Due Diligence. DD. LDD. To many startuppers these words and abbreviations still mean nothing specific.
We have prepared startups for investment many times, but usually they were at such an early stage that our actions were only limited to verification if the in-kind contribution to the company is free from legal defects–what often proved not to be so self-evident. Recently, we have carried out LDD (Legal Due Diligence) in a company which has existed for several years now and obtained a seed investor nearly a year ago. We have also prepared another company for LDD, in which the audit was carried out by a new investor before the final funding round. This has made us realize how much startups/founders neglect formal and legal issues and how much they are unaware that these may prevent them from obtaining funding just in a near future.
I hope that this article presenting the LDD process by Szymon Tyniec will make you aware what and how a potential investor can check before an investment. And why lack of signature or inappropriately written specific task contract can thwart a month of negotiations or even prevent an investment.
Paula Pul.
Due Diligence–carrying out a wide-ranging audit of an undertaking, usually before its take-over or investment. It is also ordered by banks before granting a loan. Its aim is to identify chances and risks before making an investment decision.
It can be carried out both before the relevant stage of negotiations and upon their end, when key parameters of the transaction are determined. Within the frames of Due Diligence an undertaking is audited with regard to its financial and accounting, tax, legal, technical (including in certain situations the audit of source codes) and sometimes commercial condition.
Legal Due Diligence
Operating a startup, almost every entrepreneur strives to obtain funding from investors–already at the seed stage or at a later stage, for more dynamic development or entering new markets. Developing an appropriate business strategy, improving a product/service, marketing–these are certainly major fields on which persons managing an undertaking focus. Yet it is worth devoting some time also to issues which at first glance seem marginal and irrelevant “here and now”. In the future it can turn out, however, that negligence in managing a company discourage investors, even if the concept and performance of an idea bode well.
I mean here issues related to legal functioning of a startup. Many entrepreneurs belittle them for various reasons: saving, lack of time, unawareness or even ignorance. Especially young entrepreneurs believe that at the beginning of pursuing activity they are able to manage legal issues by themselves. But when an investor emerges who is eager to make the capital entry into the company, the Legal Due Diligence audit is usually carried out with the objective of identification and evaluation of the legal position of a given entity. It is only then that some entrepreneurs realize how many elements have been neglected within their activity.
How and what for the Legal Due Diligence audit is carried out?
Most often, the reason for subjecting a company to an audit is a planned acquisition of its shares by other entity or a merger
of enterprises. An investor has to know the company’s position before closing the transaction, that is why as a rule due diligence is carried out at one of the negotiation stages. In the case of startups, very often as early as upon agreeing basic conditions of a given investment and signing a termsheet, in which one of the conditions precedent is exactly a satisfactory result of Due Diligence
In order to understand the mechanism of this process better, you should only imagine a situation where an investor wants to purchase company’s shares to provide it with additional funding for the purpose of developing the undertaking. No potential investor, however, will contribute cash to a project whose legal position is not known to him/her. Before the investor decides on the capital entry, it will be necessary to carry out a thorough analysis of all documents. You should remember that for an investor the very entry into a company entails a great business risk. It is therefore natural that before the investor decides on closing the transaction, an audit will be necessary.
What is the object of the audit?
Every action undertaken by a company is burdened with a risk, therefore Legal Due Diligence has to be comprehensive. The scope of such audit generally covers company’s entire documentation–any agreements, resolutions of company’s bodies, HR issues, administrative decisions, patents, intellectual property (and many more elements). It is worth to make sure that before commencing the audit the auditor and audited company confirmed the scope of disclosed data in the form of a questionnaire, which in a precise manner indicates types of documents necessary to carry out the audit. Very often it can prove necessary for the company to prepare the so-called disclosure letter which describes any irregularities pertaining to issues mentioned in the questionnaire. Inclusion of incomplete or false data in this document may e.g. lead to the audited company being charged with bad faith during the audit and negotiations, which may have a negative impact on the entire pre-investment process, and even result in investor’s withdrawal.
Responsibility of the audited company
Preparing documents to be examined is a task of the audited company. Its employees provide auditors with complete documentation. That is why it is extremely important for the Due Diligence process to be prepared in a reliable manner and with utmost care–the auditor has to advise the employees on what documents and information he/she needs, but, to some extent, he/she has to verify accurateness of the employees themselves. It happens that they are not aware what a significant document they can ignore and not provide to the auditor, considering it little important or invalid. You should also remember that when closing a planned transaction, e.g. in an investment agreement, founders will have to declare that the documents disclosed during the audit were complete and true. Such declaration is usually filed under the penalty of stipulated damages, in case in the future it turns out that certain document was not disclosed or was modified. Such stipulated damages are not low and usually appropriately secure the interest of the investor, who is most often additionally entitled to claim damages from founders above the amount of the stipulated damages.
Summary
From the beginning of company’s existence (and even earlier, upon founders’ signing their first founders’ agreement) it is worth ensuring that all its affairs are carried out with due diligence. If before the audit any irregularities are revealed, it does make sense to notify advisors carrying out due diligence on such fact. In no case should anything which has even a marginal (in the opinion of the audited party) importance for the process be hidden. In the opposite, the audited company and auditors should cooperate with each other in the widest scope as only then they manage to achieve the assumed objectives of the audit fully.
It turns out that at the stage of concluding any agreement it is worth taking advantage of legal assistance, as in the future, exactly during the Due Diligence audit, it may turn out that even a simplest agreement can include a provision which makes it invalid or may provide the reason for raising claims by the counterparty. Sometimes such situations only reduce the price of the audited entity, but it also happens that founders’ negligently managing the activity is a signal for the investor to withdraw from the transaction (as being too risky). Thus, it is worth ensuring that the investor receiving a report on the Legal Due Diligence audit becomes certain that its capital is located in an activity and team which will take care of it with due diligence.
At LAWMORE, when commencing a permanent service of a new client, we begin with reviewing the company’s legal condition. Then, there is no pressure of time, though, and we can make it easily and stage by stage. Last month something happened that made me believe that founders and startups start to understand the problem–one of the startups asked to carry out LDD upon their request and at their cost as it was initiating second round talks with investors and did not want to be surprised in any way. It is a very good approach.
Paula Pul
