Due Diligence 101: 3 Things Founders & Investors Need To Focus On

Startups and entrepreneurs often rely on venture capital (VC) firms or individual angel investors to raise capital. 

The firm’s general partners (GP) have a fiduciary responsibility to the limited partners (LP) or investors to ensure that the companies in which the fund invests meet financial, legal, and regulatory requirements. VCs typically conduct due diligence (DD) to ensure the accuracy of past performance and compliance data. 

Stages Of Due Diligence

The procedure is divided into three stages, each of which allows investors to finalise their internal approval and complete the investment.

Stage 1: Review

Typically, the due diligence process begins once the term sheet is issued. A checklist is shared with the founders, which guides them through the process and the documents needed to begin the DD.

This document list is based on the scope of work of the due diligence. 

A thorough due diligence process requires certain documents. These include registration certificates, contracts, agreements, copies of filings, resolutions, statutory registers, intellectual property documents, human resource documents, tax-related documents and books of accounts. 

Once shared with the DD team, these documents typically take 2 weeks to review. Following the review, an updated checklist is distributed, which includes comments about missing/incorrect documents and information. 

The founders are expected to respond to these observations and provide supporting documentation.

Stage 2: Draft Due Diligence Report

A draft Due Diligence Report is prepared after the founders have shared their responses and the due diligence team has reviewed them.

The draft due diligence report consists of:

•  The observations of the DD team
• The responses of the founders 
• Implications to non-compliance under the relevant laws
• Recommendations of the DD team

The DD report can be viewed as an extended document with detailed information about the company. It typically includes all of the company’s material information, such as:

• Incorporation details
• Business details
• Shareholding structure
• Board composition
• Licences and registrations held by the company
• Extracts of the agreement and contracts in which the company and/or the founders are a party
• Properties held by the company (including intellectual property), insurance, and litigation details
• Human resource details
• Extracts from the charter documents, timelines, and financial statements
• Shortfalls and defects of financial, legal and regulatory requirements
• Any other observations identified by the subject matter experts undertaking the due diligence

This report is the investor’s single source of data and information on the investee company, dating back to its incorporation. The draft due diligence report is circulated amongst the investors and the founders. 

Stage 3: Addressing The Observations 

Once the observations are made, the DD team, investors and founders connect together and review the observations. 

The action plan and timeline for closure are presented for each observation that was not closed in stage 1. Timelines are divided into two broad categories: Condition Precedent (CP) and Condition Subsequent (CS).

CPs are the conditions that are expected to be met before the transaction’s closing, i.e. before the investors transfer their capital.  The resolution of these observations is required for the transaction to proceed. 

CSs are the conditions that must be met following the transaction within the time frame specified.  CP and CS are both included in the transaction documents (SSA and SHA). 

The Shareholder Agreement (SHA) also includes a CP completion certificate, which the company must issue to the investor once the CP observations are resolved and the investors move forward with the transaction. 

Conclusion

Venture funding assists entrepreneurs in raising the initial capital to invest in their business and allocating the capital according to their business plan. Before making an investment, VCs conduct due diligence to learn everything they can about the company.

Furthermore, due diligence is important not only from the standpoint of the investor, but also from the standpoint of the founder. In the spirit of building a business, many founders do not pay much attention to compliances early on in the journey, which can have a compounding effect as time passes.

Due diligence provides the founders with a 360-degree view of how their teams are implementing processes and performing in areas where they may lack expertise. So, it is recommended that founders conduct due diligence every 2-3 years to ensure the hygiene of these functions as the founders may lack expertise and may not regularly monitor these functions.