Emmy van Hengel

Rockstart Law School: The due diligence process

Setting up and running a startup requires knowledge of the industry that you are in. It also requires knowledge about finance, marketing, customer service, management, and legal matters. There is no way of knowing everything you need to know, which is why the network that supports you becomes a valuable tool and asset.

Rockstart Law School is a combination of blog posts by outside contributors and vlog posts by Rockstart’s very own legal counsels Els Metten and Lisette Schuilwerve. They will show the roadmap to the legal side of starting and running a startup company. Rockstart Law School focuses on the Dutch law system and is meant as a resource and gives you lessons learned and suggestions, but is not meant to be used in the place of legal advice. Always consult your lawyer, but we hope these series of posts will give you a greater understanding of the legal needs and points of attention that you may encounter during your startup journey.

If your startup intends to raise money through a financing round, one of the documents that you will come across is the term sheet. The term sheet usually contains language around the investor conducting a so-called ‘due diligence process’. The good news is that you are one step closer to getting to a “yes,” the bad news is that a due diligence procedure can be—well, let’s be honest—a time-consuming process. Nonetheless, a due diligence process is a necessary means to get to ‘money in the bank’  and therefore very important. This blog will tell you all you need to know about the due diligence process.

Due diligence is the process of investigating a target company and its business to determine the object of the investor’s investment. As investing in early-stage companies – or in any company actually – may be risky, conducting a due diligence investigation may identify smoking guns at an early stage, enabling the investor to either mitigate the risks at hand, renegotiate the deal on the table or in the worst case, blow up the deal.

So what did you get yourself into? Some investors do very little in terms of due diligence, others may request you to provide the whole shebang. Generally a due diligence is done at least on financials, legal, tax and structuring. The due diligence process usually starts with a ‘due diligence checklist’ sent by the investor, which lists all information requested. The list of documents requested can be long and usually contains at least information on the cap table, finance or funding history, material contracts, IP related documents, employees and any litigation related documents. The number of documents you will be able to provide depends on how long you have been in business.

To prevent anyone’s mailbox from overflowing, the due diligence documents are usually uploaded in a ‘virtual data room’, a digital source in which you can upload the requested information. To prevent looking for a needle in a haystack, be sure to keep your data room organized. Bonus points for matching the folders to the investor’s due diligence checklist. Once the filling of the data room is completed, the data room will be shared with the investor. Usually the investor and/or its advisors may have some questions in respect to the documents provided. Any of such subsequent due diligence requests are usually submitted through the ‘Q&A’. Although some fancy data rooms have a special folder and format for the Q&A, the questions and answers are usually submitted in an Excel file.  The whole process of submitting and answering Q&A’s and uploading additional due diligence request may repeat itself several times.

The due diligence process can take from several days to several weeks, depending on the complexity of the transaction and the number of issues requiring additional analysis. The due diligence process is completed once the investor has gathered enough information to decide whether to invest or not. Yup like we said, time consuming.

So what should you disclose to an investor?

Anything that is material for a potential investor investing in your company should be disclosed. Although you want to present your company in the best possible way, never try to hide something. Not only your relationship with the investor is at stake but you may also risk liability under the final transaction document. The transaction document usually contains a set of representations and warranties, or just ‘reps and warranties’, in which the company or the shareholders represent certain facts and give certain assurances about the company and its business to the other party. For instance ‘the company is not involved in any litigation’. If after the deal is done it transpires that the company actually was involved in litigation and this has not been disclosed to the investor, the company or the shareholders may be held liable by the investor for breach of the reps and warranties. This would be different if the investor was or could have been aware of the litigation because you disclosed it in the data room. In other words, disclosure is your friend.

In Europe it is very common to disclose the entire data room. This means that you cannot be held liable for any breach of the reps and warranties in case such information was disclosed in the data room. In US deals disclosure of the data room is not very common, which means that even if you shared it through the data room this does not prevent you from being liable for any breach of the reps and warranties. Anything you want to disclose against a specific rep and warranty must be specifically disclosed in a disclosure letter to avoid liability. This means additional work on your or your lawyer’s side.

So what should you do with any issues or red flags? Some issues may be fixed with the help of a lawyer before you put yourself out there. If it cannot be fixed in time, keep in mind to disclose it early on to the investor. If they are interested in working with you, they will actively engage to help you get through your challenges.[1]

Seven key due diligence takeaways:

  1. If you snooze you lose. Make sure to organize all documents that may be requested by a potential investor before you go out to raise money so you don’t slow down the process.[2]
  2. Be sure to keep the data room organized. Bonus points for matching the data room folders to the investor’s checklist.
  3.  Engage a good lawyer who understands start-up/scale-up funding.
  4.  Disclosure is your friend. You want to make sure any issues are clearly disclosed.
  5.  Ask the investor to share the due diligence results with you. You’ll want to know whether the investor focused on the relevant questions and if necessary you can explain why something is not an issue in your view. Even if the investor kills the deal, you’ll want to know what the showstoppers are.
  6. Install a deadline for the due diligence, to make sure to keep up to pace.
  7. Last but not least, due diligence is not a one way street. Make sure that you conduct your own due diligence on the investor.

Emmy van Hengel is an experienced corporate law attorney at Van Doorne, a full service law firm in Amsterdam. Within the corporate team, Emmy focuses amongst others on advising start-ups, venture capital and more in general M&A. If you have any questions in relation to due diligence, start up investments or corporate law please give her a call (+31615871080) or drop her an email (Hengel@vandoorne.com) and she will be happy to help.

[1] Venture deals by Brad Feld & Jason Mendelson 2011, p. 23

[2] Venture Deals by Brad Feld & Jason Mendelson 2011, p.23

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