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How Startups Can Navigate the Due Diligence Process With Ease

After successfully negotiating a term sheet on behalf of your startup, the due diligence process begins. Often a dreaded step in the venture capital process, it’s the last thing standing between you and your funding. The process is frequently time-sensitive. Investor requests pile up as you push to close your deal and access funding. The good news is that you can significantly ease the due diligence process with careful preparation and forethought.

What is the Due Diligence Process?

Due diligence is when your prospective investors request and scrutinize a long list of documents, corporate records, and financials. If the results aren’t satisfactory, you could wind up producing more documents. This may lead to significant legal fees to correct mistakes and omissions, or you could lose the investment entirely. Investors often identify issues not previously considered or problems that seem insignificant in the context of your operations. 

How to Prepare for the Due Diligence Process

Prepare the requested documents in anticipation of the process early on during the startup investment rounds. With the help of an attorney, the due diligence process can be significantly less painful and more productive. While the list will vary depending on your business, an attorney can help you prepare documents. The most frequently requested information includes organizational documents, board records, human resource files, financial statements, and intellectual property licensing. 

Organizational Documents

Investors want to see your charter, including any amendments, your bylaws, relevant state qualifications, and certificates of good standing. Have your legal counsel look over these documents and make sure they are up-to-date and in order.

Board and Stakeholder Records

You will need to produce any board and stakeholder meeting minutes, along with written consents. Therefore, you should review these documents with your attorney to ensure authorization of corporate action.

Capitalization Records

It’s best to have stock purchase agreements and option agreements for all equity issuances to date. Specifically, these should be Board approved (see the prior item). You should provide an updated capitalization chart. Some investors want to see historical capitalization charts if you’ve had significant events affecting capitalization other than share issuances. For instance, stock splits or dividends may constitute a significant event. Also, gather your stock certificates prepared (including any canceled certificates) and a stock ledger.

409A Valuation

If undergoing regular 409A valuations (read the tax consequences of option pricing), you need to provide documents from your valuation firm. Be sure to have copies of documents supporting your internal valuations, including board consents and minutes adopting these valuations.

Human Resource Materials

You should have executed versions of all offer letters and a current version of your employee handbook. Also, documentation of any special compensation arrangements (including significant bonuses, retention payments, commission plans, or other performance-based cash compensation). Finally, all materials related to your equity compensation plans are critical.

Intellectual Property Documents

This area may be the most carefully-scrutinized in typical equity financing involving startups, particularly tech startups. Investors want to know what intellectual property (IP) comprises your business. Also share whether you have full ownership over that IP, and what steps you have taken to protect it. Below are questions to guide your preparation for due diligence in this area:

What IP is involved in the Company’s business?

As a foundational matter, it is appropriate to review the Company’s business with your counsel. Also, consider what intellectual property is needed today and in the long-term. Questions that you’ll explore are: 

  • What are the Company’s trade names and marks? 
  • What technology or designs comprise its products? 
  • Which tools do you use in the business? 
  • As the business grows, what concepts, ideas, trademarks, designs, etc., might be necessary to its operation in the future?
Does the Company own all of its IP?
  • Has the IP been created by founders, employees, and consultants of the Company working under valid IP assignment agreements? Are there any gaps in the IP assignment (i.e., periods where a consultant worked without a contract)?
  • Is there any IP licensed from third parties? If so, carefully review the license agreements. Ensure that the Company is adequately protected and is compliant with the terms of those agreements. Such as the terms of use of third-party web services.
  • If the Company’s IP consists of computer code, is it subject to open source licenses? Do any licenses contain “copyleft” provisions that might require the Company to submit its source code to the public? Has the Company complied with all open source attribution requirements?
  • Is the Company using any IP without permission from third parties? Identify the costs of addressing this issue and have an attorney review the Company’s exposure. Solutions may include obtaining a license from the third-party IP. Or it may include removing the infringing IP from the Company’s products or tools. It is better to address this sort of issue proactively before closing a deal or being sued. 
  • Has the Company taken adequate steps to protect trade secrets? Have all employees and consultants executed confidentiality agreements? Did relevant third parties complete nondisclosure agreements or agreements containing appropriate confidentiality provisions?
What is the status of the Company’s IP registrations?
  • Does the Company have any patents (either pending or awarded)? Has the Company registered any trademarks or copyrights?
  • Has the Company received any notices that you’re violating any third party registrations?
Contracts

Investors will want to review all customer contracts. The review could be of all your agreements or a small sample. You may have to produce your lease agreements, terms of use or service, privacy policies, and any other agreements. Be prepared to provide third party service agreements, for instance, any outsourcing, consulting, or product purchase agreements.

Miscellaneous Documents

In addition to the items outlined above, you also be asked to provide: 

Disclosures 

Consider the nature of your business and whether it might require unique disclosures. For instance, if operating in a highly regulated industry, you might need to share proof of compliance and required permits. Therefore, if you handle any “individually identifiable health information,” be prepared to demonstrate compliance with HIPAA rules and related legislation. If you are in a manufacturing business, you may need to produce equipment leases.

Court Records

Produce related documents and responses if adverse regulatory, litigation or other action (such as patent troll threats) exist.

Business Plans

You have likely already produced a business plan for review. In addition, consider providing past business plans, sample marketing materials, and any internal sales or marketing strategy materials.

Financial Statements

You will likely have to produce financial statements and reports. This process may uncover holes in your internal financial reporting mechanisms. Consider this an opportunity to ensure that you are ready for the next stage of your Company’s growth.

Make Sense of the Due Diligence Process with Bagchi Law 

Put yourself in your investor’s shoes. They love your business! They’ve listened to your pitch, examined your business plan, believe in your success, and agree to provide financial support. The due diligence process helps investors ensure minimal surprises and that your business is what it appears to be. If your investor discovers problems, they would likely want you to address them before they invest. Having responsive legal counsel, you can ensure that the process is beneficial for you and an investor. As a founder, your equity in your business is only worth what the Company is worth. If your investor finds problems, you should want to fix them as much – or more – than your investor does. Bagchi Law can help you leverage the opportunity to improve your business while impressing investors. 

Contact us for more information about how our team can help you prepare for the due diligence process.

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