(Almost) Everything you need to know about the Due Diligence Process

In the venture capital world, investors’ attention is constantly focused on entrepreneurs with fresh ideas and innovative technology. However, no matter how good the idea is and impressive the team may be, before any agreements are signed and champagne bottles opened, the entrepreneurs and the venture must successfully pass the due diligence process. Despite the importance of this step, only few entrepreneurs properly prepare for this step in advance.

This article presents the different aspects of the due diligence process, and explains why it is such an important step for a startup on the way to getting an investment.

What is a Due Diligence process?

Due diligence is a process initiated by an investor, whether private like angel investors or bigger organizations like VC funds, to investigate and evaluate the startup he plans to invest in (the “Target”). The process is intended to evaluate both the business and legal aspects, in trying to analyze the feasibility of the transaction. Therefore, the process is usually done by a lawyer and/or an accountant. The result of the due diligence is a prospectus of the company, which is a document that discloses to the investor extensive information about the venture, allowing him to make an informative decision, whether to invest in the company or to part ways with it. The due diligence is therefore obviously done before the investor transfers any funds.

What does the due diligence process include?

The process changes according to the lawyer or investor performing it, however, certain key elements are likely to be carried out in every due diligence. The issues covered include the following (some may not be relevant depending on the status of the venture):

  • The company’s legal documents, such as its incorporation documents, board of directors’ resolutions, stock/shares ledger (assuming the venture has incorporated as a company), shareholder agreements and general shareholder information.
  • Its business plan, income (if any), expenses (a good way to see how the Target has managed its funds).
  • Contracts between the company/venture and third parties, contracts between the founders and third parties prior to incorporation and its employee options plan.
  • Information on the venture’s Intellectual Property (“IP”) such as patents, provisional patent applications, copyrights and registered trademarks.
  • Legal information such as past disputes and ongoing or potential law suits.
  • Any other points of risk: for example, was there any disgruntled worker or founder who left the venture without signing a waiver? Did any of the founders work on the venture whilst working for another company ( potential IP issues )? Any unsigned documents? Any local or international laws that have or may be broken? Business risks – for example, the venture may require a unique material that is only supplied by one supplier who can then influence the business dramatically.

In general, the investors’ due diligence team looks for any document or information that holds business or legal information regarding the Target that may influence its value. The above is just a partial list, which goes to show the extensiveness and thoroughness of the process.

Why is Due Diligence Process Crucial for Receiving an Investment?

For the venture, if it does not pass the process, it will have lost both time and money, and when I say money I don’t only mean theיעל2 potential investment amount, but also the amounts spent on providing all the information that the investor wants – whether it’s for an accountant, a lawyer or other related costs. But that’s not it, because if the process is done by a well-known VC, and if the reason is a significant one, then there is a chance that word will get out and then other VC’s may not invest.

For the VC – it is a loss of money and time. Additionally, if they get a reputation of doing long and tedious due diligence processes, then this can also deter other ventures from contacting them – although this largely depends on supply and demand in the market at the time.

How Do I Pass the Due Diligence Process?

To increase their chances, the entrepreneurs behind the venture have to ‘play it right’ from day one. This is easier said than done because it’s difficult for most people to plan so far ahead especially when you’re not exactly sure what you’re planning for. Nevertheless, here are some basic tips to help you plan ahead:

1. Read-up: unlike 20 years ago, today we really do have all the information at our finger tips. Read everything you can about the business and legal aspects of a startup. Just by doing so, you will avoid most of the potholes along the way. Remember: don’t let what you read scare or deter you.

2. Consult with a lawyer from day one: yes, we know, lawyers are expensive and who has money for a lawyer at such an early stage. That said, most hi-tech lawyers will be willing to give you a free consultation or at least a reduced price, and in just one short session, the lawyer should be able to give you a map of the landmines that lay ahead – by just knowing what to expect you’ll be able to avoid a lot of them.

3. Due Diligence today, not tomorrow: whenever you’re about to make a business or legal decision, try to imagine that it will be recorded and reviewed during the due diligence process and ask yourself whether you, as an investor, would look at that action favorably. Does it add risk/value or reduce it?

4. Be organized: keep all your paper work and documentation in order. That said, some things between the founders regarding day to day work should be said verbally and not by email – just imagine that someone might be reading all your ‘work emails’ – so if you ever wrote something like: ” just take the code from ___’s website…‘ you’re probably going to have some explaining to do.

5. Be truthful: be truthful with what you disclose. This does not mean you need to be mother Teresa and describe every irrelevant detail, but you are required under good faith to disclose any material and/or relevant information to the transaction – if not, not only do you run the risk of creating a bad relationship with the investor, but you also might be sued.

6. Don’t ‘just do it’: if you’re looking at a potential big investment, take a lawyer. Don’t try to ‘just do it’ yourself, because in all likelihood you will make a mistake.

7. Breath: you’re neither the first nor the last to get on this roller-coaster. If you’ve done the above, all should be ok.

The due diligence process begins when you give your pitch to the potential investors. So plan ahead and go over any negative aspects that may be asked about by the investor. Hope for the best, but prepare yourself for the worst – if you do so, you won’t be taken byyosi3 surprise and you’ll be able to respond with reassuring answers, for example: “we are aware of this point and are taking the following actions to solve the matter…“.

Food for thought

The due diligence process can be a daunting experience – but it doesn’t have to be. Plan in advance, follow some of the basic steps mentioned above and all should be ok. Remember, the investor is also taking a risk, and although they might have deeper pockets, they too have a right to protect their investments. All startups have legal or business issues – the only difference is how and when they deal with them. Show that you’re aware of what’s going on and have a plan in motion and you’ll have the investors’ confidence. Lastly, it’s worth mentioning that even if you have a legal risk that cannot be solved, it doesn’t always mean that the deal won’t go through – it might just mean that the investment amount will be a bit less in order to factor in the risk that the investors are taking. 

The information presented is not legal advice, is not to be acted on as such, may not be current and is subject to change without notice.

About the Author:

Yossi Morel
Law & Business student at the IDC Herzlyia. In his free time he enjoys playing tennis, swimming or participating at any other sport activity offered to him!