Due Diligence Financial Records: The Data Room, Seed to Series A

What financial records do investors ask for in due diligence?

Investors may ask for the financial statements, the general ledger, bank and card statements, filed federal and state returns, payroll filings, proof of good standing, and the documents behind the cap table. Each item comes from a record the company already keeps, and an investor may check one against another.

The IRS recordkeeping rules already require books that show income and deductions, plus supporting documents such as invoices, deposit slips and receipts. A data room assembles those records; it does not create new ones.

A case is not simple when the books are behind, a return was never filed, founders paid company costs personally, the company has staff or a parent in another country, or the cap table and the books disagree. Gather first: bank statements for every account since formation, the filed returns, payroll filings, the cap table with every signed equity document, and the customer contracts behind revenue. If the books are not ready, see cleaning up your books before fundraising.

What changes between a seed round and a Series A?

A seed round often asks for less: recent statements, bank statements and the cap table. A Series A often adds the general ledger, monthly statements and a revenue build that traces revenue to contracts. Each lead investor sets its own list, so ask for it in writing early.

The Series A list is longer because more cash is at stake and the company has more history to check. Problems found late can delay closing or move into the deal terms, such as extra promises in the purchase agreement.

Will investors check our bank statements against the books?

They may. Cash is the easiest number to verify, so a bank balance that does not tie to the books stands out. Treat every balance in the data room as one that someone will check.

Publication 583 describes the monthly reconciliation: make the bank statement, the checkbook register and the books agree, and record any item the bank shows that the books do not, such as fees. For a data room, that means:

• A reconciliation for every bank, card and payment-processor account, each month, through the latest month-end.
• Year-end cash on the balance sheet that matches the bank statements to the dollar.
• Transfers between company accounts recorded on both sides.
• Money a founder put in or took out recorded as a loan, equity or reimbursement, not left in an unexplained account.

A trap: an account opened for a single purpose, such as a foreign account or a payment platform balance, that never made it into the books. Include every account the company owns. A company account outside the US may also need an FBAR; see FBAR for company accounts abroad.

Does the ARR in our deck have to match the books?

No law makes annual recurring revenue (ARR) equal to revenue in the books, but investors may build ARR again from contracts and compare it with booked revenue. ARR is a forward-looking measure of contracts in force; revenue in the books is what the company earned in the period. The two should differ only for reasons the company can show.

A bridge from deck ARR to booked revenue usually explains the gap with:

• Contracts signed near period-end that have earned little revenue so far.
• Annual or multi-year plans that started part-way through the period: ARR counts the full yearly value, but revenue counts only the months of service given, and any prepaid balance sits in deferred revenue.
• Customers who churned, downgraded or have not started.

The traps are counting deals that are not yet signed, annualizing month-to-month plans as if they were annual commitments, and mixing one-time fees such as setup or services into recurring revenue. Write down how the company counts ARR and keep a contract-by-contract list that adds up to it. For the deferred revenue schedule behind the bridge, see deferred revenue for SaaS subscriptions.

Which tax returns, IRS transcripts and payroll filings go in the data room?

Put in the filed Form 1120 for each year since formation, the state income and franchise tax returns, the payroll returns, and IRS transcripts that show what the IRS actually has on file. A transcript lets an investor see that a return was filed and processed, not just prepared.

The IRS offers business transcripts at no cost:

Check the transcripts before investors do. A return transcript that says "No record of return filed" may mean the return was never filed or not yet processed; the IRS says to allow 2 to 3 weeks after e-filing and 6 to 8 weeks after paper filing. If a return or payroll filing is missing, see tax clean-up before investor due diligence.

The balance sheet on Form 1120, Schedule L, "should agree with the corporation's books and records". A corporation with total receipts and year-end assets both under $250,000 may skip Schedule L, but the return still has to come from the books. The trap is books changed after the return was filed, for example during a clean-up. If the books now differ from a filed return, explain the change; an amended return may be needed. The clean-up guide covers how to reconcile the two.

Payroll filings usually mean the quarterly Forms 941, the annual Form 940, Forms W-2 and W-3, and each state's withholding and unemployment filings. The IRS compares Forms 941 with W-2 data it receives, so the two should agree with each other and with payroll expense in the books. Redact employees' Social Security numbers before posting W-2s or payroll registers.

Sales tax returns, if any, belong here too. If the review finds the company sold taxable software without collecting tax, see sales tax on SaaS and software.

Should investors get tax transcripts from us or from the IRS directly?

