How to Navigate Due Diligence: A Checklist for Startup Founders Seeking VC
As a founder, one of the most crucial phases in securing funding for your company is the due diligence process. This process allows investors to evaluate the financial, legal, and operational health of your business. To ensure a smooth and successful process, it's essential to be well-prepared and organized. In this blog post, we will discuss how to work with your company counsel to remediate any deficiencies and provide a list of typical documents requested by investors during due diligence.
Understanding Due Diligence
Due diligence is a comprehensive investigation that investors undertake before entering into an agreement with a company. It involves examining various business aspects, including financial records, contracts, intellectual property, regulatory compliance, and management team qualifications. The primary purpose is to identify potential risks and ensure a sound investment.
Typical Legal Documents Requested by Investors
To streamline the process, it's essential to have the following documents readily available:
Corporate Records: Articles of Incorporation, Bylaws, Shareholder Agreements, and Stock Option Plans.
Financial Records: Cap table, audited financial statements, tax returns (including 83(b) elections), budgets, and revenue projections.
Contracts: Customer and vendor agreements, partnership agreements, and leases.
Intellectual Property: Patents, trademarks, copyrights, and trade secret documentation.
Regulatory Compliance: Licenses, permits, and documentation demonstrating compliance with relevant laws and regulations.
Management and Personnel: Organizational chart, employee agreements, Proprietary Information and Inventions Agreements (PIIA).
Litigation and Government Investigation: Information on any current or past litigation, investigation, or disputes involving the company.
In addition to the general legal documents listed above, investors will often request industry-specific documentation to ensure your company meets the unique requirements and standards of its sector. For example, companies in the healthcare sector are often asked to provide evidence of their compliance with the Health Insurance Portability and Accountability Act (HIPAA), including evidence of data privacy protection measures, HIPAA policies and trainings, and business associate agreements. Similarly, SaaS companies should be prepared to present documentation such as IP assignment from employees and independent contractors, termination agreements with key personnel who developed the software, service level agreements, and data security protocols, among others. This information helps investors gain a deeper understanding of your company's market position and potential risks in your specific industry. To sum up, ask yourself what makes your company valuable. Investors will want to see evidence of those valuable assets and how you protect them.
Photo by Maarten van den Heuvel on Unsplash
Working with Your Company Counsel
Involving your company's legal counsel in the due diligence process is crucial to ensure that all legal matters are adequately addressed. Here's how to work with your company counsel to remediate any deficiencies:
1. Conduct an Internal Review
Before the investors begin their due diligence process, it's recommended to perform an internal review with your company counsel. This will help identify any potential weaknesses or red flags that may arise during the investor's review and enable you to address these issues proactively.
2. Organize and Update Documents
Ensure that all essential documents are up to date and well-organized. Your company counsel can assist in reviewing and updating contracts, intellectual property filings, and corporate records to ensure accuracy and completeness.
3. Remediate Legal and Compliance Issues
If your internal review uncovers any legal or compliance issues, work closely with your company counsel to resolve them promptly. This may involve drafting new agreements, amending existing contracts, or developing a plan to address regulatory violations. It would be ideal if you could resolve or mitigate any red flags before opening up the data room to investors. If not, you should work with your counsel to craft a story without drawing unnecessary scrutiny from investor counsels and perhaps a proposal for post-closing fixes.
4. Prepare for Questions and Negotiations
Your company counsel can help anticipate the questions investors may ask during the due diligence process. By preparing detailed responses and supporting documentation, you can expedite the process and build investor confidence in your company. Additionally, your counsel can advise you on negotiation strategies to secure favorable terms in the investment agreement.
Tips for Saving Legal Costs During Investor Due Diligence
Maintaining good corporate hygiene and diligently organizing your company's corporate documents from inception can significantly reduce legal costs during the due diligence process. Are all relevant exhibits attached to executed board resolutions and stockholder consents? Have you filed 83(b) elections on time and retained all IRS receipts? Appointing a dedicated individual or team, either in-house or through outside counsel, to manage and maintain all corporate records on a cloud-based platform can further streamline the process. If you are using an outside law firm, this is a task that an associate or paralegal can perform. When it's time to create a data room for investors, copying and pasting well-organized folders into the virtual data room will save valuable time and resources, allowing you to focus on other aspects of securing investment.
Conclusion
Preparing for investor due diligence is a critical step in securing funding for your company. By understanding the typical documents requested, working closely with your company counsel, and addressing any deficiencies proactively, you can increase your chances of a successful investment outcome. Remember, thorough preparation and organization will go a long way in demonstrating your company's value to potential investors.