Venture capital investors typically complete a due diligence review process before finalizing an investment. Investors perform due diligence to confirm information previously provided by the company’s management and assess the strengths, weaknesses and risks of the company’s business and plans. The process, which involves reviewing and gathering information and documents about the company and investment opportunity, includes both business diligence and legal diligence.
During the business diligence process, investors review the details of the proposed company and investment opportunity. At the early stages, investors may attend one or more presentations led by the company’s management team and ask questions about projects, market opportunity, the business model and competitors. At later stages in the diligence process, investors may review financial projections, financial statements (if available), references, and data or other details on the company’s business, products, services or market potential.
During the legal diligence process, investors primarily focus on confirming company information and assessing potential risks and liabilities of the proposed investment. The lawyers representing the investor or lead investor in the proposed financing often lead the legal diligence process at the direction of the investor.
The legal diligence process typically commences once the primary terms of the proposed investment have been agreed to in the form of a non-binding term sheet or other similar format. At this stage, the investor or the investor’s counsel will often deliver a list of requested documents for completing this process, known as a “due diligence request list.”
As the diligence process continues, the investor or the investor’s counsel may issue supplemental due diligence requests based on the materials provided or other business diligence conducted. The documents to be reviewed will vary based on the company’s business and industry. However, the legal diligence process will often include a review of the following materials, among others:
- The company’s corporate records, including board and stockholder meeting minutes and actions, the company’s bylaws and certificate of incorporation and documents relating to prior issuances of securities
- The company’s capitalization table and a pro forma capitalization showing the impact of the proposed investment
- Agreements or forms of agreements relating to the company’s capital stock (including equity incentive plan materials)
- Confidentiality agreements and proprietary information and invention assignment agreements (or forms thereof)
- Employment agreements or offer letters with the management team member and other important employees
- Material agreements, including real estate leases, consulting agreements and commercial agreements
- Materials and information regarding the company’s intellectual property (IP)
The company usually sets up a virtual data room that houses and transmits the documents to the investor or the investor’s counsel through a secure web portal. To facilitate review and feedback, the company often organizes these materials in folders that correspond to the various items in the due diligence request list.
As part of the legal diligence process, an investor and an investor’s counsel often review the company’s capitalization table and the documents relating to prior important issuances of securities. In particular, the investor team may focus on confirming the material elements of the company’s capitalization and the company’s prior compliance with state and federal securities laws. If the proposed financing is not the company’s first round of funding, an investor and its counsel may also aim to identify the rights of prior stockholders and the terms of prior investment rounds, if relevant.
An investor and an investor’s counsel commonly focus on reviewing certain terms of material agreements identified in the schedule of exceptions to the purchase agreement. Specifically, they may try to confirm that such agreements align with the company’s prior representations and do not contain problematic provisions (e.g., “most favored nation” provisions in customer agreements, non-competition obligations, significant out-licenses or other provisions that could, at a later date, impair a liquidity event such as a sale of the company).
Depending on the company’s industry sector and stage of development, an investor may engage in a detailed review of the company’s IP. For instance, the investor’s IP counsel may review the company’s patent portfolio to assess the existing IP rights and investigate risks relating IP rights. In addition, an investor or an investor’s counsel will review the diligence materials to confirm whether current and former employees and consultants have appropriately assigned IP rights to the company.
Legal diligence usually coincides with the drafting and completion of the definitive agreements and documents reflecting the proposed investment. A primary definitive agreement for the investment is the purchase agreement, which provides for the purchase of the securities the company will issue. Representations and warranties the company makes to the investor are critical to this agreement. These representations and warranties are often extensive and allow the company’s management team to provide assurances to the investor regarding the accuracy of information about the company (for example, information about ownership of the company’s stock, financial statements and intellectual property rights held by the company).
As part of the definitive documents, the company will also list any exceptions to the representations and warranties in a schedule of exceptions to the purchase agreement, known as a “disclosure schedule.” This schedule of exceptions is an important step in the legal diligence process. The investor’s counsel will review this schedule and the documents that it references to understand and assess the company and any risks of the proposed investment.
Recommendations for the Due Diligence Process
- Be Organized and Responsive. To facilitate an efficient and streamlined diligence process for all parties, the company should be organized and responsive to requests and questions from the investor and the investor’s counsel. A company may consider preparing and organizing its applicable due diligence materials in a virtual data room before commencing a funding process to prevent delays when the documents are requested. Such delays may slow down the timing of a financing and reduce a deal’s natural momentum.
The company’s substantive responses to requests and questions are, of course, important for the investor’s evaluation of the proposed investment. However, the company should keep in mind that the manner in which it responds to requests reflects on the company’s existing organizational processes and management.
- Limit Diligence Requests and Responses to Necessary Information. An investor should only request information that is necessary or appropriate in order to evaluate the proposed investment. In addition, an investor should keep in mind the burdens that particular requests may place on a responding company. If a specific request imposes significant burdens or requires a long response time, the parties should discuss alternative responses. Alternative ways to address an investor’s underlying concern exist for many forms of requests.
- Be Prepared to Respond to Known Issues. The company should be prepared to explain any known potential issues that may arise during the course of the diligence process. If appropriate, the company should also be ready to provide a planned course of action to address the issues going forward.
Overall, companies can expect to field comprehensive questions and requests from potential investors focusing on both the commercial and legal basis of a partnership. Preparation goes a long way in helping ensure a smooth, efficient due diligence process that results in funding.