The due diligence process is maybe one of the trickiest parts of an investment. While younger companies go through it easily – there’s not much diligence to do after all – it also marks the first moment when they define their business structure.
Alina Stavaru Counsel at RTPR Allen & Overy, experienced due diligence counsel, will discuss at this year How to Web Conference’s Angel investment track, The due diligence process – lessons learnt, about the how investors can optimize this process and focus on the most important steps.
Alina joined RTPR Allen & Overy in 2009. She is is a qualified cousel, member of the Bucharest Bar and of the National Union of Romanian Bar Associations. She is primarily involved in mergers and acquisitions, particularly private equity, complex corporate and capital restructurings, spin-offs, capital markets and other corporate matters, as well as energy related matters.
How to Web: What are the key aspects that are analyzed in the due diligence process? Are there only legal aspects involved or does due diligence expand beyond that?
A due diligence usually covers legal, financial, tax and technical matters in order for an investor to understand all key areas for the potential target company. As lawyers, we deal with the legal due diligence, while the other areas mentioned above are covered by specialized tax/financial/technical advisors.
The legal due diligence covers all the key legal areas for the transaction, such as:
- corporate (title to shares, corporate organization, special rights of certain shareholders (eg veto rights, rights in relation to the transfer of shares), compliance of the corporate documents with the legal requirements);
- employment (terms and conditions of employment for the key employees (eg golden parachutes clauses, remuneration), compliance of the employment agreements with the minimum legal requirements, bonus and severance payments policies, intellectual property rights for the creations of the employees);
- real estate (ownership or non-ownership titles offering to the target company the right to occupy the premises where the business is carried out);
- main commercial agreements (change of control clauses, unusual or onerous provisions, anti-competitive clauses);
- regulatory (existence of all licenses, permits etc for carrying out of the business);
- intellectual property rights (making sure that the target company is the lawful owner or licensee for the intellectual property rights needed for the business);
- competition (assessment whether the proposed transaction will require a competition clearance before being implemented, any anti-competitive clauses in the agreements of the target company or anti-competitive practices (eg price fixing) creating risks for the company).
How important is the transparency of the process for both sides? Isn’t it uncomfortable for a startup to fully disclose all the aspects and couldn’t this negatively affect the amount of the investment?
Transparency is definitely important for both sides.
Founders’ point of view: In almost any investment process, the founders of a target company in which the investment is made will be required to grant certain “warranties” to the investor in the transaction documentation (ie guarantees relating to the status of the company) and anything which is disclosed in the due diligence process will usually exempt the founders from liability for the warranties (in other words, “we warrant the following, unless otherwise disclosed in the due diligence”). Having said that, it is obviously in the best interest of the founders to disclose as much as possible.
Investor’s point of view: It is essential to understand the business with all its positive and negative aspects in order to be able to make an informed investment decision. Important information withheld in the due diligence process and disclosed only in the very late stages of the transaction may lead either to the reduction of the investment amount (the valuation of the company changes in the eyes of the investor) or even the termination of the process (if there are real “deal breakers”). Once the transaction is signed, information withheld in the due diligence process can lead to the liability of the founders for the warranties or even the unwinding of the transaction if major information has been withheld.
The discomfort of disclosing information can be mitigated through various methods, such as disclosing information only when there is a comfortable degree of certainty that the discussions are serious, putting in place proper confidentiality agreements, offering rather aggregated data in the beginning of the discussions with further breakdowns when the negotiations reach an advanced stage etc. However, nothing important should be withheld.
How does due diligence bring discipline to the investment process?
Most of the issues identified in the due diligence process can be remedied, either until the completion of the transaction or afterwards. This means that the company will be in a better position for the next investment round or, why not, for the successful exit from the company of both the founders and the investor.
What are some key elements of this process that early-stage startups are sometimes unprepared for and what can they do to consolidate their legal preparations?
The most important elements are the psychological ones: understanding that a fair due diligence process is necessary for all parties to the transaction (even if in small startups this will mean that the same people will have to deal with both the questions of the investor’s advisory teams and with the continuation of the business in the ordinary course) and that transaction documents are generally complex instruments which require time and attention in order to be brought to a form acceptable by all parties.
As an objective preparatory element, the target company may have its own preparatory due diligence carried out by the company’s advisors in order to get ready for the investor’s due diligence. This way the due diligence documents would be ready for the investor’s teams and some problems or housekeeping matters may even be fixed in advance.
What role does the due diligence process play in the relationship between startups founders (if there is more than one) and in the relationship between founder(s) and angel investors?
The due diligence might not change anything between the founders or between the founders and the angel investors. However, in practice the angel investor would usually request the founders who are also involved in the day-to-day business to take care of any remedial actions and to assume the business warranties granted to a new investor, given that the angel investor has not been actively involved in the management of the business.
Similarly, if the management of the business is split between the founders (e.g. one person takes care of the employment matters and another person takes care of the commercial agreements), they would probably want to have reciprocal assurances between themselves with respect to the fact that there is no major hidden issue in the part of the business managed by each of them.
What are some key issues that angel investors should closely follow and analyze in the course of this process?
Generally the key areas listed in relation to first question above. In addition to this and provided, of course, that the angel investor believes in the business and wants to invest in it, the next phase is in relation to the transaction documents in which the parties should find a balance to ensure that, on one hand, the angel investor does not need to get actually involved in the day-to-day management of the company and, on the other hand, the angel investor has certain protections for its investment (e.g. a veto right in relation to a few major decisions in the life of the business).
What faults in the due diligence process can affect the further growth and development of a startup?
Generally potential faults affecting the further growth of a startup are not due to the due diligence process but only discovered (and most of the times remedied) in the context of the due diligence. If we are talking about potential issues existing in a startup, there is no magic answer to this, as things vary from business to business.
Just by way of example, I would mention only one of the most common legal issues we see in our due diligences in the IT industry: unclear regime of the intellectual property rights of the target company due to improper paper work. As a general rule, intellectual property rights for the creations of the employees made in the context of their job duties belong to the employer/company unless there is a contrary provision in the employment agreement. Nice and easy.
But what happens in practice is that employment agreements sometimes do not include proper job descriptions in order to be able to identify whether a specific employee has any creative role or not, so we will need to fix this after the due diligence through proper written agreements signed with the relevant employees.
How does the due diligence process change in the course of time, as larger investment rounds are made and the company grows bigger?
While a business grows more and more, the legal aspects to be taken into account become more and more complicated compared to a startup. But this is a nice problem to have. Also, to the extent an investment round has already occurred, the first lessons are already learned and the company may become more cautious and ready to grow for a new investment.
How long can a due diligence process be and could negative effects occur due to its length?
It really depends on how fast the founders/the target company can provide documents and answers to all the questions addressed by the Investor’s teams. And there is rarely only one round of questions, normally documents and answers provided trigger additional questions and this make take time.
But all in all, in a well-organized process, a complete due diligence should not last for more than one or two weeks for a startup. Protracting the due diligence may lead to the parties partially losing the momentum (one or more parties becoming less interested) or, if we talk about a significant period of time, even the valuation of the target may change depending on its business evolution.
The Angel Investment Track has been initiated and developed in partnership with VIBE (Venture Initiative in Balkan Europe), a regional eco-system accelerator supported by the European Commission. VIBE is one of the projects of the South-East Europe (SEE) Programme.