Any sort of Investment or Funding, Mergers & Acquisitions, etc. involves a huge amount of due diligence that should be typically conducted by the Investor. Before making such investment, Investors want to ensure that the company in which they are investing is worth of such investment and would fetch them return. By planning and conducting proper due diligence on the proposed investee company, the Investors can protect themselves from complexities and undue losses. This would also help the founders and other stakeholders of the target company to create a synergy thereby giving birth to a win-win situation.
Decoded for VC: Maximize return from Startup Investment
Listed below are some of the key areas of due diligence decoded for VC which if conducted properly before finalizing a deal can maximize return from Startup Investment:
1) Financial Due Diligence
The Investor should be concerned with all of the investee’s company financial details and information which is the first step towards deciding on the next course of action. The details would include:
a) Company’s Quarterly, Half-Yearly, and Annual Financial Statements
b) Notes to accounts (detailed) which forms part of the above Financial Statements
c) The quality of Debtors and Creditors
d) The working capital requirements of the company
e) Short term loans taken by the company which shall be repayable on demand
f) Percentage of Bad Debts in the books of the company
g) Life cycle of the accounts receivable
h) The condition of the assets of the company
One of the most important information that is often missed by the Investors include Cash Flow Statement and this is very important to gauge the financial health of the company as in the present competitive scenario, it is important to understand whether the company has positive cash flows and if the company is able to meet the working capital requirements from the existing revenues of the company.
2) Contracts or Arrangements
Intentionally or unintentionally, this part remains grey and it takes huge time to establish, inquire, and review all the contracts and commitments of the investee company. The key areas for inquiry and review should include:
a) Shareholders’ Agreements
b) Promoters’ Agreement
c) Power of Attorney
d) Customer and Supplier Contract
e) Employment Agreements
f) JV / Partnership Agreement / MoU
g) Service Agreement
h) Exclusivity Agreement
i) Lease Agreement
j) Equity Finance Agreement
k) Indemnification Agreement
l) Non-Competitive Agreement
Apart from the above, there might be various other contracts or agreements depending on the sector the target company is working on. The due diligence process should include all such agreements and contracts which has been entered into by the target company.
3) Related Party Transactions
The Investor should pay special attention to this section to understand and review the ‘related party transactions’ entered into by the target company. This should also take into account the employees of the company apart from the Directors, Officers, Managers, or their relatives.
The Investor should review all such transactions and should also check if there are any specific agreements between the related parties and what the agreements speak about.
4) Customer Due Diligence
Many times when the founders pitch in front of the Investors with excellent figures, it gets difficult for the Investors to find the time and conduct a thorough due diligence check on the target company which leads to a bad investment decision.
For a company to grow, it should have customers who are ready to buy the products or services by paying a particular price which the company can offer. And the Investors should take every such step to understand the customers and their needs and the life cycle of such products or services which is being offered by the target company. This is important because a product or service might be in demand for a particular period but may lose the steam later which would adversely affect the business making a huge loss of investment for the investors.
5) Intellectual Property
It has recently been noticed that a lot of companies have faced hassles due to infringement of trademarks and other intellectual property and as a result, the founders have been penalized heavily and also they have been sent for imprisonment. Apart from this, the complainant has also filed a petition claiming monetary compensation and the founders and the company has gone bankrupt due to the same.
The above factors should be noted very well by the Investors before they invest in a company. The basic checkpoints should be:
a) Registered Trademarks and Patents the company and also the pending applications
b) Copyrighted and other IP protected products and services used by the company and the legal right to use them
c) The dependency of the business on the name or brand which the company uses
d) Any IP rights granted by the company to any other third party and how are they guided
e) The indemnities company has provided to or obtained from the third parties in relation to IP disputes
Investors often fail to check the sanity of the investee company in terms of legal actions, if any, taken by or against the company. But, an investment made in a company which is facing a legal battle in a court or some other quasi-judicial bodies might lead to a loss for Investors. Thus, to protect oneself from such untoward incidence, here are the few check points in litigation due-diligence:
a) Litigations filed by or against the company
b) Litigations settled by the company
c) Any order passed against the company including stay orders
d) Cases pending under Arbitration
e) Governmental or Quasi judicial proceedings against the company
7) Other Corporate Affairs
This includes the basis documents of the company which is the first set of documents being asked by the Investors from the founders. The list of documents which forms part of this due diligence includes:
a) Certificate of Incorporation
b) Articles of Association
c) Memorandum of Association
d) Statutory Registers
e) Name of Directors and Promoters along with their shareholding details
f) Details of other security holders which might include Debenture holders, Preference Shareholders, Convertible Notes, Warrants, etc.
g) Details of ESOP granted or vested, Sweat Equity promised or issued
h) Any agreement or document on capitalization of loan, etc.
i) Minutes of the Board Meeting and Shareholders’ Meeting
Although the above matters seem to be very basic but while due diligence, in case of any misstatement or wrong information, the Investors can move out of the deal making the task very difficult for the founders. Similarly, in the event of improper due diligence of these documents, the Investors can also land in trouble in the long run.
Any investment process would involve the process of due diligence wherein the two sides (Investors and the Investee company) will work together to come to a conclusion wherein the target company is able to receive the funding and the Investors are ready to give funds having a common objective of growth and development for all the stakeholders and thus to ensure a greater good it is inevitable that the due diligence is done appropriately.