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Legal Due Diligence : What Startups Need To Know

Due diligence is a term that we hear quite popularly when it come to startups, venture capital funds, and the like. So, why due diligence? Why is it so important?

Any financial decision that is taken, bears a significant amount of risk along with it. It is only fair that the person who has invested a large sum of money gets an idea regarding the level of risk involved, what the impact of the risk will be on his investment, etc.

What then is due diligence?

Due diligence, is an investigation procedure that provides a potential investor with enough information to make an assessment of a startup. A potential investor first needs to see if the acquisition fits into his overall strategic plan, and that’s where due diligence comes of use. Investing in a startup is an inherently risky venture; therefore, it is heavily advised that a potential investor does complete and thorough scrutiny of the startup that it intends to invest in. Another point to be considered is, compared to other established businesses, startups have a considerably high level of uncertainty when it comes to attaining milestones, which makes the need for due diligence all the more crucial.

When an Investor conducts due diligence for a startup, it means that the angel investor will have accountants and legal professionals review and understand the company’s records. They’re trying to ensure that the financial records, intellectual property, and staff warrant the investment amount. Due diligence for a startup is how the Investor verifies everything claimed during the pitch.

Before the due diligence begins, the parties sign an NDA (Non-Disclosure Agreement) because this process involves sharing of the sensitive data of the company with regard to its financials, operations, finances, legal and other regulatory information.

What then do Investors ask the Startups for during the Due Diligence Process?

This is different for every investor , but there are some checklist that they will follow.However, with that said, there are some in particular, that every investor will want to explore while conducting the due diligence for the startup.

  • Corporate Documents :  Any investor will want to know that your corporation has the right legal structure and is up-to-date with all registrations. For corporate entities, expect to produce your articles of incorporation, letters of good standing, and annual meeting notes. If your company is a Limited Liability Company, you will have to show its incorporation documents and evidence that your company is in good standing with the appropriate government authorities. Your investors are looking to verify that all your corporate forms are in order, avoiding potential fines and someone being able to pierce the corporate veil.
  • Financials:  Every investor will want to see your historical financial records. Be prepared to send over your balance sheet, income statement, cash flow statements, the general ledger, and other pertinent financial documents. The investor will want to make sure that your business isn’t drowning in debt or have some other anomalies that would make it a bad investment.
  • Litigation:  An Investor will want to know If your company is involved in any lawsuits, you will have to produce documentation about them, including their potential outcomes. An investor will need to consider those before coming onboard your Company.
  • Management and Employees:  Before writing a cheque, an investor may wish to know the Management and Employees of the company,Management organizational chart and bios of senior personnel,Detail of any labor disputes,Employee and Management compensation plans; including pension, options, profit sharing, deferred compensation and retirement and any non-cash compensation.Employee confidentiality Agreements,Number of employees, Credit history and Resume Verification on all principals, managers, and directors.
  • Contracts and  Agreements:  Investors will want to know List of Bank and non-Bank lenders,Joint venture and partnership agreements,License agreements,Purchase agreements,Liens, equipment leases, mortgages or any other outstanding loans Insurance contracts and agreements,Contracts with suppliers, vendors and customers.Any additional agreements or contracts relevant to the business of the company

These are just some of the checklist an Investor may want to know about a Startup. These Due Diligence checklist is different for every Investor, depending on what information about the startup they are looking for.

Conclusion

In conclusion,show your investor that you’re serious about getting past the due diligence phase and bringing them on board to help your business grow.

Due diligence for startups might sound intimidating at first, but it’s an essential part of any investment deal. Fortunately, with prompt responses and a general expectation of what to expect, your business can quickly meet the challenge and provide the necessary documents and assurances to make the investor comfortable writing you that cheque.

Disclaimer: The materials provided herein are solely for information purposes. The information presented on this site does not constitute legal or professional advice and should not be relied upon for such purposes or used as a substitute for legal advice from an accredited Lawyer in your state or Country.

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Email: modupe@getfundedafrica.com

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