Crossing Your T's and Dotting Your I's: Start Preparing for Diligence From Day 1

08 April 2014 Innovative Technology Insights Blog

Young companies deal with a million moving parts, and typically without enough personnel bandwidth or financial resources to handle it all. Every bit of progress is thrilling, but founders are stretched thin, pushing as hard as possible for that next product milestone, that next investment, and paying bills for that next month of operating costs. While young companies focus a lot on the networking and pitching required to harness more funds, many founders don’t think about the practical process of what’s next: yes, the money will come in, but what stands in the way of that happening? Diligence can slow things down, whether in a simple investment round or full-blown M&A transaction. Founders who focus on prospective diligence from Day 1 have an easier time when that deal comes around, hard stop. Here are a few diligence items to focus on from Day 1.

  • Contracts: A big stumbling block. You enter contracts with suppliers, customers, agents, landlords, service providers—you name it. You later amend those contracts to lease more space, to increase the scope of a project, or to terminate a relationship. You’re dealing with that bookkeeper at the supplier who’s going to be on vacation for a few weeks, starting now. You’re dealing with that person who doesn’t have access to a scanner or fax machine, who apparently lives in an off-grid cabin deep in the woods. The process is messy. While all the terms of a contract might be hammered out to your liking, somehow the final product gets lost in the shuffle of someone’s inbox or filing cabinet. When it comes to diligence, we often see companies provide copies of all their contracts—half or more of which are missing schedules, signatures by both parties, amendments, dates, and pages. Then, when an investor or buyer wants to see all “fully executed contracts with all attachments and amendments,” you need to go digging while simultaneously trying to focus on the substantive aspects of the deal. You need to go back to that supplier whose bookkeeper left the company since you signed the contract, dealing with internal bureaucracy there, or worse, tipping off the supplier about a pending deal. The guy who can’t fax or scan still can’t fax or scan. And meanwhile, the investment or acquisition is stalling, leaving more time for buyer to focus on additional diligence requests, to fixate on small details, and most importantly, to gain leverage as a function of time. Save yourself the hassle: at the beginning of a deal process, when your counsel or banker says, “We’ll need to see all your contracts worth more than $____”, be ready to send a file containing everything you compiled since Day 1. Also, just because a contract has expired or been amended, don’t throw it out—keep a copy. Inevitably someone will want to see it.
  • Employment Documents: Your attorneys send you so much paperwork—amended employment agreements, stock restriction agreements, options, related consents and minutes, etc. In the same vein as above, make sure you collect all the signatures you need from your employees and consultants. Too often, we see companies say—“Oh, right, I forgot to ask Belinda for that IP Assignment Agreement because I knew I could get it from her later”—until a deal is already underway. While access to employees and consultants is often easier than with other parties described above, people change jobs and Belinda chooses to hike in Peru at a remarkably inconvenient time for your deal. All of a sudden, buyer’s counsel is worried that the value of the company—represented by its shares, its IP, its contracts, etc.—has somehow been compromised internally. I saw a situation recently in which a programmer at the bottom of a company totem pole stalled a multi-million dollar deal on the eve of closing because he wanted to negotiate his NDA’s terms, ultimately refusing to sign it. The deal didn’t founder over something so small, of course, but it definitely made some waves that easily could have been avoided. Messy, messy—and really, unnecessary. Save yourself the hassle: make sure to follow up with your own people early to collect fully executed documents on time. That’s really just the first level of the issue, though: keep in mind that, as you’re onboarding new employees or consultants, everyone should sign the necessary group of documents.
  • Corporate Actions: Work early to coordinate with your attorneys about how best to keep records for the company’s actions. Your attorneys can be a really great resource for record keeping, making all your lives easier when diligence begins. Ready to enter into a new stock restriction agreement or option agreement with an employee? Ready to take on a big loan? Ready to make some changes to your equity plan or appoint new directors or officers? In each case, and in many others, your board or shareholders will need to be involved. While it’s tempting to jump into corporate action as the need arises, your attorneys will help paper each action, rather than needing to deal with any retroactively. A simple one-liner to your attorneys can help a lot—“Listen, we’re about to do X and we’re not sure whether we need any consents associated with that. Thoughts?” We really appreciate having received those e-mails later on.

As an overzealous pro tip: ask your attorneys for a model diligence request list really early in your company’s life cycle. Each list is customized for a given transaction, so any given list won’t necessarily be representative of the transactions you may choose down the line. That said, any list can give you a general sense of the scope and breadth of minutiae that buyers or investors may request. If there are terms or documents referenced in the list that you don’t know about, sit down with your attorneys and ask about them to gain the legal vocabulary you’ll need later.

Long story short: stay on top of your records, and I promise, you’ll thank yourself later. Now get back to building that company.

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