What is due diligence?
Due diligence allows investors to evaluate potential investment opportunities, assess risks, validate information, prepare to negotiate terms, and ultimately make well-informed investment decisions.
Typically, the due diligence process starts with business due diligence. This involves examining the company’s business model, financial performance, team, market opportunities, competitive environment, and potential for growth.
If the results of the business due diligence are satisfactory, legal due diligence will usually be the next step. In the course of the legal due diligence, the investors (usually with their legal advisors) analyze the company's legal affairs, including corporate matters, contracts, liabilities, intellectual property, regulatory compliance, pending litigation, and other legal aspects relevant to a given deal.
In practice, the investor’s advisors present a list of inquiries, which the company addresses by providing the relevant documents and information in a secure platform or via the cloud (a virtual data room). These are then reviewed by the investor’s advisors. This initial analysis is usually followed by a Q&A exchange between the investor’s and the company’s teams. As a summary of the evaluation, the investor’s advisors prepare a due diligence report describing the major legal aspects, identified risks (if any), recommendations on mitigating the risks (prior to or after the transaction), and potential showstoppers.
Key areas of legal due diligence and their significance for future investment
Typically, the following areas hold significance for VC investors:
- Corporate governance and structure: understanding organizational setup, cap tables and underlying shareholder agreements or other arrangements between founders and/or key shareholders.
- Contracts: reviewing commercial contracts with key customers and suppliers. This helps identifying material obligations, unusual provisions (e.g., most favored customer clauses), potential liabilities (contractual penalties), and operational restrictions (such as exclusivity or non-compete clauses).
- Intellectual property (IP) rights: evaluating trademarks, patents, copyrights, and other intellectual property rights – to assess whether the company actually owns key intellectual property and/or does not infringe the intellectual property of third parties.
- Compliance and regulatory matters: ensuring the company adheres to all material applicable laws and regulations, such as GDPR, environmental compliance and industry specific regulations (e.g., in the med-tech sector).
- Litigation and disputes: identifying ongoing or potential legal disputes with shareholders (e.g., related to shareholding), customers/suppliers (e.g., related to breach of contract), and employees (e.g., related to improperly transferred IP rights) is crucial for assessing potential financial exposure.
- Employment matters: reviewing template employment contracts, HR policies, non-compete clauses, bonus plans, and ESOP schemes. Investors assess the quality of arrangements with key team members, labor disputes, compliance issues, and liabilities associated with employees to (i) make sure that the participation of key team members is guaranteed over a long-term period and (ii) gauge any future impact on the company's operations or finances.
How is legal due diligence different in VC transactions?
Legal due diligence in venture capital (VC) transactions often differs from standard due diligence, for example:
- Focus on intellectual property: in VC transactions, there’s often a higher emphasis on assessing the startup’s intellectual property. Startups in IT, tech or innovation-focused industries heavily rely on their IP for a competitive advantage. VC investors thoroughly examine the strength, ownership, and potential risks associated with the startup's IP portfolio.
- Scalability and growth potential: VC due diligence centers on evaluating the scalability and growth potential of the startup. It involves assessing not just the current legal standing but also the future prospects, team capacity, market potential, and legal framework (local and international) in place to support rapid growth. This differs from standard due diligence, where the focus might be more on existing operations and compliance.
- Understanding startup dynamics: startups often have unique structures, agile operations, and rapidly evolving business models. Legal due diligence in VC transactions requires an understanding of these dynamics and flexibility in assessing risks and opportunities in a fast-paced and innovative environment.
- Risk tolerance and long-term vision: VC investors, due to the nature of VC investments and target companies (especially the long-term vision and innovative business models), have a higher risk tolerance and more flexibility compared to traditional investors. Hence, it is common to include so called 100-day post-closing covenants in transaction documentation aimed at dealing with identified risks.
- Deal timelines and flexibility: VC transactions typically move at a much faster pace than standard mergers or acquisitions. Due diligence processes in VC need to be efficient and flexible to accommodate the expectations of the founders. Therefore, due diligence in VC projects is typically less formalized, focused on key matters and conducted in parallel with negotiating transaction documentation.
How can startups prepare legal due diligence?
Here are some tips that may be useful for startups in preparing for upcoming legal due diligence processes, as well as for the smooth handling of ongoing audits:
- Organize legal documentation: gather and organize all legal documents related to the business from the very beginning. It is worth arranging the documentation according to the standard areas of legal due diligence. If you do not have time or capacity for this (which is often the case), involve a lawyer or other advisor to take care of this for you. This will pay off later when due diligence will need to be performed within a very tight timeframe.
- Review and clean up documentation and registers: review legal documents and registry entries to ensure they are up-to-date, accurate, and in order.
- IP portfolio evaluation: conduct an audit of the intellectual property portfolio. Ensure that all the relevant patents, trademarks, copyrights, and trade secrets are properly documented, registered, and protected.
- Resolve pending legal issues: Address any ongoing or pending legal disputes or litigations. Be prepared to provide comprehensive information about the nature of these issues, steps taken for resolution, and their potential impact on the business.
- Engage legal counsel: consider engaging experienced legal counsel to assist in the due diligence process. Legal advisors can help identify potential issues, provide guidance on compliance matters, and streamline the due diligence process.
- Be transparent and proactive: provide clear and comprehensive answers and documentation for inquiries raised by potential investors. Be prepared to honestly discuss potential legal issues or risks. Proactively address concerns and demonstrate a commitment to resolving outstanding matters.
Key conclusions
Legal due diligence helps VC investors understand the legal landscape of the target company. A reliable and in-depth legal examination helps the investor to:
- assess the overall legal situation of the company,
- understand potential risks, liabilities, and pending issues that might affect the investment's value or the company’s future operations,
- make informed decisions about whether to proceed with the investment and under what conditions,
- adopt proper risk mitigation strategies to be implemented prior to or after the investment is completed,
- assess risks associated with a given transaction and negotiate terms that protect the investment.
Legal due diligence constitutes a crucial part of the overall due diligence process. This also applies to VC investments, even given the specific nature of VC transactions (including a generally higher tolerance of risks on the investors' side), so a properly organized legal audit should not be overlooked in any transaction.
Related Posts:
Intellectual Property Protection Strategies for VC-Backed Startups (by Leszek Małecki & Damian Staszewski, Małecki Legal)
Term Sheet Demystified: Key Clauses for Founders and Investors (by Leszek Małecki & Tomasz Kiełczykowski, Małecki Legal)
How To Successfully Get Grant Funding For Your Startup? (by Jure Tomc, Director, Cresco Innovation)
