In our most recent articles, we discussed setting valuations for SMEs and the importance of starting an acquisition with a term sheet. The natural step that follows in a venture-stage transaction is due diligence, commonly abbreviated as “DD”. Legal due diligence in an acquisition refers to the detailed examination by investors of the target to assess the non-market risks of the business, and the verification of the information presented by the founders during the valuation negotiations. Market-based risks, such as whether the product or service is technically viable, marketable, profitable, and can be competitive would have presumably been addressed during the valuation negotiations and prior to arriving at a term sheet. DD therefore refers to the verification of the information forwarded at such time, and the examination of legal, management, financial, and operational considerations of the target business. This exercise allows the investors to have a deeper understanding of applicable risks, and therefor work to address them with the founders, commonly through conditions precedent to closing.
Except for financial DD, the exercise is typically led by the investors’ lawyers, and results in the compilation of a DD report that summarizes for the investors the documents reviewed, documentation and contracting gaps, and the legal, governance, and contractual risks identified.
Below, we set out the common categories requested for an investment DD exercise in a venture-stage company. It is important to note, however, that the parties’ attitude towards DD is of utmost importance to managing the process in a timely and friendly manner. Overly suspicious and vilifying investors and defensive and argumentative founders generally drag the process needlessly, costing valuable time and increasing the transaction’s legal spend. Remembering that SMEs are inherently imperfect and that investors are keen on the business is key. From our experience, the right attitude with which DD should be approached is transparency and collaborative risk mitigation. We have seen DD exercises take as little as two (2) weeks with well-prepared entrepreneurs that compiled their virtual data rooms “VDR” at the commencement of their raise, and we have seen the process last four (4) months, force the target to bridge finance, and poison the relationship between the founders and the investors.
The DD List
The DD exercise commences with the lawyers circulating a list of documents to be disclosed for examination. Disclosure is usually through uploading the documents onto a VDR. The founders and the target will be requested to disclose all items on the list or represent that such items do not exist. It is important for the founders to review the list carefully with their lawyers; the wrong response can be considered misrepresentation, and aside from its relationship impact, may allow the investors to either cancel the transaction and seek compensation for their costs or lower the valuation. The DD list is generally tweaked for every transaction, but for regional tech SMEs, it is commonly composed of the following categories:
- CORPORATE: Includes the constitutive documents (memorandums and articles of association, bylaws, certificates of incorporation or registration, etc.) of the target (and subsidiaries), and the corporate structure thereof.
- REGULATORY: Includes all the applicable regulatory permits, licenses, and registrations of the target, and an examination of the applicable regulations to the target and the transaction.
- MANAGEMENT: Includes mapping out the management structure of the target and the appointment documents and authorities of each director and officer of the target (and subsidiaries).
- MATERIAL CONTRACTS: Includes all supply, maintenance, sale, and purchase contracts of a certain threshold and other contracts important to the business of the target, and any notifications related thereto.
- FINANCIAL: Includes financial statements, forecasts, business plans, loan or financing agreements, revenue analysis, and bank statements.
- IMMOVABLE ASSET: Includes deeds, contracts, and property information for all real and immovable property, including lease agreements
- INTELLECTUAL PROPERTY AND INFORMATION TECHNOLOGY: Includes all patent, trademark, and copyright information, descriptions of the code, website programing, and programs owned by or licensed to the target, and all website registration information.
- EMPLOYMENT: Includes lists of target employees, employment contracts, employment entitlements, benefit plans, employee complaints, and employee regulatory filings.
- CUSTOMER INFORMATION: Includes information about the target’s largest customers, customer lists, and customer analysis.
- INSURANCE: Includes the target’s maintained insurance policies, including employee health insurance, vehicle insurance, and asset insurance
- LITIGATION AND INVESTIGATIONS: Includes information on any dispute, litigation, or arbitration to which the target is a party, and any regulatory investigations of the target, its management, shareholders, or employees.
- CONSENTS TO TRANSACTION: Includes lists of and the relevant documents setting out the consents required to approve and execute the investment transaction, including committee or board approvals, lender consents, and shareholder approvals.
An Example of How DD is Carried Out
To give an example of how DD is carried out, we will use two common items on DD lists: (a) officer employment contract for every officer of the target, and (b) any litigation to which the target is a party.
With respect to item (a), the target will have to disclose CEO, CFO, CTO and all other officer employment contracts. If certain contracts do not meet investors’ satisfaction or are missing, the investors will include as a condition precedent “CP” to closing that the target enters into employment agreements with the officers in a form satisfactory to the investors.
With respect to item (b), the target will have to disclose information regarding any litigation to which it is a party, and the subscription agreement will include a representation and warranty by the target and the founders that aside from what is expressly disclosed, the target is not a party to any litigation.
In sum, DD is a very important exercise for any investor, especially professional investors such as VCs and family offices. And while it may be viewed as a probe by some founders or managers, preparation by and the attitude of all parties involved will be key in allowing the transaction to progress quickly.