Wooing investors: Why even start ups should perform due diligence

24 Sep Wooing investors: Why even start ups should perform due diligence

Madison, Wis. – From movies and television, most people are familiar with “discovery.” The discovery process is used in a lawsuit, where each party is attempting to learn (or “discover”) everything it can about the position of the other party. When you hear about discovery requests, these often are in the form of written questions (interrogatories) or oral questioning (depositions).
What many people do not realize is that a very similar process takes place when you ask someone to invest in your company, or if you are at the exit point in your company’s lifecycle and you are trying to sell your company. This process is called “due diligence,” and buyers and investors use this process to learn as much as they can about your company. It is very similar to the discovery process in litigation, albeit much less formal and much less limited. In other words, the due diligence process is not run by a strict set of rules or officiated by a judge, and there are essentially no questions that are off limits. If you want the purchaser’s or the investor’s money, you have to answer every question they ask about your company.
So, if you live in the fast-paced world of technology and are busy starting up your company, why should you worry about due diligence now? The simple answer is that a bit more work today can make your life much easier down the road. Doing things right first, or correcting mistakes early, is far easier than fixing things later.
In this column and the next, we will look at the due diligence process and what it typically entails. If you find yourself wondering if your own house is in order as you read this, do yourself a favor and ask your advisors. Accountants, bankers, and lawyers are intimately familiar with due diligence and can help you solve your problems now, which will save you time, headaches, and money.
Due diligence checklist
Because virtually every investor in a tech company is looking forward to an “exit” and because the sale due diligence process arises after the company has been operating for a while (and, therefore, has more potential problems), I’ll focus on the due diligence process in the sale of the company.
To put this in context, a typical acquisition transaction will start with a letter of intent, which makes both parties comfortable that they are close on the basic economic terms of the deal. These letters are always non-binding, and are always subject to the purchaser’s due diligence review. The next step in the process typically involves the purchaser sending the selling company a due diligence checklist. That checklist will rule your world for the next weeks and months.
These are the areas that often are covered in the due diligence process:

• Financial information (historical financials) and taxes.
• Intellectual property.
• Corporate organization and structure.
• Contracts and other agreements.
• Assets, both real and personal (including the condition of those assets).
• Litigation.
• Human resources.
• Environmental and safety issues.
• Information systems.
• Insurance.
• Specific questions relating to your company’s particular area of business, such as manufacturing, distribution, design, quality control, etc.)

In our next column, we will look at some of these categories in more detail. These seem relatively benign when considered as general types of information, but like many legal issues, the devil is in the details. In the meantime, let’s look at why your answers to these questions are so important, and why you need to go to a great deal of effort to get those answers right.
Representations and warranties
After, and sometimes concurrently with the due diligence process, your lawyer will begin negotiating the purchase agreement. You will hear your lawyer talk at great length and negotiate endlessly over the representations and warranties section in your agreement. This section, which typically fills much of the agreement, is the section in which you make a number of statements (otherwise known as representations and warranties, or “reps”) about your company. The purchaser will rely on these statements, and you will have to indemnify the purchaser if you make any errors in those statements.
The reps you will have to make include everything from a statement that you have the required corporate authority to enter into the agreement to, sometimes, specific reps about specific agreements – in other words, everything you disclosed during the due diligence process and, perhaps, even more. Thus, even though you disclosed everything to the seller in the due diligence process, the seller still wants promises about your company.
Take this provision from a recent transaction in which I was involved, and imagine whether you could unequivocally stand behind this statement for your company:
All Trade Rights that are or were registered have been properly registered, and all maintenance, renewal and other fees relating to such registrations or applications are current and proper. Seller has no pending registrations or applications with respect to Trade Rights, which have not been listed on Schedule A. To exploit the Purchased Assets, Purchaser does not require any intellectual property or other rights which are not listed on Schedule A. “Trade Rights” are defined as all of the (i) trademark rights, business identifiers, trade dress, service marks, trade names, logos, and brand names; (ii) all copyrights and all other rights associated therewith and the underlying works of authorship; (iii) all patents and proprietary rights associated therewith; (iv) all contracts or agreements granting any right, title, license or privilege under the intellectual property rights of any other party; and (v) all ideas, concepts, devices, inventions, mask works and mask work registrations, “look and feel,” know-how, discoveries, improvements, designs or trade secrets, currently or previously owned, controlled, used or held (by license or otherwise) by Seller that currently relate or previously related to the Purchased Assets.
As you can see, you will be asked to make very detailed representations about the minutest details of your company. This is why the due diligence process and your answers are so important. If you have done your job well through the due diligence process, you will feel much more comfortable making these reps to the purchaser.
Next time
I hope this has given you a good taste of the due diligence process and why it may be important to you. In my next column, we will look at some of these broad due diligence categories in more detail and describe some steps you can take now to make this process easier later.