Founder'ssimple.Capital(blog)What founders should consider when preparing for a legal due diligence

July 6, 20210

More speed, less haste. What do we mean by this statement? 

For a prospective investor in a start-up business, they want to enable you to get your idea off the ground as fast as possible, but it must occur within the bounds of due process. By this, we mean meeting the criteria that will protect both the investor and the start-up in the long term. 

If you’re looking to obtain outside investment into your start-up business, we’ve prepared everything you need to know about preparing for legal due diligence, including understanding the due diligence process, receiving a favorable outcome to your due diligence and getting the funding you need. 

Due diligence is beneficial for both you and your investors 

The due diligence process is important for both start-ups and potential investors. 

For the start-up, the ability to demonstrate that your organisation has its house in order throughout the process will show investors that you have a thorough knowledge of the business and its executive capabilities, as well as its possible contingencies and risks. It is in your best interests to cooperate fully with a potential investor and to provide them with as much information as possible so they can make an informed decision on whether or not to invest in your business.

For an investor, due diligence gives them greater insight into your business, particularly:

  • whether the valuation of your business is justified;
  • how your business operates; 
  • the potential of the business going forward; and
  • possible risks in:
    • the transaction specifically; and
    • your business generally

As a founder, it is important to disclose any risks and liabilities associated with the business, irrespective of whether they are commercial, legal, tax or otherwise. Full disclosure is important to mitigate any liability a potential investor may have against you in future. 

4 steps to start preparing for the due diligence process

Step 1: Start your preparations for the due diligence process as early as possible. 

Preparation of relevant and necessary legal, financial and other key documentation in advance will alleviate much of the pressure and stress which comes when preparing for review and populating a data room on short notice. Steps 2-4 should therefore be taken as soon as possible to avoid any shortcomings that could make or break the deal:

Step 2: Review your business structure.

You will want to structure your business to be attractive to investors. For many investors, this means they are looking for:

  • a dual company structure; and
  • founder share vesting.   

Why is a dual company structure so appealing? 

In a dual company structure, a holding company owns your intellectual property (your “IP”), cash, as well as any major assets. The holding company will hold complete ownership of another company, which will function as the operating company. This set-up is attractive to investors because it means your valuable assets are protected. 

How does founder share vesting instil confidence in investors? 

If your start-up is raising capital, investors will want proof that your shares (including founder/s shares) are subject to a vesting period. Investors seek confirmation that key stakeholders are unlikely to exit, thereby sustaining the company’s potential for success. 

Step 3: Entrenching ownership of your IP. 

Investors will want you to confirm that your start-up owns its IP and its trademarks (or that it possesses the correct licences to use them), and that you have registered the IP where necessary. 

Remember: If you created any IP before your company was incorporated, you must ensure you have assigned it to the holding company.   

Step 4: Ensure all relevant contracts are signed, dated and in place. 

Investors will want you to present proof that:  

  • valid and binding agreements are in place with your employees, key clients and suppliers; 
  • the appropriate terms and conditions are contained in the relevant agreements; and
  • agreements are comprehensive (this does not necessarily mean extensive and draconian, just that they provide sufficient detail and provide adequate safeguards for the company). 

Tip: Make sure you review every contract prior to commencing with a due diligence process. Having key contracts in place can serve as an indicator of your commitment to protecting your business and mitigating risk – especially with key employees and clients whom the business might depend on.

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