Navigating the Venture Capital Due Diligence Process

Congratulations! After months of networking, pitch meetings, phone calls, and negotiations, you’ve finally signed a term sheet for your company’s first round of venture financing. What you face next could be one of the biggest hurdles to successfully closing your round—the due diligence process. Read on for insights to help you prepare and avoid any disruptive surprises or delays.

What Is Due Diligence?

You likely have heard of “due diligence” in a variety of contexts. In the world of venture capital, due diligence is a comprehensive investigation conducted by potential investors to assess the viability, potential risks, and growth prospects of your company. A level of business due diligence was probably conducted before your company received its term sheet, but the process doesn’t end with the term sheet. Both the investors and their legal teams will now thoroughly review your company records and history to validate information you may have provided in pitch meetings and determine whether there are any material issues they should be aware of before investing. The scale of the due diligence investigation can vary significantly based on the size and complexity of your business and the investors’ internal policies and practices. In any case, the due diligence process is often a significant gating item to closing your financing round.

Preparing for the Due Diligence Process

The discovery of material issues by an investor or their legal team in connection with their due diligence investigation is a sure-fire way to slow down the fundraising process, substantially increase your legal fees, and potentially affect the final financing terms or even whether your financing is consummated. That is why it is critical to be prepared and anticipate these problems ahead of time, so they do not arise at the eleventh hour.

Organize Your Documentation

Investing early in solid recordkeeping and document archival systems is not only good for corporate hygiene; it will also save your company a lot of time and money during a venture financing. The easiest way to cause a delay during the financing process—and potentially make your investors lose faith in your ability to run a rapidly scaling business—is to provide them a massive cache of mislabeled, unsigned, and unorganized documents. Thankfully, there are many low- or no-cost options available, such as Google Drive, Dropbox, or Box, that you can start using before your financing round. You can use these resources to compile and organize all relevant company documentation, such as financial statements, business plans, contracts, IP documentation, and employee and regulatory compliance records. You should keep fully signed copies of everything up to date, organized, and easily accessible. Doing this in advance of a financing can make the process of responding to diligence requests much easier and more cost-effective.

Consult With Your Legal Team

A common scenario we see is a company that avoids hiring legal counsel to keep costs low in the early stages and subsequently hires a lawyer immediately prior to their first venture financing. The legal team will then have to work simultaneously to comb through the company records and get up to speed on the corporate history while also working to move the financing documents forward. Very often, the legal team will discover a variety of issues that need to be addressed before the financing can close. Many issues can be fixed, but some require a lot more time, effort, and cost, especially when it comes to errors and improper or missing documentation related to the company’s capitalization.

Bringing in legal counsel in the early stages of your business or when you are just beginning to think about fundraising is critical and can save you both money and stress. Your legal team can analyze your documents and work with you to clean up any potential due diligence red flags well ahead of formal requests from investors. Doing this work in advance can save your company embarrassment in the fundraising process and can help avoid giving a third party the opportunity to hold your financing hostage.

The Due Diligence Process

What Documents Should You Be Prepared to Produce?

Once the term sheet is signed and the deal kicks off, the due diligence process will begin almost immediately. Likely, the first document you or your legal team will receive from your lead investor or their legal counsel is a “due diligence request list.” While every investor has their own form request list, the required documents do not deviate much from investor to investor. The types of documents you should have ready to immediately send to investors generally fall into the following buckets:

• Corporate documents. This includes your formation documents (certificate of incorporation and bylaws) and all minutes from prior meetings of the board and stockholders or actions taken by written consent.
• Financial documents. This includes your annual, quarterly, and monthly financial statements, tax filings, and any documents related to debt facilities or other financing arrangements.
• Capitalization records. This includes all documents related to the issuance of stock of your company, including stock purchase agreements, equity incentive plans, option grant documents, SAFEs, convertible notes, warrants, etc. This category of documents is critically important for investors and their counsel, since it directly relates to validating the price they pay per share.
• Employment documents. This covers all documents related to your employees, such as offer letters, intellectual property assignment agreements, confidentiality agreements, separation agreements, etc.
• Intellectual property documents. This includes anything related to ownership of your company’s intellectual property, such as licensing arrangements, patents, trademarks, copyrights, etc.
• Material agreements. This includes all of your agreements with major customers, vendors, and suppliers, as well as any out-of-the-ordinary business arrangements like joint ventures, material licenses, partnership agreements, related-party agreements, etc.
• Litigation materials. You’ll also need to produce any documents related to any litigation, whether previously resolved, ongoing, pending, or threatened. You will likely be asked to describe what led to the litigation, if any, and what the company has done to mitigate that risk in the future.

If your company is in a highly regulated sector, such as fintech or life sciences, you should expect to receive additional requests specific to your industry.

If your company has just been formed or does not have a lot of operating history, many of the requests you receive may be inapplicable, and that is okay. The requests are intended to cover the key categories of information that may be relevant to the investor.

How Do I Respond to the Diligence Request?

Once you’ve assembled all responsive documents, the next step is to upload the files to a shared data room. We recommend that you do this before the term sheet stage, so it will just be a matter of letting the investor and their counsel know where to find everything! Since these documents include confidential information about your company, the shared data room you use should be controlled by the company (not the investors) and should include industry-standard protections. There are a variety of data room providers that offer differing levels of security and administration tools, and the right tool for you will depend on the complexity of your company and your fundraising process.

Regardless of what data room you use, your legal team can help you organize it in a way that mirrors the investor’s request list and can help you fill out the due diligence questionnaire in a way that shows that you’ve addressed every question. Providing a request list that is annotated with responses can help demonstrate that your company has responded to all requests.

What Happens Next?

After you or your company’s legal counsel have provided the investor and their counsel access to the diligence documents and other responses to the diligence request list, you should expect an iterative process with follow-up questions. A well-organized data room will limit the need for your legal team to respond to supplemental due diligence requests from investors or help investor counsel locate documents. If materials are not organized or are provided in unnamed folders, this iterative process will take longer. Accordingly, it’s important that your first response is as organized as possible. It is important to note that legal due diligence can inform investor decisions on additional requirements for your company prior to funding. Having to clean up prior corporate governance mistakes or draft additional documents in the middle of a financing round often significantly increases the legal fees of a round and is one of the hardest categories of financing costs to anticipate beforehand. If your documentation is missing pages or signatures, you may be asked to chase these things down prior to closing. If this information is needed from a third party, the third party could use this as an opportunity to make demands of the company and, in doing so, increase the cost of the transaction for the company. If your documentation reveals inaccuracies in your company’s capitalization, issues with your commercial agreements or ownership of intellectual property, or significant legal or business risks that were not previously disclosed, due diligence could affect the terms of your financing or whether investors are still willing to invest. Working with legal counsel to identify and correct these issues in advance of a financing can reduce the risk of due diligence affecting your financing.

Conclusion

The due diligence process does not need to be stressful or overly time-consuming. In many ways, through the process, you are just confirming what you’ve already told the investors about your company. You can save a lot of time, money, and hassle if you plan ahead, keep yourself and your team organized, communicate with your legal team to locate any issues early, and be ready to respond to due diligence requests as soon as they come in. A smooth due diligence process can save your team headaches, minimize delays, lower costs, and, most importantly, build investor confidence.