A signed term sheet is not the same as money in the bank. Between the two sits financial due diligence, and it’s the stage where rounds slow down, terms get renegotiated, and occasionally the whole thing stops.
It’s also the most predictable part of a raise. The questions barely change from deal to deal, which means the outcome is mostly decided by work you did – or didn’t do – months before anyone asked.
Below, we go through what diligence actually examines, the findings that cost founders money, and what to fix in the quarters before it starts.
What financial due diligence is
It’s the investor’s verification exercise: confirming that the numbers you presented are real, that the business is what you described, and that there are no liabilities they’d be buying into unknowingly.
It is not an audit. An audit tests whether accounts comply with a reporting standard. Due diligence tests whether your business is what your model says it is – which is a different and broader question.
At seed, it may be one analyst with a checklist over a fortnight. At Series A and beyond, an external firm doing a quality of earnings review over six to eight weeks.
What gets examined
Revenue quality. Is the revenue recurring or one-off, contracted or at-will, concentrated in a few customers? Recognition policy gets tested against actual contracts, which is where revenue recognition problems surface.
Customer concentration and churn. One customer at 40% of revenue will affect what the business is valued at.
Cost base and margins. Whether reported gross margin survives once all delivery costs are included, and which costs are genuinely variable.
Cash and working capital. Debtor days, creditor days, whether you’ve been funding the business by paying suppliers late.
Tax and compliance. PAYE, VAT, corporation tax, whether R&D claims are defensible, and whether contractors have been treated correctly for employment status.
The cap table. Whether it reconciles to signed documents, including every option granted and every SEIS or EIS share issued.
Commitments and contingencies. Leases, notice periods, customer refund obligations, anything in dispute.
The findings that cost money
Revenue recognised too early. Annual contracts taken to revenue on invoice rather than over the term. It inflates historic growth, and correcting it mid-process undermines every number you’ve shown.
A cap table that doesn’t reconcile. Options promised in emails but never granted, share issues not filed, agreements with terms nobody tracked. We see this constantly, and it’s covered in The Most Common Cap Table Mistakes.
Employment status problems. Long-term contractors working like employees create a PAYE and National Insurance exposure that an investor will either price in or require indemnity for.
Undocumented related-party transactions. Director loans, payments to a founder’s other company, informal arrangements. Not fatal, but every undocumented one costs time and trust.
Gross margin that doesn’t survive scrutiny. Support, hosting and implementation costs sitting in overheads rather than cost of sales. Reclassifying them can move margin by ten points, which changes the valuation basis.
In most cases the finding itself isn’t what costs you. It’s that it surfaced during the process, which makes an investor wonder what else nobody has checked.
What goes in the data room
Statutory accounts for the last three years, monthly management accounts since your last raise, the current financial model with assumptions documented, the cap table with supporting documents, customer contracts with the top ten by revenue, employment contracts and the option scheme documents, tax filings and correspondence, bank statements, and any SEIS or EIS compliance paperwork.
Structure it the way an investor reads it, keep a version-controlled index, and make sure the numbers in each document agree with the numbers in the others. If two documents in the same data room disagree with each other, that does more damage than a single bad number would.
Preparing months ahead
The work that changes the outcome happens two or three quarters early.
Close your months properly and on time, so there’s a track record of monthly management accounts rather than a reconstruction. Reconcile the cap table against signed documents and fix what doesn’t match while it’s cheap. Review revenue recognition against actual contracts. Check the employment status of anyone who has been contracting for you for more than a year. And run your own diligence exercise – go through the list above as though you were the investor, and write down what you find.
Founders who do that arrive at the process with the answers already documented. That’s the difference between six weeks and twelve.
The takeaway
How diligence goes is mostly decided by preparation rather than by how well you handle the process itself. The questions are known in advance, the common findings are known in advance, and almost all of them are cheaper to fix a year out than a fortnight in.
Preparing for a round?
Running a pre-diligence review, tightening revenue recognition, reconciling the cap table and getting the data room in order before an investor sees it is regular work for our fractional CFOs – and it’s usually the difference between a smooth process and a renegotiated one. If a raise is on your horizon, get in touch with us today to book a free consultation.
Disclaimer: This article is general in nature and does not constitute financial advice. Diligence scope varies by investor, stage and deal size – speak with a qualified adviser (hey, that’s us!) about what applies to your situation.
