Before an investor will give your startup money, they will dig into your books to find out whether there is anything they need to know first.

This is called due diligence.

Legal due diligence in an acquisition is when investors make a detailed examination of a startup to assess the non-market business risks, such as pending lawsuits or staffing costs, and verify information presented by the founders during the negotiations.

This allows the investors to have a deeper understanding of any risks, and then work to address them with the founders.

Keep it friendly

Of utmost importance is the parties’ attitude towards due diligence, to manage the process in a timely and friendly manner.

Overly suspicious investors and defensive or argumentative founders can drag the process needlessly, costing time and money. Investors need to remember that SMEs are inherently imperfect, and entrepreneurs that investors are keen on the business.

From our experience, the right attitude with which due diligence should be approached is transparency and collaborative risk mitigation.

We have seen due diligence exercises take as little as two weeks with well-prepared entrepreneurs who compiled their virtual data rooms at the start of fundraising. We have also seen the process last four months, forcing the startup to find bridging finance and poisoning the relationship between the founders and the investors.

Opening the books

Due diligence starts with the lawyers circulating a list of documents they need to see.

Disclosure is usually through uploading the documents onto a virtual data room, and the founders must either provide them all or explain why they 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 deal and seek compensation for their costs, or lower their valuation.

How it’s done

To give an example of how due diligence is carried out, we will use two common items on due diligence lists: employment contracts for every employee in the startup, and litigation.

With respect to employment contracts, the startup will have to disclose them all. If certain contracts do not meet investors’ satisfaction or are missing they will ask, as a precondition to closing the deal, that the startup enters into employment agreements with the employees in a form satisfactory to the investors.

With respect to litigation, the startup will have to disclose information regarding any litigation to which it is a party. The investment deal will include a guarantee by the startup and the founders that it’s not a party to any undisclosed lawsuits.

A checklist of the documents you need to provide

The due diligence list is generally tweaked for every transaction, but for Middle East tech startups, it is commonly composed of the following categories:

1. Corporate: The constitutive documents (memorandums and articles of association, bylaws, certificates of incorporation or registration, etc.) of the startup.
    

2. Regulatory: All the applicable regulatory permits, licenses, and registrations of the startup, and an examination of the applicable regulations to the target and the transaction.
    

3. Management: Maps out the management structure of the startup, and includes the appointment documents and authorities of each director and officer.
    

4. Material contracts: All major supply, maintenance, sale, and purchase contracts as well as any other contracts that are important to the startup’s business.
    

5. Financial: The financial statements, forecasts, business plans, loan or financing agreements, revenue analysis, and bank statements.
    

6. Immovable assets: The deeds, contracts, and property information for all real and immovable property, including lease agreements.
    

7. 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.
    

8. Employment: A list of the startup’s employees, as well as their employment contracts, employment entitlements, benefit plans, employee complaints, and employee regulatory filings.
    

9. Customer information: Information about the target’s largest customers, customer lists, and customer analysis.
    

10. Insurance: This includes the target’s maintained insurance policies, including employee health insurance, vehicle insurance, and asset insurance.
     

11. 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.
     

12. Consents to transaction:The 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.

Due diligence is very important especially for professional investors such as VCs and family offices. While it may be viewed as an unwelcome probe by some founders, good preparation and a good attitude will be key in helping it progress quickly.

Feature image via Kentech.