Before they invest in or buy your startup, investors will be performing due diligence on your business's ins and outs — from finances to the business's operational structure.

If you've ever explored the possibility of investors or acquisitions, you've probably heard the term "due diligence." You might even know that it has to do with vetting a business and its future potential before the investor or acquirer decides to move forward with a deal.

But what exactly does due diligence mean? Who conducts it, and what specific aspects of a business are examined during the process?

For any startup looking toward venture capital or getting acquired, here's a basic overview of due diligence and what you need to understand about it.

What is the due diligence process and why is it important?

According to Thomson Reuters, due diligence is a formal legal investigation which helps confirm that a business investment or acquisition will be beneficial to the investor or buyer. Every financial decision comes with risk, and it's important for anyone investing a large sum of money to fully understand the specific risks that come with their decision.

Generally speaking, due diligence involves looking at the investment or acquisition target's intellectual property, business operations and financial track record. A potential buyer may also consider how well an acquisition fits with their overall strategic plan.

There are three basic phases of due diligence that are typically carried out by attorneys for the buyer or investor:

  • Preparation. This is where goals and priorities are set for the due diligence process. Depending on the investor or acquirer, some aspects of a business will be more important than others. For example, they may choose to overlook a minor operational issue in favor of strong financial figures.
  • Investigation. In this phase, all relevant information is collected from the business being investigated, including business documents, financial statements, personal interviews and more.
  • Results. The findings of the investigation are presented, and the buyer or investor makes a final decision on whether the deal is worth the risk.

[Read: What Are Trade Secrets, and Does Your Business Have Them?]

Due diligence can be a lengthy process, sometimes taking weeks or months to complete.

How long does due diligence take?

Due diligence can be a lengthy process, sometimes taking weeks or months to complete. Bill Snow, author of "Mergers & Acquisitions For Dummies," estimates that due diligence in the M&A process should take no longer than 60 days, but can often take longer than that if the seller is slow in getting information to the buyer and/or their attorneys.

Snow notes that whether you're buying or selling, you should push for a 60-day due diligence period.

"Stay proactive with the process," he wrote on Dummies.com. "Push and prod for information, and don’t be reluctant to pick up the phone and be a pain in someone’s side. However, other people don’t always work as fast as you’d like, so mentally prepare yourself for 90 days."

How to prepare your startup for due diligence

If you're getting ready to undergo a due diligence investigation, you'll want to make it as easy as possible for your potential investor or buyer to get the information they need. Some things the other party might investigate during due diligence include (but are not limited to):

  • Organizational and formation documents.
  • Company ownership.
  • Contracts with customers, suppliers, vendors and other parties.
  • Financial documents and agreements.
  • Litigation history and trends.
  • Subsidiaries and stock records (if applicable).
  • Correspondence between your company and its board of directors.

Due diligence when you're the buyer

If you're looking to grow your business by acquiring another one, you'll be responsible for conducting due diligence on your potential acquisition target.

The above information and tips can help you understand what to look for from a buyer's perspective. Essentially, you'll want to confirm that the business you're buying has shown steady growth and has potential for a strong return on your investment in the future.

No matter which side of the due diligence process you're on, it's important to understand what it entails and how to best position yourself for a smooth, efficient and successful evaluation.

[Read: 3 Expert Strategies for Attracting Investors]

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

Published September 24, 2019