Top tips on getting your business investor ready
Corporate Law - 11 May 2021
At a certain point in time, founders will want to engage investors for additional funding to help grow their business. Whatever the form the funding takes (debt, equity, or a mixture of both!), it pays to make sure the business is ‘investor ready.’ Being investor ready is ensuring that the fundamentals of the business – everything from its plan, leadership, financial reporting, a clear valuation of the company and funds statement outlining where the money will go, is ready to go and will stand up to scrutiny.
A key part of this approach is conducting vendor due diligence (also known as reverse due diligence or internal due diligence) to evaluate the legal, commercial, and financial risks of the business.
What is due diligence?
Put simply, due diligence is simply another way of saying research. A business is comprised of many moving parts, all of which interact together. A business, controlled by its directors and shareholders, will have staff who perform work to create goods or services which are sold to customers or clients from business premises in various locations, supported by third party suppliers and contractors and authorised by different government licences and regulations. All of these aspects of the business (underlined text) bring a multitude of commercial, legal, operational, financial and tax considerations that create risk for the business as a whole.
Due diligence manages these business risks by identifying risks in the first instance, characterising and if possible, quantifying such risks and implementing solutions to mitigate the risk. Businesses will often conduct due diligence on certain aspects of the business (usually commercial and operational items) but engage lawyers, accountants, and other expert consultants to facilitate and advise on other technical due diligence aspects.
If due diligence is the investor’s problem, why should the founder care?
As part of a fundraising round or exit strategy, the incoming investor, financier, or buyer of a business will likely request access to the business’ records, staff, and premises to ‘build a picture’ of how the business is run and the various risks and opportunities presented. While founders are often well informed about the strengths and opportunities of the business, they may not always understand (or even be aware of) the risks to the business which, if ignored, may scuttle a fundraising deal for the business. Investors are usually not opposed to risk per-se, but they will avoid businesses which do not effectively manage such risks.
With that in mind, before you open your books and the business to the prying eyes of lawyers, accountants, and other advisors, you should know where the skeletons are (if any!) and have a good strategy in place for managing such risks. By taking this step, issues can be identified and, in most circumstances addressed, well before the investors evaluate the business and start raising concerns. A well-oiled business is always more attractive to investors!
What does the vendor due diligence process look like?
In the first instance, one of the most important aspects of the business to conduct early due diligence investigations is the financials. Conducting an audit (or review) of the accounts will allow the founders to identify core financial discrepancies which may materially alter the valuation of the business and thus the commercial deal terms. If these fundamental issues cannot be resolved, there is often little point spending additional time and money progressing with additional due diligence inquiries at this stage.
Once the financials stack up and a materiality threshold is determined (usually 5-10% of the net asset value or turnover), founders should turn their attention to commercial and legal due diligence. In this process, the founders will assess the commercial and operational aspects of the business – how it makes money – by either reviewing the operations itself or engaging appropriately qualified expert advisors. For example, if the business’ revenue growth is largely due to its marketing and social media spend, it may make sense to engage a marketing consultant to review the marketing strategy and identify relevant risks. Similarly, if the business’ product is novel and inventive, engaging a patent attorney to file patent applications may unlock significant upside value for the business.
From a legal perspective, we would review the business’ entire operations to identify legal risks. This process includes (amongst many other things):
- reviewing shareholders’ agreements for the steps required before funding can be obtained;
- conducting intellectual property searches to make sure the business’ registerable intellectual property is registered; and
- reviewing the lease to identify any risks that may allow the landlord to terminate the lease early etc.
Often, issues will be identified, and we will devise a strategy with you for managing the risk. For example, the business’ employment agreements may not appropriately restrain its employees from soliciting clients or the intellectual property provisions may be inadequate. In these cases, we will often recommend new employment agreements are executed which appropriately mitigates the risk to the business.
We also frequently see structuring issues where the business does not own the assets it thinks it owns. More often than you would think, the business’ domain name may be owned by the founder in their personal capacity (not the company) because when starting a business one of the first things you do is register a domain name. Over time as the business structure evolves and becomes more sophisticated, these issues can be forgotten and are only identified during the due diligence process.
That’s where we can help!
Vendor due diligence is usually conducted at a higher level and on a commonly understood ‘exceptions only’ basis. That means while all the relevant material is reviewed by the advisors, only material issues are reported on in detail. This keeps costs down and ensures the review is streamlined. For that reason, you should not defer or omit the vendor due diligence process as advisors can often peg their level of review to a given budget as a means of controlling costs for the business.
Further, given a large amount of information about the business needs to be collated in an easy to access and secure data room, undertaking vendor due diligence can significantly streamline the due diligence process for the investor which saves them costs and most importantly everyone’s time. We can assist with establishing a data room which can be as basic as a Dropbox or OneDrive folder shared with the relevant advisors to a comprehensive deal room with Q&A functionality and document access tracking features.
If you are thinking about buying or selling a business, we can facilitate legal, tax and R&D due diligence reviews. Please do not hesitate to contact us here for an initial discussion to see how we can help with this important process.
Co-written by Ally Evans.
The information contained in this blog is general in nature and should not be considered to be legal, tax, accounting, consulting or any other professional advice. In all cases, you should consult with a professional advisor familiar with your factual situation for advice concerning specific matters before making any decisions. By reading this blog, you confirm your understanding of this disclaimer.