Investor Due Diligence: Five Major Issues Investors Want to Discuss with Startups
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So you're at a point now in the life of your business where you are ready to expand, but you need capital. You've decided that the best option for obtaining that capital is to seek investment from an individual investor who you believe has the sophistication to see the value and understand the risk of investment in your business, and the means to tolerate that risk. In most situations, the investor is going to need to know certain things about your business before they are ready to write you a check, and you are going to be required by law to make some disclosures about your business and the risk of investment in it. The terms of the investment, in principle, are likely going to start with non-binding agreement called a "term sheet." After the term sheet is signed, the due diligence process begins. Below is a non-exhaustive list of issues that are likely to come up in the due diligence process, and some insight into what you should expect.
1 - Corporate Status
Generally speaking, an investor is not going to invest in a business that does not have a formal business structure. If you are operating your business as a sole proprietor or a general partnership, there is no separation of liability between the business and your personal assets, so we will not be considering these formal business structures for the sake of this writing. The three most popular entity structures used by startups are the limited liability company (LLC), the C-corporation, and the S-corporation. Each of these structures carries with it different requirements with respect to filings, procedures, governance, and taxes, so an attorney or a CPA should be consulted prior to making a decision on what structure is right for your business. For example, some traditional investors may require that you form as a C-corporation, but that may carry with it negative tax implications for you; and with S-corporations there are limitations on who is allowed to invest and the types of investments that can be issued. Again, it's smart to consult with an attorney or CPA to get a better understanding of these structures before formation.
an investor is not going to invest in a business that does not have a formal business structure
Once formed, investors will also want to see an entity's internal governing documents, such as bylaws or an operating agreement. Internal governing documents are agreements that let shareholders, board members, managers, members, and other stakeholders to a business know their rights and responsibilities with respect to the other stakeholders of the business and to the business itself. Investors will want to see these documents and review them carefully as they may dictate the rights that the investor has as a stakeholder in the startup.
Picking the right structure is important for investors, and should be important for the founders as well. Make sure you know all of the relevant information before formalizing your startup.
2 - Intellectual Property
Intellectual Property can come in many different forms, but in the context of this writing, what we mean by intellectual property is a unique invention or proprietary development that differentiates your startup from your competitors. This may also include a logo or mark that you have used to build your brand and may have name recognition in your particular market. In many cases, a startup's value is going to be based almost entirely on the value of its intellectual property. Because of this, the investor needs to know that the startup's intellectual property is safe. Generally, intellectual property is registered by applying for federal protection through the United States Patent and Trademark Office, the US Copyright Office, or sometimes through a state's Secretary of State's Office. Alternatively, intellectual property can be protected by contract with non-disclosure agreements/provisions (also known as confidentiality agreements/provisions), proprietary rights agreements/provisions, non-competition agreements/provisions, letters of assignment, and through trade secret.
In many cases, a startup's value is going to be based almost entirely on the value of its intellectual property
On due diligence review, an investor is likely going to ask for any patent or trademark filing you may have filed on behalf of your startup; any agreement that you have between an independent contractor, employee or other consultant that may have helped you develop your startup's intellectual property; any employment agreement that you may have that could infer ownership of your startup's intellectual property by your current or former employer; and a statement that all of the intellectual property that you are using is proprietary and cannot be claimed by a third party. A leak in any one of these patches could cause the investor's investment to become valueless very quickly if a third party either copies or claims to own the startup's intellectual property. For this reason, this is one of the most important issues for any startup seeking capital.
3 - Business and Marketing Plan
A startup with a great product, service, or invention is valuable only if consumers think its products, services, or inventions are great. It's critically important that every startup has some idea that the market sees value in what their offering before they seek outside investment, or before the founders put too much of their own capital into the business. Some startups will be able to show investors that a market for their offering exists by showing sales traction, but other pre-revenue companies that have not developed a minimum viable product will need to rely on some other means of illustrating market interest. Pre-revenue companies can test their market through social platforms (i.e., Linkedin, Facebook, Kickstarter, Gofund me, etc.), or market surveys that they've conducted. Either way, an investor is going to need to see that others think your idea is a good as you think it is.
