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The VC Series – Legal Due Diligence

‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from VCs. Further information about The VC Series can be found here.

One of the most daunting aspects of an investment round for a founder is often the due diligence process. In this article, we will explain what due diligence is, how the process works and give some practical tips that should help instil confidence in the VC and make the process as painless as possible.

What is due diligence and why is it important?

Simply put, due diligence is the process by which an investor will obtain information about a company they are looking to invest in, to ensure that everything is as it should be and assess what steps need to be taken if any red flags are raised.

Due diligence can broadly be split into three different groups: commercial, financial and legal. This article will focus primarily on legal due diligence.

The process typically begins with the lead investor sending out a legal due diligence questionnaire with a list of enquiries that will cover all key areas of the business.

The founder (sometimes with assistance from their professional advisors) will then provide responses to the enquiries and provide any supporting documents required, generally by uploading these to a virtual data room which has been set-up specifically for the investment.

Key things that a VC is looking to establish through legal due diligence are:

  • has the company been properly set-up and are Companies House filings and the statutory books up to date
  • what does the cap table look like and are any specific consents required for the proposed investment
  • are the key relationships with customers, suppliers etc. properly documented
  • does the company own the IP that it uses and is it properly protected
  • is the founder and other key employees bound by proper service agreements
  • is there any ongoing litigation, or threats of litigation, from third parties or employees

To the extent that any material issues are identified during the DD process, then the VC might require remedial action to be taken prior to, or shortly after, its investment. In a worst-case scenario, the issue might be so significant that it causes the VC to withdraw its offer of investment.

Practical Tips to Ensure a Smooth DD Process

Rather than seeing the due diligence process as a necessary evil, it can help to view it as a great opportunity to give confidence to the VC and to make you and your company appear more investable.

With that in mind, we have set out below a few steps which founders can take to streamline the process and proactively deal with any potential issues ahead of time.

  • Undertake a pre-investment hygiene check: prior to seeking investment, work with your advisor to identify any gaps or issues and, where possible, undertake remedial action prior to the due diligence process. Where that is not possible, be ready to discuss the issue with the VC and make recommendations as to ways in which it can be addressed.
  • Data Room: in addition to the hygiene check, we would recommend that founders prepare and gather as much relevant supporting documentation as possible, and upload all material documents in an organised manner to a virtual data room. This will again give confidence to the VC and also prevent unnecessary delays that might stall the momentum of the investment process.
  • Don’t get overwhelmed! the due diligence process can seem quite daunting starting out, and it is easy to feel that your answers must be perfect. Talk with your advisor about any issues you may have, and don’t be afraid to ask them what a specific enquiry means or requires. They will have been through this process numerous times acting for both founders and investors alike, so should be able to quickly identify the investor’s underlying concern and point you in the right direction.

And remember, VCs aren’t expecting everything to be absolutely perfect in your company – they just want to make sure that they are aware of any red flags and that there is a founder team in place who they can have confidence in moving forward. Good luck!

The VC Series – Next Article

The next article in the VC Series will focus on different completion structures that you might encounter as a founder when seeking VC investment, including tranching.

You can find details of all the different articles in the VC Series here.

If there is anything that we have not covered which you would find useful, then please let us know.

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If you are interested in joining the network and attending our events please email mainstream@michelmores.com for further details. We hold five pitch events a year where high-growth early-stage...