Fundraising is a crucial milestone for any startup or growing enterprise, but it is also one of the most scrutinized phases in a company’s lifecycle. Before investors decide to inject capital into a business, they perform a thorough background check, known as due diligence, to verify the accuracy of financial, legal, and operational information. To stand up to this scrutiny, companies must maintain financial hygiene a term that encompasses meticulous financial practices, regulatory compliance, and transparent record-keeping. This article delves into the importance of financial hygiene before fundraising, with a strong focus on the legal and regulatory aspects that shape due diligence in India.

In this article, CA Manish Mishra talks about Due Diligence Ready: Financial Hygiene Before Fundraising.

Financial Hygiene in the Context of Fundraising

Financial hygiene refers to the set of best practices and protocols businesses should follow to ensure that their financial statements are accurate, tax records are up to date, regulatory filings are timely, and contracts are valid and legally enforceable. For startups and SMEs looking to raise funds be it seed capital, Series A or beyond presenting a clean, well-audited, and compliant financial structure can significantly increase investor confidence and accelerate the fundraising process.

Legal Framework Governing Financial Hygiene and Due Diligence

In India, the legal ecosystem that governs financial disclosures and investor due diligence includes several laws and statutory bodies such as the Companies Act, 2013, Income Tax Act, 1961, Goods and Services Tax (GST) laws, Securities and Exchange Board of India (SEBI) regulations, and the Foreign Exchange Management Act (FEMA), among others.

Companies Act, 2013

Under this Act, companies are required to maintain proper books of account under Section 128, ensure statutory audit of financials under Section 139, and file annual returns via MGT-7 and financial statements via AOC-4. Directors' disclosures under Section 184, related party transactions under Section 188, and the register of significant beneficial owners under Section 90 are also closely examined during due diligence.

Income Tax Act, 1961

Proper filing of income tax returns, Form 3CA/3CB and 3CD for tax audit, TDS compliance under Section 194 series, and transfer pricing documentation under Section 92E (for international or specified domestic transactions) are essential. Any tax disputes or pending assessments under scrutiny by the Income Tax Department can significantly impact investor sentiment.

Goods and Services Tax (GST)

GST compliance includes timely filing of GSTR-1, GSTR-3B, GSTR-9, and GST reconciliation statements (GSTR-9C). Mismatches between Input Tax Credit (ITC) claimed and GSTR-2A/2B filings can indicate poor financial hygiene and risk potential disallowance of credits.

FEMA and RBI Compliance

If the company has received foreign investments, compliance under FEMA becomes critical. This includes filing of Form FC-GPR (allotment of shares), Form FLA (foreign liabilities and assets), and reporting any transfer of shares through Form FC-TRS. Non-compliance can attract penalties under Section 13 of FEMA, which includes confiscation of assets and fines.

SEBI Regulations (for Listed and Some Unlisted Entities)

For startups planning an IPO or already listed, SEBI mandates include quarterly financial disclosures, insider trading compliance under SEBI (Prohibition of Insider Trading) Regulations, 2015, and related party disclosures under SEBI (LODR) Regulations, 2015.

Key Financial Hygiene Checklist Before Fundraising

A due diligence-ready company must have the following key aspects in order:

Clean and Audited Financials

Financial statements should be audited by a Chartered Accountant, preferably for at least the last three financial years. There should be consistency in revenue recognition, expense booking, and depreciation policies in accordance with Ind AS or Accounting Standards prescribed under Section 133 of the Companies Act, 2013.

Cap Table Clarity

The capitalization table (cap table) should clearly show current shareholders, including founders, ESOPs, and past investors. Ensure that all Shareholders' Agreements (SHA) and Subscription Agreements are documented and signed.

Tax and Regulatory Filings

Ensure that all taxes Income Tax, TDS, GST, and Professional Tax are paid and filings are up to date. Any delays or discrepancies should be voluntarily disclosed and resolved to avoid legal notices or inquiries.

