise or when the investor is large. The investor sends a request list, and the founder uploads the documents and answers questions. Slow replies are a common reason for delay.

Index the folders by topic, such as corporate, finance, tax, contracts, people and product, and give each document a clear name and date. Remove drafts and old versions, so the investor reads only the final signed papers.

A data room contains sensitive information, such as customer names, prices and source code. Share it only after a non-disclosure agreement or the confidentiality clause of the term sheet is in place. Limit access to named people and, for the most sensitive files, release them in stages as the deal firms up. Investors who back a competitor of yours should not see your whole customer list.

What happens when problems are found?

Problems do not always end the deal. Small ones are fixed before closing, for example by filing a late form. Others lead to a change in terms: a lower valuation, a part of the money held back until a fix, or a promise by founders to cover losses, called an indemnity. Serious problems, such as inflated numbers, can end the deal.

The final agreements include 'representations and warranties', which are statements by the company and founders that the facts are true. If they turn out false, the investor can claim compensation. So be accurate in every answer during diligence.

Founders sometimes worry that any issue will lose the deal. In practice, investors expect to find issues in a young company, and what counts is how the founders deal with them. A founder who raises the problem first, with a fix and a date, usually keeps the investor's trust.

Common red flags are unclear ownership of shares, founders who have not signed intellectual property agreements, revenue that cannot be traced to bank receipts, unpaid taxes or provident fund dues, and promises of equity made to advisers or early employees without paperwork.

Others are related-party deals on unfair terms, heavy dependence on one customer or one platform, and unresolved disputes with past co-founders. None of these is always fatal, but each needs a clear explanation and, where possible, a fix before the data room opens.

How can founders prepare?

Keep records in order from the start: sign share certificates, file annual returns on time, keep board minutes, and have every employee and contractor sign an agreement on intellectual property. Build the data room before you need it. Be honest about weak spots early, and explain what you are doing to fix them. This guide is general information. Ask a lawyer or chartered accountant to check your readiness before a round.

Assign one person, often the founder or a finance lead, to manage the process. Answer requests quickly and completely. Keep a log of what has been shared so that nothing is sent twice or forgotten. Do not hide a problem: tell the investor yourself and explain the plan.

Consider asking your own lawyer to run a quick check before the term sheet is signed, which is sometimes called vendor due diligence. It lets you fix easy problems at your own pace, rather than under pressure.

Questions people ask

What is due diligence in a startup deal?

It is the check an investor does on a company before investing, covering finances, legal papers, tax, technology and people. It confirms the facts behind the deal and finds risks.

How long does due diligence take for a startup?

Often a few weeks for a venture round, though it can run longer if there are many issues or if documents come in slowly.

What documents are needed for due diligence?

Typically incorporation papers, the cap table and share register, past investment agreements, financial statements, tax returns, key contracts, employee agreements and licences.

Can a deal fall through during due diligence?

Yes. A term sheet is usually not binding on the main terms, so serious problems such as misreported numbers or ownership disputes can end the deal or change the price.

Who pays for due diligence?

Practice varies. Often the company bears its own costs and the investor pays for its own advisers, but some term sheets make the company reimburse the investor's costs up to a limit.