Is your startup ready to start raising capital from professional venture capital investors? Or maybe your startup initially bootstrapped, asked for investments from family, friends, or angel investors, but now, you need more capital in order to scale and grow. Professional investors have more stringent due diligence requirements than earlier-stage investors, and the Series A VC round is where many founders first encounter serious diligence.
While every investor will have their own diligence framework and set of requests, VCs tend to have a similar set of questions at the Series A stage. As an accounting firm that helps venture-backed companies, we’ve answered hundreds of diligence requests and helped our clients raise billions of dollars. This list will consolidate down the most frequently asked diligence questions so you can be better prepared when it’s time to raise funding. We’ll focus on our area of expertise - accounting, tax and HR due diligence. You’ll want to work with an experienced lawyer to prepare for legal diligence, and other diligence prep will be 100% on your shoulders (like customer, technology and market diligence).
Should you outsource HR? Use this guide to decide.
What is Series A Financing?
Series A funds come from big names like Sequoia, Benchmark, Andreessen Horowitz, and Founders Fund, as well as lesser-known regional, specialized, up and coming or boutique funds. A Series A round is typically between $5M and $15M, although there are regularly much larger rounds that make the press. Many perks come along with a Series A investment if you nab the right investor. Not only do you get funding, but you may also get access to their operations and recruiting teams, best practices, professional board members and a social network of other funded founders. And you increase your chances of finding that “special” investor if you have your diligence materials ready to go.
This type of financing is only for businesses that are looking to be worth hundreds of millions, if not billions. Even though it may be a great business opportunity, Series A investors don’t like to invest in companies that can’t achieve huge outcomes. And being able to exit via an IPO or acquisition requires your accounting and HR systems to be scalable and robust, so the Series A diligence is a bit of a practice run that helps the investor get comfortable with your ability to handle the growth required to get big.
Series A Accounting, Tax and HR Due Diligence
Due diligence is a very important step all startup founders must take if they are looking to raise capital. It can be a time consuming and painful process, but preparation can dramatically reduce the amount of effort required. Here are the most common questions you’ll encounter as you raise an A:
Accounting/Financial Diligence Items
Past 3 year financial statements (income statement, balance sheet, cash flow)
Bookings history (if it applies to your startup)
3 to 5-year projections, usually by month (cash position is an important item the VCs want to see projected)
Top 10 client invoices and contracts (only matters for b2b companies)
Material contracts with vendors/suppliers
For revenue generating companies:- CAC (customer acquisition costs - they may have a particular way they want to calculate this metric)- Customer LTV- Customer churn rate (assuming this applies to your startup)
Tax Due Diligence Items
Past 3 years Federal tax returns
Past 3 years State tax returns
Any correspondence with tax authorities
Last 2 409A valuations
HR Due Diligence Items
Salary schedule for all employees
Projecting hiring plans for the next 3 years (personnel are usually the largest expense for startups, so this is particularly important)
Any transactions with executives (as in, did the founder borrow money from the startup, or vice versa)
Standard offer letter, NDA, etc. for new hires
The expert CPA team at Kruze has put together a financial, tax, and hr due diligence checklist that you can access for free. Download the full due diligence checklist here.
HR Due Diligence for Startup Fundraising
While a startup’s profitability is a chief concern for potential investors, don’t discount the HR due diligence and organizational efforts that investors also look for.
An important step in scaling up a startup is preparing a hiring and retention plan for your first few employees. If you’re churning through new hires, it kneecaps your startup’s ability to grow faster: the Society for Human Resource Management (SHRM) suggested in an employee turnover report that employee departures can cost as high as 50-60% of an employee’s salary.
Sustainably growing a team relies on important retention efforts, namely offering attractive benefits and perks that keep your employees engaged.
And to gain a better understanding of your cash flow out, it helps to have software that can provide accurate payroll reporting, so you know how your team’s growth factors into your financial growth.
How Long Does Due Diligence Take?
Due diligence can take as long as several months, or as short as only a single meeting. It really depends on the type of relationship you have with your Series A investor and how prepared you are. If you have been having regular conversations with them prior to the funding process, it may take only two to four weeks. If it is a cold pitch type situation and you don’t have a previous relationship, it may take a bit longer. Regardless, being prepared can dramatically reduce the time you spend doing diligence.
To conclude, preparing for Series A due diligence can seem like a lot. It may even seem overwhelming. Just know that getting all the requested documentation together will be worth it in the long run. The investor wants to know that you are organized and have your systems in place.
If however, the task still seems daunting to do on your own, know that there are folks out there that can help alleviate your stress, make the process run smoothly, and help you get your financials ready for Series A funding. Look for a financial services team that knows how to navigate the startup funding diligence process.
About the Author
Healy Jones runs FP&A (Financial Planning and Analysis) for Kruze Consulting at Kruze Consulting. Formerly he was a venture capitalist and an executive at VC-backed startups. He was a venture investor with the technology team at Atlas Venture and started in venture capital with Summit Partners. His career began in investment banking at Hambrecht and Quist (eventually became JP Morgan Chase).
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.