Legal Due Diligence For Venture Capital Investments

 

There are few buzz-words in venture capital more prevalent than “due diligence”.  Due diligence in venture capital is best described as the dating phase of a relationship where a venture capital firm decides if it wants to make a commitment to a prospective investment, and the current shareholders & management team of the company also decide if they are interested in the venture capital firm as an investor.

The venture capital industry uses due diligence to describe what the investor does to evaluate a potential investment opportunity.  By definition, investing in early-stage companies is risky. The due diligence process should select the potential winners, identify the critical risks associated with the investments and develop a risk mitigation plan with company management as part of a potential investment. Defining more comprehensively, due diligence is a rigorous process that determines whether or not the venture capital or other investors will invest in your company. It can also be described as a fact-gathering process by which a buyer or investor obtains information about the business they are seeking to buy or in which they are trying to invest, both from a business and legal perspective.

Due diligence is a critical phase of any financing or merger/acquisition, but it can be a confusing and burdensome process, especially for companies going through their first transaction. The process involves asking and answering a series of questions to evaluate the business and legal aspects of the opportunity. Once the process is complete, the investor will use the outcomes of the process to finalize the internal approval process and complete the investment. If the VC acts as a lead investor in a syndicate, then they may also share the outcome of their due diligence with other investors. There are three stages of due diligence:

  • Screening due diligence
  • Business due diligence
  • Legal due diligence.

The primary focus of this article is legal due diligence. An investor uses legal due diligence to confirm if the assumptions and assertions they may have made about a company are correct and if they are paying a fair price. This analysis involves making sure there are no significant unknown issues and that the company has good growth prospects. If they uncover problems, they may ask that those problems be fixed before their investment.

The first step in the legal due diligence process is a request by the VC asking for certain categories of documents and other related information.  VCs will generally want to know if the views they have taken from the business perspective are supported. This includes understanding the structure your company has, your employee headcount and cost, your staff need to accomplish your business goals (i.e., how many more engineers will you need and when), and any liabilities your company may have such as pending lawsuits. Some examples of documents they will look to are:

  • Board of director meeting agendas and minutes
  • Ownership information and agreements
  • Financing agreements
  • Real estate leases
  • Stock option plans
  • Equity participation and incentive compensation
  • Confidentiality and invention and proprietary information agreements
  • A capitalization table
  • Articles of incorporation
  • Shareholder arrangements
  • IP related agreements
  • Government authorizations and agreements
  • Any other material agreements.

When responses are reviewed, substantial missing or incomplete information, missing signatures on contracts, items that show any inconsistencies with previous discussions or the term sheet, any significant undisclosed debts, liabilities, obligations or other impediments may raise concerns with an investor and could require pre-closing correction and/or purchase price reductions. If you are looking for investment opportunities? We got you covered, contact us immediately. We will work with you every step of the way by empowering, building, and growing your companies.

An often-overlooked aspect of the due diligence process is called “reverse due diligence” which is where the company investigates the VC and determines if they think the firm might be a good fit as an investor and seeks out any potential risks with the VC as an investor in their company. Important areas of reverse due diligence include an understanding of the VC investor (likely a limited partnership) legal structure, the covenants and restrictions imposed by its governing document and whether the VC firm is subject to any current litigation, specifically litigation with its portfolio companies or limited partners. Companies should not be afraid to ask the VC for relevant information related to the reverse due diligence process as VC firms are very used to this process and will often have the information readily available.

Spectrum Venture Capital and its affiliates do not provide tax, legal, regulatory or accounting advice. Nothing contained herein is intended to provide, and should not be relied on for, tax, legal, regulatory or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in or refraining from any transaction, as this site should not be used as a substitute for competent professional advice from a qualified practitioner in your jurisdiction. 

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