Valid Licenses and Registrations

Make sure that the company has valid PAN, TAN, GST registration, Startup India DPIIT certificate (if applicable), FSSAI license (for food businesses), and Import Export Code (IEC) for trade-based companies. Licenses should be renewed before their expiry to avoid regulatory hurdles.

Contracts and Legal Agreements

Review all contracts with vendors, employees, and clients. Employment contracts should clearly mention IP ownership, non-compete, and confidentiality clauses. All major vendor or customer contracts should be stamped and enforceable under the Indian Stamp Act, 1899.

ESOP Policy and Documentation

If the company has issued ESOPs (Employee Stock Option Plans), the Board and Shareholder approvals under Section 62(1)(b) of the Companies Act must be in place along with proper valuation reports under Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.

Recent Legal Updates Impacting Due Diligence and Fundraising

In recent years, several legal developments have impacted how startups prepare for fundraising:

• MCA V3 Portal Enhancements (2023–2025): The Ministry of Corporate Affairs has introduced stricter checks, auto-validation of filings, and digital scrutiny tools under the V3 portal. Companies must be extra cautious while filing AOC-4, MGT-7, and SH-7 forms to avoid rejections or discrepancies.

• Income Tax Department’s AI-based Assessment Notices: Under the Faceless Assessment Scheme and introduction of AI/ML-based scrutiny, any anomalies in ITR, TDS returns, or Form 26AS could trigger automated notices impacting your fundraising timelines.

• Startup India and DPIIT Recognition Push: DPIIT now mandates startups to furnish updated Startup India certificates, Form 80-IAC tax exemption documents, and incorporation documents for availing tax benefits and pitching to government-backed venture capitalists.

• Data Privacy and DPDP Act, 2023: Companies dealing with personal data must now comply with India’s Digital Personal Data Protection (DPDP) Act, 2023. Non-compliance may result in litigation or investor pullout, especially from overseas funds concerned about data misuse.

How Founders Can Stay Prepared

Founders must treat fundraising as a legal and financial audit exercise. It is advisable to engage a Virtual CFO, legal counsel, and statutory auditor months before the fundraising round to identify and plug any gaps in financial hygiene. Tools such as Virtual Data Rooms (VDRs), proper folder structuring of legal documents, and cloud-based accounting systems such as Tally, Zoho, or QuickBooks can streamline the due diligence process.

Conclusion

Being “due diligence ready” is not just about compliance but about building trust with potential investors. A clean financial slate backed by statutory compliance and transparent reporting signals credibility, minimizes delays in fundraising, and helps in securing better valuations. As regulatory oversight tightens and investor expectations evolve, businesses that prioritize financial hygiene are better positioned to thrive in competitive capital markets. Ensuring that every financial record is legally backed, up to date, and verifiable is no longer optional it’s essential.

Frequently Asked Questions (FAQs)

Q1. What is financial hygiene in the context of fundraising?

Ans. Financial hygiene refers to maintaining clean, accurate, and up-to-date financial records, tax filings, regulatory compliance, and legal documentation to ensure transparency and readiness during investor due diligence.

Q2. Why is due diligence important before fundraising?

Ans. Due diligence allows investors to verify a company’s financial, legal, and operational health. A due diligence-ready company builds trust, accelerates investment decisions, and can command better valuations.

Q3. What are the key legal documents needed during due diligence?

Ans. Common documents include audited financial statements, income tax returns, GST filings, cap table, shareholders' agreements, board resolutions, MCA filings (AOC-4, MGT-7), and compliance certificates under Companies Act, FEMA, and SEBI.

Q4. How does the Companies Act, 2013 relate to due diligence?

Ans. The Companies Act mandates proper maintenance of books (Section 128), statutory audit (Section 139), disclosures of related party transactions (Section 188), and filing of annual returns and financial statements all of which are scrutinized during due diligence.

Q5. What are common red flags that can delay or derail fundraising?

Ans. Red flags include non-filing of returns, inaccurate financial statements, unresolved tax notices, legal disputes, unclear shareholding patterns, non-compliance with FEMA or GST laws, and lack of proper agreements with vendors or employees.