Investors will also want to see that the startup knows how to manage its finances and grow its business, and that's why they'll want to see a business plan. Even startups that are post revenue will have a hard time attracting private investment if they can't show that they are fiscally responsible. For example, if your startup is profitable, but every bit of profit is going to executive salaries, a private investor is not likely to view your startup as a good investment. Investors want to see that you have a plan in place for their investment, that you have the discipline to execute that plan, and that there is some mechanism in place for accountability. This is all information the investor will be able to glean from a well constructed business plan.
4 - People
In the beginning, a startup is nothing but one or more people with an idea and the ambition to turn that idea into a profitable business. An early investment in a startup is really an investment in its people. For that reason, the investors are going to need to know some information about the people that they will be investing in. This includes the founders, employees, and even the other investors who have stakes in the startup.
Some of the information the investor will want to know about the startup's people will involve their professional and educational background, whether they are or were employed/contracted with other similar (maybe even competing) organizations, their roles and responsibilities in the startup, and whether or not there have been any adverse actions against them from prior employers or regulatory agencies. It's important that an investor feels confident that the people involved in the startup have the talents to get their business from where it is to where they believe it will be if given adequate capital. Evidence of past successes (educational or professional) will help the startup's people carry that narrative forward. It is also important that investments made in the startup are not wasted on administrative costs or conflicts that would otherwise not have happened if the startup's people had not been the subject of a legal or disciplinary action by an agency or other third party. In some cases, disciplinary actions by certain agencies against stakeholders in the startup can keep that startup from being able to take advantage of exemptions necessary for their issuance of securities (common stock, preferred stock, SAFEs, convertible notes, etc.). For example, startups will not be able to use the SEC Rule 506(b) registration exemption (which is the most commonly used among startups), if any of their "covered persons" are considered "bad actors" in the eyes of the SEC. Restrictions such as these can make it nearly impossible for a startup to raise capital in a cost effective manner, so investment in startups that have these restrictions may not yield the results an investor wants (see more information about "bad actors").
It is also important for new investors to have information about businesses or entities that have already invested in the startup. If your familiar with the term "activist investor," then you'll know that the disposition of the individual who invests in a business can have a major impact on that business. Startups whose investors try to exercise too much control over the direction of the business, or create too much tension within the organization, can be poisonous for the startup, and can create problems when trying to bring on new investors. Make sure that when you take investment in your startup that you and the investor have clear expectations of their rights and responsibilities as an investor, because once they're in, it's nearly impossible to get rid of them.
5 - Litigation
The last, and possibly the most determinant issue that you'll discuss with an investor is whether or not the startup has been, is, or will likely be a party to a lawsuit. This includes being sued by a private party, a government agency such as the IRS or the SEC, or a local municipality. As was mentioned before, investors want to know that the money they are investing in your startup is going to be used to grow your business, but if your business is being sued, that is nearly impossible. The reason for this is that civil litigation is extraordinarily expensive, even if you win. Attorneys fees for litigation on a single issue can cost tens-of-thousands of dollars. In rare instances, the prevailing party can get attorney's fees covered by the losing party, but that's really of no great consequence. Being involved in a lawsuit will take up so much time and emotional bandwidth of everyone involved that you won't be able to focus on growing your business; lawsuits tend to be all-consuming for startups. For this reason, it would likely not be worth your time and effort to try to obtain private investment if you are a relatively new startup and a party to a lawsuit. Many promising startups get a rude awakening of a lawsuit when they thought they were doing everything right (and truly, they may have been!). Unfortunately, there is a myriad of risks to starting a business. Luckily, many entrepreneurs are excellent at seeking and absorbing knowledge and solutions to mitigate risk from bona fide resources within their network or resources that have verifiable favorable reviews.
The bottom line: Have the mindset of an investor, because the biggest investor in your startup is you.
The bottom line is this: if you know what investors are looking for and understand the basis of their concerns, and you make sure that you incorporate those philosophies into your startup early on, you may able to avoid some of the legal pitfalls startups run into that make them ineligible for investment later on. It's important to remember that the investor is asking questions because they want to make sure your business is sound, sustainable, and profitable; you should be asking those same questions of our own business. After all, the biggest investor in your business is you!
If you haven't already, take our Due Diligence Quiz and see if you're ready to start answering the tough questions about your small business. We not only help startups get buttoned-up for investors, but have also advised many investors about the startups they were considering making an investment in. We can speak to what both sides of due diligence dance is like. If you'd like to take advantage of our services, please call us at (336) 582-0040.