If you are planning to raise capital or sell shares in your startup, you should be prepared for due diligence. Due diligence is the process of investigating a business to understand its assets, liabilities and potential. Investors who are thinking about investing in your startup will want to know everything about your company before they make any payment.
In this article, we explain how you can prepare for due diligence, and what happens during the process.
Why is Due Diligence Important?
The due diligence process is important for both you and your potential investors.
For you, being organised throughout the process will demonstrate to your investors your deep knowledge of the business and its executive capabilities. It is in your best interests to cooperate with a potential investor and provide them with as much information as you can to help them come to an decision.
For your investor, due diligence gives them a greater understanding of your business, particularly:
- whether the valuation of your business is justified;
- how your business operates;
- the potential of the business going forward; and
- what risks are involved in the transaction and in your business generally.
As a founder, you should disclose any risks and liabilities associated with the business, whether they be commercial, legal, tax or otherwise. This is so the investor cannot make any claims against you in the future. This is particularly important if the investor is taking on a large stake in your startup.
How Can You Prepare?
The earlier you prepare for the due diligence process, the less pressure and stress you and your business will face. In particular, there are three main topics in which you should be across.
1. Business Structure
Structuring your business to be attractive to investors is important. For many investors, this means they will want you to have:
Dual Company Structure
In a dual company structure, a holding company owns your intellectual property (IP), cash and major assets. The holding company will wholly own another company called the operating company. It is the operating company that will enter into contracts with clients and suppliers, and employ staff. This setup is attractive to investors because it means the startup’s valuable assets are protected.
Founder Share Vesting
If your startup is raising capital, many investors will want to see that your shares (including the founder’s shares) are subject to a vesting period. This is important to investors because they want confirmation that the people key to the startup’s success are unlikely to leave.
2. Intellectual Property
Investors or purchasers will want confirmation that your startup:
- owns its IP;
- owns its trade marks or has the right licences to use them; and
- has registered its IP where necessary.
Investors or purchasers will also want to check that:
- appropriate contracts are in place with suppliers and clients; and
- the terms and conditions of these contracts are appropriate.
Make sure you review these documents before the due diligence process begins.
Due Diligence in Practice
In a capital raise, due diligence will begin after you have made your pitch to investors, around the time of signing a term sheet. The process may continue until formal investment documents are signed.
Similarly, in an exit event, due diligence will start around the time that a term sheet is signed, and can continue until the form share sale documents are executed.
The investor will generally provide you with a list of their requirements. You will then need to put together the relevant documents and evidence to satisfy these requirements. These may include:
- financial records;
- company records;
- employment and superannuation liabilities;
- customer lists;
- litigation and impending legal issues;
- IP and other asset lists; and
- any costs and commitments your startup faces.
In the past, due diligence was usually conducted in a physical data room. Investors would go through all the information provided by you, with your lawyer being present at all times.
Nowadays, this process generally occurs electronically. This allows the parties to access the documents simultaneously. The investor’s lawyers will then review all the documents and prepare a report for their client about whether there are any risk items.
Finally, the investor will decide whether to proceed with the deal. Sometimes an investor will agree to proceed as long as certain conditions (based on their due diligence findings) are met.
For example, an investor may discover during due diligence that you as a founder had not assigned your startup’s IP to the company. They may request that you enter into an Intellectual Property Assignment Deed with your company as a condition precedent to the deal.
Due diligence is a key part of raising capital or trying to sell shares in your startup. It will often play a significant role in an investor’s decision, so it is important you are well prepared for the process. You can ensure this by structuring your business with investors in mind, ensuring you have access to any business-related documents, and paying attention to detail when entering into contracts or keeping company records.
If you would like assistance with preparing your startup for due diligence, call LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.
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