How Founders Can Manage Costs During Due Diligence

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Table of Contents

• Due Diligence Process
• Due Diligence Costs Under the AVCAL Term Sheet
• Recommendations
• Due Diligence With Angel Investors

We continue our analysis of the “Open Source Seed Financing Documents” released by the Australian Private Equity and Venture Capital Association Limited (AVCAL). Below, we turn our attention to the due diligence process and the incurred costs under the AVCAL term sheet and set out recommendations to enhance your outcomes.

Due Diligence Process

Naturally, potential investors will want to investigate a founder’s company in the pre-investment period and in doing so, may incur fees from professional advisors. It’s important to put some restraints on an investor’s rights during the diligence process. In doing so, you will minimise the total costs, your liability for their costs and ensure the investor ultimately fulfils any investment commitments you obtain.

Due Diligence Costs Under the AVCAL Term Sheet

The AVCAL Term Sheet promotes the interests of investors. Under the AVCAL Term Sheet:

• Clause 16 sets out that the company will pay for investors’ expenses related to the preparation of legal documents for the investment deal up to a specified cap that the parties are to negotiate; and
• Clause 10 sets out that between the execution of the Term Sheet and other transaction documents, the investors may withdraw from the deal, without cost, depending on their due diligence during the interim.

Recommendations

A founder may consider the following recommendations to enhance their outcome during the due diligence process:

• When negotiating the fee cap with a venture capital firm investor, you can flag that as the parties are familiar with the document suite and deal type, it isn’t necessary to engage a top-tier lawyer in preparing the documents;
• Manage due diligence costs on the founders’ side by hiring firms who specialise in startup law and use plain English drafting styles to reduce the time needed from non-lawyers (i.e. developers) to understand the documents;
• Adding mutual non-compete obligations that apply to the investor during and after the agreement to prevent the investor from poaching people and interfering with relationships during the due diligence process; and
• Negotiate a reasonable fee cap (rather than an hourly rate). Otherwise, increasing legal costs may serve as a disincentive to negotiate the transaction documents as robustly as a founder otherwise would.

Due Diligence With Angel Investors

As a side point, if the interested investor is an angel investor as opposed to a venture capital firm, standard commercial practice is that the investor will bear their due diligence costs. In such cases, the founders should not bear any of the investor’s costs incurred during the due diligence phase. If an angel investor makes extensive due diligence requests before making any form of investment commitment, a founder may want to protect their time and money, and also not disclose sensitive financial information.

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If you need assistance with the due diligence process in your angel or venture capital funding rounds, get in touch with our startup lawyers on 1300 544 755.