Due Diligence Overview
Due diligence is the process venture capital (VC) funds and other investors use to screen and evaluate potential investment opportunities. To mitigate the risks of investing in an early-stage company, investors will perform both business due diligence and legal due diligence to confirm information, assess the strengths and weaknesses of the investment, and identify risks of a company’s business.
During business due diligence, investors will attend one or more presentations by the company to learn about the company’s management, product, market opportunity, and business model. They may also review a company’s financial statements and contact references.
After business due diligence, investor focus shifts to confirming the information a company has provided and assessing potential legal risks to an investment through legal due diligence.
Legal due diligence typically begins after the general terms of an investment have been finalized and when the investor counsel has sent the company a “due diligence request list” (the “DD Request List”).
The length and content of the DD Request List may depend on the thoroughness of investor and its counsel as well as the stage of the company (whether early or late-stage financing). Some DD Request Lists may be a few pages. Others may be over 20 pages long. But overall, most DD Request Lists will request items like:
Corporate records and charter documents
Business plan and financials
Security issuances and previous financing documents
Employee documents and benefits information
Information regarding litigation, investigations or disputes
Investor diligence during a financing tends to be lighter compared to diligence during a company’s acquisition. But founders should still be prepared to provide all relevant documents and information and make themselves available to answer any questions during the diligence phase.
Throughout the process, investors may send over supplemental diligence requests. The parties will also likely create a secure virtual data room for the company to share requested documents.
What Do VCs Look for in Legal Due Diligence?
Although investors may request different documents depending on factors like the company’s industry and stage of growth, VC investors and their counsel generally focus on several key areas in their legal due diligence requests.
Corporate. Investors want to see that all key decisions have been properly documented and approved by the board and, where necessary, the shareholders. Most often, investors will request organizational documents, certificates of good standing, shareholder actions and meeting minutes, and the board of directors’ actions and meeting minutes. Although relatively straight-forward, it is critically important for a company to be organized and prepared for this request.
Equity. Investors will focus on confirming material elements of a company’s capitalization, compliance with federal and local securities laws, and identifying rights of stockholders. In practice, this means that investors will look to see that all equity grants, vesting schedules, and transfer restrictions have been documented properly (and, as necessary, approved by the board or shareholders). Through this process, investors will be on the lookout for deadweight equity and off-market grants. Documents requested could include:
Capitalization table showing current shareholders and optionees
Summary of vesting schedules and options subject to vesting
Stock purchase agreements, option agreements, etc. and their correlated authorizations
Documentation related to qualification or exemption under federal and state securities laws
409A valuations, if any
Intellectual Property. Investors want to know what IP comprises a business, whether the company has full ownership of that IP, and what steps founders have taken to protect it. If a company has patents, trademarks, or copyrights, investors will request documentation. They may also request documentation related to any material licensing agreements—such as open source licenses for proprietary code. For the most part, investors will want to see that material licensing arrangements are non-exclusive and properly documented.
It’s important to note that most often, investors don’t expect patents—especially for software, which can be very difficult to obtain. They will, however, expect a company to have entered into proprietary information and invention assignment (PIIA) agreements with its employees and work-for-hire agreements with its independent contractors and will request copies of these agreements.
Financial. Investors will want to confirm how much debt a company is carrying and any restrictive terms of prior loans. Namely, prior loan terms can’t be overbearing on the company or impact its ability to grow. Investors could, for instance, look to confirm that money raised under SAFEs, bridge note rounds, or debt-financing agreements prior to institutional investment came with market discounts and caps. Investors will likely also request a company’s most recent audited financial statements, if available, and unaudited monthly financial statements. Of course, legal due diligence should not uncover any major undisclosed debts, liabilities, or obligations.
Employment. If a company has any employees, investors will want to make sure their human resources house is in order. To ensure everything is organized and properly documented, investors may request:
Agreements with any employees, officers, directors, or affiliates including employment agreements, indemnification agreements, loans or guarantees
Employee benefit and profit-sharing plans, including stock option, stock purchase, deferred compensation, bonus plans, etc.
Records of accrued and outstanding salary, PTO, reimbursable expenses
Generally, VC investors will look to see that everyone is an at-will employee. And, unless there is an outstanding reason, they will disfavor large severance packages for any employees.
Legal Proceedings. Understandably, investors will look for any red flags on the horizon or any past legal disputes that could limit the company’s ability to grow. A standard due diligence list will include requests for documents and correspondence related to any pending or threatened litigation (or any disputes that could arise in litigation in the future), as well as any existing consent decrees, injunctions, judgments, orders, or settlement agreements against the company.
Material Agreements. Investors’ counsel will request and review any material agreements a company has entered into to make sure there are no provisions that would hinder the company’s ability to scale. These could include non-competition and non-solicitation agreements or clauses, as well as most favored nation clauses in customer agreements. Generally, companies should expect to the following material agreements for review:
Real property or capital leases
Joint venture or partnership agreements
Management, service, and marketing agreements
Confidentiality agreements and nondisclosure agreements (NDAs)
Agreements or letters of intent or term sheets related to acquisitions
Agreements restricting competition
As companies prepare to tackle the legal due diligence process, they need to be aware of any issues in these agreements that VC investors would consider red flags, including missing signatures, incomplete information, or contradictory information from discussions or the term sheet.
Compliance. Depending on a company’s industry a company is in, investors will want to confirm the company complies with necessary local and federal regulations. These could include environmental regulations, Food and Drug Administration (FDA) regulations, or federal laws like the Health Information Portability and Accountability Act (HIPAA) for those in the health sector. And for any company collecting consumer data, investors will want to ensure data privacy practices and compliance with regulations such as the CCPA or GDPR, so companies can expect to submit their privacy policies.
Bad Press and Publicity. Increasingly, investors are looking closely at a company’s—and its managers’—reputation as part of their investment assessments. If an investor learns of bad practices related to, for instance, racism, sexual harassment, or environmental issues during legal due diligence, it could be grounds for non-investment or, in some cases, a lawsuit to recoup an investment. If any of these issues exist, it’s better to be upfront about them during early stages of due diligence.
Advice for Companies.
As companies prepare to tackle the legal due diligence process, they need to be aware of—and ready to address—any issues VC investors could see as a red flag.
Stay Organized. To identify potential deal-killers early, companies should organize their documents in secure cloud sites in folders that roughly correspond to the categories described in this article, either independently or with the help of their lawyers. This type of early organization will allow a company’s management to focus on running the business when due diligence requests come through, rather than cleaning house.
Be Responsive. When legal due diligence begins, companies should respond to due diligence requests and follow-up questions in a timely manner. More specifically, management should have a plan to respond to any known issues. It may be helpful to preemptively name one person on the company’s management team to serve as the company’s point person for investor and counsel requests during the legal due diligence process.
Organization and responsiveness will inspire confidence in investors as they review a company’s legal documents, which will generally reduce the likelihood investors will try to re-negotiate deal terms or walk away. More broadly, it helps with setting a positive long-term relationship between a company and its investors.
DISCLAIMER: The subject matter discussed above is constantly evolving and may change on a frequent basis. The information contained in this post is for general education and informational purposes only. It should not be construed as legal advice or as creating an attorney-client relationship between the reader and TKN Law.