Due diligence in early-stage venture financings
Unlike private equity investments that deploy capital into established later stage companies with years of cash generation, growth and audited financials, early-stage venture capitalists invest in companies that have yet to reach maturity. Technology start-ups typically don’t have a significant track record or historic financial data to establish an empirical basis for valuation.
Early-stage venture deals also tend to be much smaller in terms of cash invested when compared to growth-stage financings or M&A transactions. It might therefore be tempting for early-stage investors to overlook due diligence but, in reality, early-stage legal due diligence is a necessary process albeit must be proportionate with the level of financial exposure the investor is taking on.
Early-stage investors will likely be evaluating multiple opportunities at the same time. Therefore, early-stage due diligence has to be nimble and focused so that decisions can be made quickly and cost-efficiently.
This article identifies the key considerations in early-stage due diligence as distinct from the diligence that would typically take place on more mature businesses to help demystify the process for founders and teams on the receiving end of due diligence requests.
...early-stage due diligence has to be nimble and focused so that decisions can be made quickly and cost-efficiently…"
Stages of due diligence
Before deciding to invest, prospective investors will carry out an initial screening process where they will consider, among other things, a company's:
- product market fit and product road map
- competitive landscape
- addressable and serviceable markets
- go-to-market strategy
- commercialisation/monetisation plan.
VC’s will be looking at several start-ups at any given moment, so this screening process will help them narrow down their investment choices and determine whether a company fits their investment thesis.
While VCs may have different approaches to conducting due diligence, generally the process is divided into four key review categories: commercial, financial, technical and legal. Once a start-up has passed the screening stage, investors will carry out commercial due diligence where they’ll look closely at the business model, the company’s current progress, future commercial potential and evaluate their likelihood for a profitable exit.
If the results of commercial due diligence are compelling, then legal, technical and financial due diligence is carried out. These due diligence workstreams are often outsourced to specialist advisors and consultants, and with legal due diligence, an investor’s legal advisors will lead this process. Below we cover what this legal due diligence process looks like.
Legal due diligence
In legal due diligence, a deal team will be looking for any key issues (referred to as red flags) that may materially impede the company’s ability to operate. This would include an assessment of the company’s corporate structure, regulatory environment, assets and the right to exploit them (primarily this means IP) as well as identifying any discrepancies against what the company has reported to its prospective investors. Ownership dynamics, the cap table and shareholder rights (both economic and governance rights) are also considered in legal due diligence.
At the start of the process, legal counsel will often prepare a 'due diligence request list', which seeks to elicit the sharing of documents and information by the company, with the review process commencing once documents have been shared with the lawyers. Additional or supplementary due diligence requests for information may be made as the review progresses.
While the documents to be reviewed will vary depending on the company’s business, the following are considered the key areas of focus for a legal deal team:
- Constitutional documents – to ensure that these governing documents evidence the due and proper incorporation of the company.
- Corporate records, including board and shareholder resolutions – to verify that historic corporate actions have been duly authorised in accordance with the company’s constitutional documents and bylaws.
- Historic funding round documents, including sales and issues of shares or other equity securities – to confirm that such transactions have been duly approved and executed and identify the rights of existing shareholders and the terms agreed in any prior investment rounds.
- Founder share ownership rights – to assess any vesting rights over founders’ shares as well as any other rights or obligations agreed between the founders.
- Employee share option grants and share incentive plan documents – to determine whether there’s an appropriate authorised option pool, and the terms on which options have been or will be granted in the future.
- Corporate structure – to test the effectiveness of the corporate structure adopted by the company and its subsidiaries and identify any deficiencies.
- Cap table – to understand the fully diluted share capital of the company, including any outstanding options, convertible instruments or other rights to acquire shares, and the impact this may have on ownership dynamics prior to and after closing of the investment round.
- Employment agreements, non-competes and non-solicits – to assess the terms on which key employees have been engaged by the business and ensure the company is adequately protected.
- Intellectual property matters and assignment agreements – to determine whether appropriate patents, trademarks and other intellectual property rights along with non-registrable IP have been appropriately protected. Intellectual property assignment agreements are reviewed or put in place to confirm that intellectual property rights developed by employees, the founders or any third-party consultants have been transferred to the company.
- Regulatory and licensing matters – to ensure the business is appropriately licensed to undertake its desired business activities, and if not, what the requirements and challenges may be to be able to secure the necessary licenses and consents from regulators.
After completing their review of the documents, counsel will produce drafts of the transaction documents underpinning the investment. It’s common for investors to request certain protections or conditions precedent in the transaction documents to mitigate or address risks or concerns identified during the due diligence process.
Best practices for founders
If you're thinking about seeking investment, there are some common pitfalls you should avoid to make the process as easy as possible for prospective investors.
Avoid inaccuracies where possible
A common pitfall of venture due diligence is inaccurate information which could lead to investors pulling out of deals. Founders should avoid exaggerating any element of their business including product development, the company’s customer base or financials. Although generally this isn’t intentional, it's important that founders are clear, precise and honest about company details as discrepancies will undoubtedly be brought to light through the due diligence process. Founders should do their best to address any investor doubts upfront.
Don’t conceal issues
While this may seem obvious, no start-up is free from legal issues, particularly during its early stages. A transparent discussion between founders and their investors is the best approach to disclose and resolve any issues. Furthermore, investors may well have rights to claim compensation against a start-up or its founder for concealment or a failure to disclose information, which might not exist had the information been appropriately disclosed at the outset.
Get organised before you approach investors
Founders that already understand the due diligence process from an entrepreneur's point of view are at a great advantage. To facilitate a smooth process, before seeking funding founders should ensure they have a virtual data room set up with folders corresponding to the different categories of due diligence requests and with all the key documents uploaded so that investors can review them easily.