Want to invest in a capital but afraid of nasty surprises with your feet deep in the water? While funding has increased and investing sharks exacerbated, the unicorns also seem to be an all-time high. The only possible way to avoid a catastrophe later on down the road is to understand the company innards early on. This process is called due diligence.
Although an imperfect process, due diligence is the best way venture capitalists (VCs) can reduce the chances of their investment mismanagement or loss. Starting with signing of a term sheet and ending in the final money transfer, due diligence should make up most of the midway process for an acquisition by a venture capitalist. This may include rifling through a bulk of documents, analyzing financial data of the company, in-person meetings, visits to the company premises, customer reference calls and market research.
What is Due Diligence?
According to Merriam Webster Dictionary, ‘due diligence is the research and analysis of a company or organization done in preparation for a business transaction (such as a corporate merger or purchase of securities’).
Ideally, due diligence is meant to be done before an investment. Investments in a venture capital encompass substantial risks which can be tackled early on through due diligence. It helps a venture capitalist deepen their understanding of the target company, ensure that there are no obstacles for the investment, and identify the issues that need to be fixed for an ideal capital environment following investment. While this process used to take months in the past, today VCs have only a week or two to pull this off due to the immense competition and time pressure. This is why it must be done right in the first time.
How to Carry Out Due Diligence as a Venture Capitalist?
Elephant in the Room
The first step in due diligence pre-investment is to assess the company’s management. You need to ask certain questions regarding three main niches to understand the potential of the company you are seeking to invest in. These include:
- Expertise level: Understand all types of domain the company staff have an expertise on.
- Total Experience Level: This goes beyond saying but a team with relevant market experience is almost always a bonus for productivity in the company.
- Individual Value Contribution: Make sure that each member on the company’s team has sufficient technical support and/or long-term vision to support the company to thrive in the long run.
Double-Check the Sales Metrics
While VCs are out there looking for potential companies to add to their venture portfolios, the companies are also on the hunt to attract good venture capitalists for investments. Which is why oftentimes when a VC approaches a company, their sales team bombards them with fancy, sugar-coated sales metrics assisted with complex jiggery. Never take the sales metrics provided to you as a VC as given. You have all the rights to ask the salesperson or the responsible customer management staff for full data, including the life cycles of all contracts for the past two years. Get yourself a team or software to reconstruct what they reported for the past two years and match it with their present claims.
Key-person Risk Assessment (Inter-executive relationships)
Needless to say, one person quitting has always a ripple effect on the whole team. This goes true even for companies with double-digit staff members. It is important that you understand who the ‘key’ person in the company is. And while you’re at it, make sure you sort out what happens if the key person quits and their relationship with others. Do they quit also? This is important to know in case you have to make a personnel decision (i.e., fire a key person or any other team member, to understand who else goes with them).
Don’t be afraid to ask difficult questions
This is important in case a catastrophic event takes place such as the company goes bankrupt or is overtaken by another company. As a VC, you need to sort out whether or not if someone else takes over would null or void the contract with you? One way to tackle the unprecedented would be to ensure you make contracts for such deals, for instance ‘damage control’, or ‘change of control issues’. This way you would be able to renegotiate the terms with the new owners even if something happened to the current leadership.
Protective Provisions (Veto Rights of the Venture Capitalist)
After a venture capitalist has signed their check, they automatically hold a minority interest in the company. The types of actions included in minority rights may include a right to a say in amendment of the company’s charter, redeeming or acquiring any common shares (on terms approved by the board), payment of dividends, payment of debt over a specified dollar amount, increasing the size of the company’s Board of Directors, creation of any new series or class of new shares and sale or liquidation of the company. However, most founders/management sometimes try to mitigate this veto right through various ways such as arguing it should not apply to a venture capitalist who receives a minimum share on his/her investment. However, it is important that you do not give up that right in order to be able to have a say in case the founder(s) decide to sell the company (if it’s important to your investment).
Right to Participate in Future Financing
Most major investors automatically receive a right to purchase more stocks in relation to their shares in equity. However, many of the investors do not know that in order to maintain their percentage share in the company, they would have to purchase more stocks in relation to the equity issuance, and typically terminate on public offering. Hence, while you’re carrying out due diligence, make sure you raise this point with the company’s management.
As much as the present right to hold more stocks is important, the right for future redemption is also crucial to ensure safety for an investor. As a VC you should request a provision allowing you to cash out of your investment through a redemption feature (assuming that the company you’ve invested in has cash). A typical redemption provision would state that the investor may, by majority vote starting immediately following the first five years of investment, elect to be redeemed, i.e., repurchased at their original price. As a VC you could also specify the time period of the redemption payments, such as in this case, a three year period in equal installments. **Although redemption rights are rarely triggered, they provide the VCs a safe and financial way out in case they want redemption due to any reason.
Additional Checklist for Due Diligence for a VC
Some other types of due diligence you must carry out to ensure a smooth investor-relationship with a company includes:
- Review of material contracts
- Carrying out product efficiency, product differentiation and product market-fit
- Review of corporate charter and reasonableness of underlying assumptions
- Review of any litigation or previous claims
- Review of key intellectual property rights
- Review of litigation, bankruptcy, conviction or governmental proceedings of any of the founders
- Review of any ‘related’ party transactions including with shareholders, officers, or directors or their affiliates
- Checks on social media posts of the founders
- Review of any harassment, discrimination or misconduct claims
- Competitor analysis
- Confirmation that appropriate Confidentiality and Invention Assignment Agreements have been signed by all employees and consultants
- Capitalization structure of the company and any prior investment agreements
In addition to that, a VC may also seek to ask for provisions related to confidentiality rights, drag-along rights, exclusivity/no shop rights, registration rights (such as to sell the investor shares), rights of first refusal/co-sale rights, stock option rights, rights of financial obligations and anti-dilution protection (against the company issuing stock at a valuation lower than the valuation represented by their investment).
Remember, due diligence, by nature, is an imperfect process with its complications and difficulties. However, the only chance you’ll ever get to see what goes on in the company once you’ve invested is before you’ve invested. Because once you are all in, even if you happen to get a board seat and have invested, you won’t be able to get the same quality/level of insight that you do now. Hence, it must be reiterated that the most leverage you hold is before you write your check. If you’re afraid you might piss off some of the management with your questions or queries, it means the company management doesn’t make you comfortable enough to put your full trust in it. How the administration responds to your concerns as a venture capitalist is a decent sign to tell you what is yet to come after you sign your check. If it’s only hand-waving, pushback, hiding information, misleading metrics, etc, make sure you cross-check if you really want to invest in that company.
Seek Help from a Professional
Due diligence is a complicated process which if done wrong could cost you both lost time and money. If you are an investor seeking help in any part of your due diligence for your corporate matters, you can contact our professional corporate attorneys here.