Due diligence is a fact gathering process by which a buyer or investor obtains information about the business they are seeking to buy or in which they are seeking to invest, both from a business and legal perspective. Due diligence is a critical phase of any financing or merger/acquisition, but it can be a confusing and burdensome process, especially for companies going through their first transaction. This article summarizes the basic aspects of a company’s role in the due diligence process of an investment from a venture capital fund (a “VC”), in an effort to help companies be more prepared.
An investor uses legal due diligence to confirm assumptions they may have made about their investment during business due diligence. They are looking to confirm that the assumptions and assertions made about the company are true and that they are paying a fair value. This analysis involves making sure there are no significant unknown issues and that the company has good growth prospects. If they uncover problems, they may ask that those problems be fixed prior to their investment.
I. The first step in the legal due diligence process is a request by the VC asking for certain categories of documents and other related information. Here is a sample due diligence request list that we often use for this purpose.
A. What are VC’s looking for from a business perspective? VCs will generally want to confirm your company’s current and projected financial health, organization, market size, management team quality, growth abilities and the competitive landscape of your market. Some examples of documents they will look to in evaluating your company from a business perspective are:
- organizational charts;
- financial projections;
- business and marketing plans;
- management reports;
- stockholder communications;
- customer and supplier agreements or other information on your relationship with customers/supplier;
- credit agreements and loan/debt obligations;
- a capitalization table; and
- partnership or joint venture agreements.
B. What are VC’s looking for from a legal perspective? VCs will generally want to know that the views taken from the business perspective are supported. This includes knowing the structure of your company, what obligations your company has, your employee headcount and cost, your staff needs to accomplish your business goals (i.e., how many more engineers will you need and when), and any liabilities your company may have such as pending lawsuits. Some examples of documents they will look to are:
- board of director meeting agendas and minutes;
- ownership information and agreements;
- financing agreements;
- real estate leases;
- stock option plans (including vesting schedule and acceleration on change of control terms);
- equity participation and incentive compensation;
- confidentiality and invention and proprietary information agreements;
- a capitalization table;
- articles of incorporation;
- shareholder arrangements;
- IP related agreements;
- government authorizations and agreements; and
- any other material agreements.
C. Red Flags. When reviewing what you have produced in response to a VC’s request, substantial missing or incomplete information, missing signatures on contracts, items that show any inconsistencies with previous discussions or the term sheet, any major undisclosed debts, liabilities, obligations or other impediments may raise concerns with an investor and could require pre-closing correction and/or purchase price reductions.
II. Tips in responding to due diligence requests?
- Know your documents and be organized – have an understanding of where your documents are and any major issues with those documents.
- Know who the right people are to disclose the required information – have a team in place made up of those people who know each category best to ensure that the right information is put together accurately and timely.
- Seek clarification and communicate with the investor – discuss any difficult to disclose items along the way and resolve how to address them before you respond.
- Work with attorneys to manage/complete process – hire a good attorney with experience managing due diligence and securities offerings to lead you through it and communicate with the VC.
III. The next step in the due diligence process is that the VC and their lawyers review items turned over in the request. The VC will follow up on business any issues. This follow up will generally be in a discussion or question and answer format. For example: they may ask something like “can you really get a revenue generating product released in your estimated 18 month time frame?” The VC’s lawyer will follow up on legal issues. This may include, for example, asking for documents supporting or verifying data such as board minutes and stock option paperwork reflecting the outstanding stock options shown on the company’s capitalization table.
IV. Assuming the VC still wants to proceed, you’ll next be asked to clean up any problem areas (i.e., missing board minutes or signatures on contracts). There may be some issues that can not easily be cleaned up. These issues may be addressed by agreeing on changes to the transaction documents, such as adjustment to price, number of shares purchased, or investor rights and responsibilities. Once all of the problem areas are handled to VC’s satisfaction, you will have completed the due diligence process and the transaction will proceed to signing.
Here is some advice from others in the industry.
From the other direction, here is an interesting perspective on doing due diligence on your potential VC investor.
Here is our post regarding due diligence in the context of an M&A transaction.