Early-stage venture-style due diligence – a primer
By Ingy Darwish, Senior Associate and Laura Sperling, Associate
For investors participating in early-stage venture financings, due diligence has taken on a more prominent and fulsome role over the last 12–18 months.
Sophisticated VCs will always undertake some form of due diligence (DD) as part of their participation in priced equity venture financings. In years past, the focus on due diligence in smaller convertible rounds was largely determined by the risk appetite and volume of transactions undertaken by a VC. However, with start-ups choosing to undertake extension or bridge rounds over the past year, the use of convertible instruments for these interim rounds has increased substantially. And yet in almost every case, we have seen investors delve deeper and more seriously into due diligence on such companies.
What’s different?
The fundamental principle behind venture DD hasn’t changed. VC deal teams will be looking for any issues that may materially threaten the ‘value’ of the company by, for example, impeding the company’s ability to operate or the value of its assets. Typically, this would include an assessment of the company’s corporate structure, regulatory environment, assets and the right to exploit them (primarily meaning intellectual property) as well as identifying any discrepancies against what the company has reported to its prospective investors. Ownership dynamics, the cap table and shareholder rights (both economic and governance rights) are also considered in legal due diligence.
While the documents that need to be reviewed will vary depending on the company’s business, the following are considered the key areas of focus for a legal deal team.
Constitutional documents and corporate governance
to ensure due and proper incorporation of the company and compliance with required corporate approvals for historic investments.
Historic funding documents
to identify the rights of existing shareholders and the terms agreed in any prior investment rounds to ensure compliance with the same.
Founder share ownership rights and obligations
to assess (i) any vesting rights over founders’ shares, and (ii) any restrictive covenants on the founders to ensure the company is adequately protected.
Cap table
to understand the fully diluted share capital of the company, including any outstanding options, convertible instruments or other rights to acquire shares, and the impact this may have on ownership dynamics prior to and after closing of the investment round.
Intellectual property matters and assignment agreements
to determine whether appropriate patents, trademarks and other intellectual property rights along with non-registrable IP have been appropriately protected. Intellectual property assignment agreements are reviewed or put in place to confirm that intellectual property rights developed by employees, the founders or any third-party consultants have been transferred to the company.
Regulatory and licensing matters
to ensure the business is appropriately licensed to undertake its desired business activities, and if not, what the requirements and challenges may be to be able to secure the necessary licences and consents from regulators.
...with start-ups choosing to undertake extension or bridge rounds over the past year, the use of convertible instruments for these interim rounds has increased substantially. And yet in almost every case, we have seen investors delve deeper and more seriously into due diligence...
What’s the best practice for founders?
Due diligence is unavoidable in the fundraising process and there are some common pitfalls founders should avoid to make the process as easy as possible for prospective investors.
Try to provide structured information
Whether or not your investor sends you a due diligence questionnaire or information request, it is always worth investing the time in completing such a document with fulsome information and as much narrative explanation as possible. If done well, someone who knows nothing about your company can be sufficiently informed on the key diligence questions and can use your data room to verify what they have read in the document you prepared.
If you go the extra mile and provide a column with cross-referred links to the data room documents that are relevant to the answers you have provided, your investor will thank you and, in our view, this approach will substantially increase your chances of closing the deal with your investor in a timely fashion. Any founder who wants to see what a good early-stage VC-style DD questionnaire should contain is welcome to reach out to us and get a free copy of our Taylor Wessing template.
Avoid inaccuracies where possible
It’s always advisable to treat your investors as your partners and your biggest supporters. Good investors could have a profound effect on the business and its growth. Managing the relationship with investors is a crucial part of the start-up cycle and relies on transparency, honesty, and a shared vision.
Therefore, it is very important to avoid sharing inaccurate or exaggerated information with the investors as this could lead to investors pulling out of deals. Although generally this isn’t intentional, it’s important that founders are clear, precise and honest about company details as discrepancies will undoubtedly be brought to light through the due diligence process. Founders should do their best to address any investor doubts up front.
Involve your investors in the issues
While this may seem obvious, no start-up is free from legal issues, particularly during its early stages. A transparent discussion between founders and their investors is the best approach to disclose and resolve any issues. Furthermore, investors may well have rights to claim compensation against a start-up or its founder for concealment or a failure to disclose information, which might not exist had the information been appropriately disclosed at the outset.
Building a strong relationship with investors could lead to increased credibility and reputation, enhanced network and business opportunities, strategic guidance and mentorship and the ability to weather economic downturns. Founders should always avoid exaggerating any element of their business including product development, the company’s customer base, or financials.
Be prepared
Founders that already understand the due diligence process from an entrepreneur’s point of view are at a great advantage. To facilitate a smooth process, before seeking funding founders should ensure they have a virtual data room set up with folders corresponding to the different categories of due diligence requests and with all the key documents uploaded so that investors can review them easily.
