Investor due diligence has one simple objective: to reduce the risk of the venture capital (VC) investor losing their money.
In the early stages of a budding relationship between a VC and a founder, due diligence is an informal “get to know you” process. Startups are vetted on the basis of qualities such as the size of the market, the strength of the founding team and evidence of early wins in the form of traction.
Potential investors will also gather information to later verify before the deal is done. This information forms the basis of a term sheet and usually includes information such as the valuation, types of shares and liquidation rights. The term sheet is essentially an agreement to invest, subject to conditions that will come under a microscope in a more formal legal due diligence stage.
The focus of legal due diligence varies by investor and by startup, however, by and large, it is designed to reduce the risk of the investment and provide a degree of comfort that the startup to able to make good on the promises made in the pitch.
Legal due diligence also allows the investor to challenge the assumptions that they may have made in the early stages. In the same way that a homebuyer might assume that real estate agent particulars are accurate, it must also go through a process of using a conveyancer to validate the details.
For founders to stack the odds in their favour as much as possible, there are a number of questions they should anticipate and be able to answer before entering into any discussions with investors.
Is the business able to operate in the regulatory environment?
Sectors such as banking, investment, real estate and healthcare have greater levels of regulation impacting a new business entering the sector.
And B2C businesses where large sums of money are invested or those in the healthcare sector have greater regulation to reflect the higher stakes involved.
Investors will be seeking to understand the regulation that exists and whether the startup has been able to negotiate the requirements.
Who owns the intellectual property?
For many startups, particularly in the technology sector, intellectual property is their key asset.
A founder will need to demonstrate their legal strength on different forms of IP rights including patents relating to their invention, method or process, copyrights the business holds, design protection, any registered trademarks they may hold as well as any trade secrets that are fundamental to the performance of the business.
Trade secrets are recipes or formulas such as KFC’s 11 secret herps and spices, or Coca Cola’s tightly guarded recipe.
Investors are looking for reassurance that IP rights are vested with the company.
This takes the form of an agreement called an IP assignment which prevents founders, employees or contractors using the same IP to set up a new business.
A warning bell may sound if a bad leaver has no agreement to prevent them from using the same IP to set up a competing business.
What are the terms of service for customers?
Terms of service are contracts of sale such as subscriptions that allow an investor to see how easily customers and revenue can be retained.
Investors will be seeking to understand whether terms of service exist and whether they are reasonable and likely to result in long-term, satisfied and happy customers.
What are the obligations of the startup?
This includes financial agreements such as debts, leases and loans, as well as contracts with third parties upon which the business relies, and distribution agreements. The latter will alert an investor to any exclusive agreements that might hamper expansion plans or alternatively may result in a substantial loss of customers if the distribution agreement is cancelled. The potential investor will also seek knowledge and reassurance around any pending and potential litigation the founder is aware of.
Is the business open for new investment?
For a VC investor to get onboard the startup will need to be incorporated, with a constitution that supports the issuance of new shares and a current shareholder register in place. These legal requirements must support new equity holders entering the business.
For the most part, if investors make it to the legal due diligence stage, they are serious about the investment and the success is in the hands of the founder. The more thorough the due diligence process and the more forthcoming founders are with information, the easier it will be to secure the investment.
- Benjamin Chong is a partner at venture capital firm Right Click Capital, investors in bold and visionary tech founders.