Due diligence has always been an important part of the funding journey. And, as companies progress through funding stages, expectations around what needs to be in place are increasingly more demanding.
In March, LegalEdge and Capsule brought together investors and advisers to discuss what’s changing in due diligence – and what hasn’t changed.
We’ve summarised the key takeaways from the session below.
How Due Diligence Evolves as a Business Grows
Key: 🟢 Limited / early-stage focus 🟠 Growing focus / validation 🔴 Significant / detailed focus
| Area | Seed | Series A | Series B |
| Corporate / cap table | 🔴 Critical | 🔴 Critical | 🔴 Critical |
| IP ownership | 🔴 Critical | 🔴 Critical | 🔴 Critical |
| Financials | 🟠 Basic validation | 🔴 Detailed | 🔴 Detailed / QoE where appropriate |
| Customers / revenue | 🟠 Early evidence | 🔴 Major focus | 🔴 Major focus |
| Product / technology | 🟠 Product viability | 🔴 Scalability & technical diligence | 🔴 Scalability, resilience & technical risk |
| Team | 🔴 Founders & key roles | 🔴 Leadership & hiring | 🔴 Leadership, structure & key-person risk |
| Regulatory / data | 🟠 Depends on sector | 🔴 Increasingly important | 🔴 Often material |
| Tax / R&D / EIS | 🟠 Eligibility & basic compliance | 🔴 Detailed review | 🔴 Detailed review |
| Governance | 🟠 Foundational | 🔴 Increasingly formal | 🔴 More mature governance |
| Market / competition | 🔴 Investment thesis | 🔴 Product-market fit & market validation | 🔴 Market position & competitive advantage |
| Insurance / risk management | 🟢 Early-stage / proportionate cover | 🟠 Increasing focus | 🔴 Significant / detailed focus |
| International / group structure | 🟢 Where applicable | 🟠 Increasingly relevant where applicable | 🔴 Detailed where applicable |
Due Diligence Standards Are Evolving
For companies approaching a Series A, due diligence can take around eight weeks from term sheet to completion, sometimes longer. So for businesses nearing the end of their runway, any delay along the way can create significant pressure/ stress and potentially worse. The challenge is balancing relevant due diligence with commercial reality and the need to get deals done quickly.
The Same Issues Keep Coming Up
Despite changes in the funding landscape, many of the issues that come up during due diligence remain the same. Common red flags include:
- Questionable / inaccurate cap table: Are people on it that shouldn’t be (e.g. ex co-founders holding a significant stake). Is it accurate, up to date and consistent? Is it sensible for the company’s stage?
- Unclear IP/ tech ownership: Can the company show it owns the rights to key intellectual property? With increasing use of AI, human contribution and being able to show chain of title and provenance is key.
- Financial story: Do the numbers stack up?What’s the recurring revenue and retention rate? Do contracts back up the numbers. What’s the cash/runway risk? What’s the pipeline? Are forecasts justifiable?
- Co-founders/ key staff: Are they trustworthy, capable and can they step up? Are roles, responsibilities and rights clear and documented? Are they incentivised? Do those with equity have sensible cliffs/vesting schedules?
- Tax liabilities: Are R&D claims justifiable? Does EIS/SEIS eligibility stand up to scrutiny? Does the ESOP/ EMI scheme work?
- Technical risk, cyber security and data protection gaps: Is there technical debt? Are there security vulnerabilities. What’s the incident history? How is business continuity handled? Are appropriate contracts, policies and processes in place?
- Regulatory Risk: Are there any significantregulatorygaps, i.e. legal/ compliance debt?
Some of these may seem straightforward to address, but trying to fix them during a deal can create significant delays. So the earlier the key foundations are in place the better. And bear in mind that some can be hard/impossible to fix (e.g. cap table and IP ownership).
How Is AI Changing the Way Due Diligence Is Done?
AI can review large volumes of data quickly and at a fraction of the traditional cost of human review. But key considerations are:
- Accuracy: Does AI reliably identify the issues that matter? Is there a system so hallucinations will be spotted?
- Confidentiality: Is sensitive/ confidential information being shared with AI tools? If so, are sensible guardrails in place?
- Human oversight: Where is professional review and judgement still needed?When is a full human review needed? Or just spot checks?
- Liability: Who is responsible if something is missed or wrong?
The question is not whether AI can be used for due diligence, because it can. But where is experienced human oversight and judgement needed/ sensible.
AI Is Also Creating New Risks (as well as opportunities)
AI is an area of diligence in its own right. With businesses increasingly creating and using various tools, investors are asking: How are AI tools being built? And how are they being used? What controls are in place? You need to think about:
- Has vendor due diligence been carried out on AI tools being used/bought in? Are robust contracts in place?
- What information is being put into them? Will it be using date for training the tool? If so how? How secure is it?
- Are appropriate data protection and confidentiality controls in place?
- Who is responsible for overseeing AI within the business? Do they have the right skill set? Are users trained on what’s OK/what’s not OK to use tools for.
- Are their potential IP risks? Who owns the IP created by AI tools? Could IP disputes be brewing (e.g. for breach of copyright)? Can you show chain of title and provenance?
As AI becomes more embedded, being able to demonstrate that these risks are understood and managed is likely to become increasingly important.
Why Is Insurance an Important Part of Investment Readiness?
Insurance is increasingly becoming part of the investment readiness conversation.
Cyber insurance is increasingly expected, while IP insurance is becoming more relevant for venture-backed businesses where IP is central to value.
Investors are also looking for greater visibility around:
- Cyber risk
- IP risk
- AI-related risks
- The level of insurance cover in place
Having the right cover in place can help demonstrate that these risks are being actively considered and managed.
Professionalisation Needs to Happen at the Right Time
Businesses can sometimes wait too long to put the right legal and financial infrastructure in place, leaving them scrambling when diligence begins. That does not mean trying to cover off all risks too early. Fractional and interim support can provide the right expertise at the right time, helping businesses prepare for their next stage without over-engineering their operations.
The aim is to build the right foundations without adding unnecessary complexity or cost.
Getting the Legal Foundations Right
The goal is not to over-do it, but to get the right level of support for the risks involved.
Particular attention should be paid to:
- Cap table, co-founder agreements, and share option schemes
- IP ownership
You need to get these things right from the outset. Many other things can wait.
Investment readiness starts before the funding round.
The investment landscape may be changing, but the message remains the same: preparation matters.
Getting the right legal, financial, insurance and governance foundations in place as a business grows can make the next funding round significantly smoother – and help prevent avoidable issues from becoming deal-delaying problems.
Looking Ahead
LegalEdge and Capsule will revisit these themes on Thursday 15 October, joined by Cooper Parry, to explore what has changed in the investment landscape and what founders and investors should be thinking about now.
The session will bring together perspectives across legal, finance and risk, with a focus on practical insights and investment readiness.
If you’re preparing for your next fundraise and want to make sure your legal, financial and risk foundations are in place, get in touch with the LegalEdge team at info@legaledge.co.uk.
