THE RULES OF DUE DILIGENCE At last, after all the dog-and-pony shows, your business plan has met with success and you have an investor ready to lead your first round of financing. You have run the gauntlet of negotiating the term sheet and the only thing left is documenting the deal, a formality the lawyers can handle; you feel close enough to pop the cork on the champagne. Not so fast! What many startups may not realize in today's rush for venture capital is the process of due diligence (both business and legal) that stands between them and funding. Unlike buying a piece of machinery, where it's relatively easy to "kick the tires," investing in a business involves understanding the myriad issues facing a dynamic enterprise. Different investors will focus on different issues; some need to understand every aspect of your capital structure, others want to learn all about your intellectual property protection, while others are especially concerned with employee relations. Often the areas of concern reflect problems your investors have faced in past deals. Whatever the focus, they will use the due diligence process to uncover weaknesses in your business. Most term sheets expressly condition the financing on the completion of satisfactory due diligence by investors and their counsel. In the extreme, unsatisfactory due diligence can topple a deal. Short of that, due diligence can be both expensive and time consuming. Tracking down answers to due diligence questions and addressing a long list of concerns discovered in the process is often painfully slow, sometimes lasting a month or more, especially if the records are in disarray. Not only will you have to pay your own counsel to address the many questions raised during this process by disorganized materials, but you will typically have to pay the fees of investors' counsel to conduct the due diligence. Finally, having records in a state of disorder, oral agreements that haven't been documented and numerous questions from investors that you can't answer - that all makes your business look unprofessional. This impression can have a profound impact on how the investors view management generally. In the view of many investors, disorganization and inattention to process are systemic; a company whose legal affairs are in disorder usually have other organizational problems. Major issues uncovered in legal due diligence will often echo other concerns the investors have discovered in their business and financial due diligence, and the combination can kill a deal. For all these reasons, you want to streamline the due diligence process by planning ahead. From the very first days of your enterprise, get in the habit of documenting all agreements with third parties, paying careful attention to agreements with employees and consultants. You should also organize all of your records and agreements in advance of the financing, rather than in the thick of the process. Make sure there is one person in your company who is ultimately responsible for the administration of the due diligence process. Here are some areas in which we have seen the due diligence process uncover significant problems. You should focus on each of them well in advance of your financing: Have all consultants who have developed part of the intellectual property sign agreements assigning their work product to your company. This includes founders who may have done some development work before forming the company. Review all agreements between your personnel and their prior employers for non-compete agreements and similar limitations. Investigate the work history of employees and consultants and the development history of your key technologies. Be especially alert to possible claims of violating the trade secret and confidentiality covenants of former employers. Document all equity commitments to employees and consultants as soon as you make them. (There is always as difference of opinion unless it is in writing!) Maintain careful records of all stock issuances, stock transfers and all grants of options as well as all vesting arrangements. Spend the time to negotiate and draft licenses of critical third-party technologies that are unambiguous and ironclad. Pay attention to contract administration, particularly for license agreements or other contracts that impose significant obligations on your company. If investors uncover a failure by the company to adhere to obligations which could allow the third party to terminate the contract, they will often require that you remedy the breach before closing. The timing on this can be awkward. Similarly, you need to be aware of the term of each contract to begin extension discussions well in advance of the expiration of the term. Also, keep track of which contracts require consent upon a "change of control" or a financing event, such as a bank line of credit; third-party consents always involve lead time. Get your customer contracts signed. Telling your investor you have three major customers "signed up" and then having investor's counsel discover none of the contracts are actually signed is at best embarrassing, and at worst a reflection on how your entire organization is run. Derby Management 399 Boylston Street, Boston, MA 02116 Tel: 617-292-7420