How to Avoid Presenting a Flat Tire for a Buyer to Kick:
A Guide to the Venture Capital Due Diligence Process for Early-Stage Startups
Congratulations, you have successfully negotiated a term sheet on behalf of your startup! Now comes the not-totally-painless corporate equivalent of a full cavity search: due diligence. During the due diligence process, your prospective investor(s) will kick the tires on your business by requesting and scrutinizing a long list of documents, corporate records, and financials. If the results aren’t satisfactory, you could wind up producing more documents, incurring significant legal fees to correct past mistakes and omissions, being forced to give extensive representations, warranties, and/or covenants in the deal documents, or, in the worst case scenario, losing the investment entirely. Frequently, the issues your investor identifies are issues you have never considered, thought had been addressed, or that seem insignificant and nit-picky in the context of the business you are busy running. In addition, the process is frequently conducted under significant time pressure, with investor requests piling up even as you push to close your deal, receive your funds, and get on with the business of growing your business.
The good news is that much of the stress associated with this is not inevitable. With some careful preparation and forethought, you can significantly ease the due diligence process.
First, put yourself in your investor’s shoes. She loves your business! She has listened to your pitch, examined your business plan, and thinks you will be successful. She is so confident in your future success that she has agreed (in concept) to put her hard-earned money on the line. If everything goes according to plan, in a few weeks or months she will write a check or trigger a wire for a large sum of money, and will then trust you to turn that money into more money (hopefully with her active participation and guidance). All she wants to do in the due diligence process is make sure that the business she is investing in is, in fact, the business you have sold her.
And that’s what the due diligence process is: making sure that your business is what it appears to be. If there are problems with it, your investor wants to figure out what those problems are and see if they can be corrected before she invests.
In this goal, you and your investor are aligned. As a founder, your equity in your business is only worth what the business is worth. If your investor finds problems with your business, you should want them fixed as much – or more – than your investor does. This does not mean that investors (or attorneys for investors) never become over-zealous in the process of due diligence. But it does mean that in concept the process should be beneficial to you as well as to investors.
With that as preamble, consider the following types of documents frequently requested by investors in early startup investment rounds. This list is not comprehensive, and these documents will vary depending on the nature of your business. However, if you (with the help of your attorney) ensure that the following documents are in order prior to the start of due diligence, you will find that the due diligence process is significantly less painful and more productive.
Note that the following assumes that your startup operates as a Delaware corporation. If this is not accurate, the principles behind this list are still relevant.
Generally, an investor will want to see your charter and any charter amendments, your bylaws, any necessary 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 Stockholder Records
You will need to produce any board and stockholder meeting minutes, along with written consents. You should review these documents with your attorney to make sure that all corporate action has been appropriately authorized.
You should have stock purchase agreements and option agreements for all equity issuances to date. These should be authorized by the Board (see the prior item). In addition, you should have a fully updated capitalization chart. Some investors may wish to see historical capitalization charts, as well, particularly if there have been significant events effecting capitalization other than share issuances (for instance, stock splits or dividends). If you have had stock certificates prepared, you should have PDFs of all stock certificates (including any cancelled certificates) and a stock ledger.
Depending on the stage of your startup’s development, you may be undergoing regular 409A valuations to support your board’s determination of the exercise price of option awards (read our article on the tax consequences of option pricing). If this is the case, you should make sure you have all necessary supporting documentation provided by your valuation firm. If you are conducting internal 409A valuations, be sure to have copies of all 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 (particularly for key employees), a current version of your employee handbook, if any, documentation of any special compensation arrangements (including significant bonuses, retention payments, commission plans, or other performance-based cash compensation), and all materials related to your equity compensation plans.
Intellectual Property Documents
This area may be the most carefully-scrutinized in a typical equity financing involving startups, particularly tech startups. Investors want to know what intellectual property (IP) comprises your business, whether you have full ownership over that IP, and what steps you have taken to protect that IP. This area could be the subject of its own article, but, broadly speaking, 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 and consider what intellectual property is used in the business, or might be necessary to the business in the future even though it is not used today. What are the Company’s trade names and marks? What technology or designs comprise its products? What tools are used in the business? As the business grows, what concepts, ideas, marks, 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/or consultants of the Company working under valid IP assignment agreements? Are there any gaps in IP assignment (i.e., periods where a consultant worked without a contract)?
- If the Company’s IP consists of computer code, is it subject to open source licenses? If so, do any of those 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? If so, attempt to identify the costs of addressing this issue (either by obtaining a license to such third party IP or removing the infringing IP from the Company’s products or tools) and have an attorney review the Company’s exposure. It is better to address this sort of issue proactively than have an investor identify it at the eleventh hour before closing, or, in an even worse scenario, discover it when a third party sues the Company for infringement.
- With respect to its trade secrets, has the Company taken adequate steps to ensure that those secrets remain confidential? In particular, have all employees and consultants executed confidentiality agreements, and have all third parties who might be exposed to trade secrets executed 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 it might be in violation of any third party registrations?
Finally, consider the nature of your business and whether it might require unique disclosures. For instance, if you operate in a highly regulated industry, you might need to disclose documentation demonstrating that you are complying with all necessary regulation and/or have required permits. For instance, if you handle any “individually identifiable health information” under HIPAA, you should be prepared to demonstrate that you are in compliance with the rules of HIPAA and related legislation. If you are in a manufacturing business, you may need to produce equipment leases.
If you have had any adverse regulatory, litigation, or other action (such as patent troll threats), be prepared to produce documents related to that action as well as your response to it.
You have likely already produced a business plan for review; consider providing past business plans, sample marketing materials, and any internal sales or marketing strategy materials.
Finally, depending on your stage of growth, you will likely have to produce extensive financial statements and reports. This process may uncover holes in your internal financial reporting mechanisms; consider this an opportunity to make sure that you, your CPA(s), and any internal financing personnel are prepared for the next stage of your Company’s growth.