Usually, the company gives copies. The company can download transcripts itself and post them, which keeps control of what leaves the company. Form 8821 lets a named third party, such as an investor's adviser, receive the company's tax information straight from the IRS when the investor insists on an independent copy.

Form 8821 has limits worth reading before anyone signs it:

• It does not let the designee represent the company or speak for it; that takes Form 2848.
• It must list specific tax forms and years. "All years" or "All taxes" gets the form returned.
• When used for a purpose other than resolving a tax matter, the IRS must receive it within 120 days of the signature date.
• Unless line 4 (a specific use not recorded by the IRS) is checked, a new Form 8821 automatically revokes the company's earlier ones on file, unless the company attaches copies of those it wants to keep and checks line 5. That can cut off an accountant who holds an earlier Form 8821.
• For a corporation, an officer with authority to bind it or a person the board designates can sign, among others.

Limit any authorization to the forms and years the review needs.

How do we show the company is in good standing in Delaware and our home state?

Order a certificate of good standing from Delaware and a certificate of status from each state where the company is registered to do business. Each state's record is separate: a company can be current in Delaware and delinquent in the state where it operates.

Delaware requires every corporation formed there to file an annual report and pay franchise tax by March 1 of the following year. Delaware's online status check shows the company's status but is not an official certificate; an investor or lender asking for proof usually wants a certificate ordered from the Division of Corporations, which offers a short form showing current status and a long form listing every filing.

In the home state, a Delaware corporation doing business there is usually registered as a foreign corporation, with its own annual filings and taxes. Some states keep one status with the secretary of state and another with the tax agency, so check both where they exist. If either status has lapsed, see reinstating your company before the data room opens.

Which records back the cap table, SAFEs and option grants?

Every line of the cap table should trace to a signed document and, where money changed hands, to the bank and the books. Investors may check that the number of shares, the price and the date on each document match the cap table.

For options, the price a holder pays to exercise should not be less than the stock's fair market value on the grant date, or the option may be treated as deferred pay under section 409A. An independent appraisal dated no more than 12 months before the grant is one of the methods presumed reasonable. Keep each valuation report with the grants it supports.

A corporation that transfers shares when an employee exercises an incentive stock option must file Form 3921 for each transfer and give the employee a statement. Copies may truncate the employee's tax ID on the statement, but not on the copy filed with the IRS.

If a founder's 83(b) or a Form 3921 is missing, see tax clean-up before investor due diligence. If investors ask the company to confirm its stock is qualified small business stock, see the small business stock exclusion for startups.

How far back should records go, and how long do we keep them?

Investors may ask for records since formation, or for several recent years plus the current year to date; the lead's request list sets the period. The company's own duty to keep records is set by tax law and usually runs longer than any diligence request.

The IRS retention rules count from the filing date (an early return counts as filed on the due date):

Keep the filed returns themselves permanently in practice, along with formation documents, board minutes and every equity record; investors and later buyers may ask for them. Publication 583 also warns that lenders or insurers may require records kept longer than the IRS does.

Example

These examples are illustrative; figures are in US dollars.

A seed round of $3 million

The lead investor asks for 12 months of financial statements, bank statements and the cap table. The company's December 31 balance sheet shows $1,240,000 of cash. The three bank statements add up to $1,240,000 at that date, and every transfer between the accounts appears on both sides. The cap table traces to signed founder stock agreements and two SAFEs whose cash shows on the bank statements.

A Series A with $2,400,000 of ARR in the deck

The books show $1,900,000 of revenue for the last 12 months. The company's contract-by-contract build shows the $500,000 gap: $300,000 of ARR comes from contracts signed in December that have earned only a few weeks of revenue, and the rest from annual plans that started during the year, so only some months of each have been earned. Each contract in the list ties to a signed order and to the deferred revenue schedule.

The transcript shows no Form 1120 for one year

Before opening the data room, the founder downloads the company's account transcripts. One year shows no return filed. The company believed its preparer had filed it. It files the missing return and pays any penalty before the data room opens, and posts a copy of the return with proof of filing, since the transcript can take weeks to show it.

Different for you?

• Missed tax filings turned up in the review: see tax clean-up before investor due diligence.
• The company lost good standing in Delaware or another state: see reinstating your company.
• The books are behind or kept in a spreadsheet: see cleaning up your books before fundraising and get bookkeeping help.
• Investors want monthly statements after the round: see monthly financials for investors and the board.
• Prepaid annual plans make revenue hard to explain: see deferred revenue for SaaS subscriptions.
• Software sales were never taxed: see sales tax on SaaS and software.
• The company is being sold, not funded: see tax clean-up before selling your startup and get corporate tax help.