Due Diligence and Why Full Disclosure is Your Friend

Written by Narda Ben Zvi, Adv., Partner and Head of High tech and IP department at Yaacov Salomon, Lipschutz & Co.

Okay. Full disclosure. I will admit it right up front. There is nothing more irritating for a start-up than the due diligence process that is part and parcel of almost every investment. It is time consuming. It is picayune. It focuses on things that can seem insignificant to the founders ("In a previous round, did all the shareholders waive their preemptive rights? No? Well please go sign them on this waiver before I put my money in."). It takes all of your time and energy just when you need to get the beta version of your product out to market. It can drive you nuts.

I see this article as a form of innoculation. By explaining why due diligence is so important, I would hope that you will have the patience to deal with it.

A company is in many ways a cat in a sack. Due diligence is an investor's way of taking the cat out of the sack, having a good look at the cat and trying to make sure it isn't mangy and doesn't scratch or bite. In the course of due diligence, an investor will check, among a multitude of other things, a) whether all the current shareholders received their shares properly. Do any of them have possible claims against the company or the investor about their shares; b) does the company really own its technology? Does a university or hospital have rights to the technology because a founder or an employee works or worked there? Have all of its employees signed proper technology transfer agreements that do not leave the company exposed either to a cash suit or to a claim that the employee owns the technology? Has the company granted overly broad licenses to others that would impair its ability to commercialize its technology?; c) do all the company's employment contracts have everything in them that they need to insure the company as much as possible from claims for violation of an employee's rights? Does the company have exposure for severance pay to its employees or is it protected by Section 14?; d) what shareholder or third party approvals are required to do the deal? Will merger notices to the Antitrust Authority be required? Has the company received NTIA (the new name for the OCS) funding and will it need to get any approvals in that context? And while we're at it, is the company compliant with its NTIA grant approvals and with the NTIA law? e) is anyone suing the company or about to? How likely are the suits to succeed and what happens if they do?; f) are there any founder agreements or shareholder agreements or undertakings to previous investors that could complicate the investment? g) is the company using open-source software that imposes an obligation on it to license the company's software for free or to give out the source code of the software?; h) what options has the company issued or promised to issue to employees? What are their strike prices and vesting schedules? Has the ESOP been properly set up and reported to the tax authorities? And on and on.

Now the cat's out of the sack. The cat could be so ugly that the investor doesn't want to invest or the cat could be so sleek and fit that the investor thinks it has made the best investment decision of its career. Does the investor think anything about the cat requires plastic surgery or therapy? If so, the investor is likely to make the company do the surgery or provide the therapy prior to closing. For example, if it turns out that some of the company's shareholders have potential claims against the company, the investor will want to take care of those claims before the closing. As a result of due diligence, the investor will make a go/no go decision. Fortunately for start-ups, no goes are a rare result of due diligence. Founders can make them even less likely by disclosing things that they regard as particularly problematic even before due diligence, at the termsheet stage. No surprises makes happy investors.

That brings us to the most fundamental rule about due diligence. Founders (forget it: humans) do not like disclosure about themselves in general and they especially don't like disclosing bad things about themselves. But in due diligence, the company must disclose absolutely everything. When there is doubt whether to disclose or not, always disclose. If you don't disclose, it can come back to haunt you. Why is that?

It's because the end result of due diligence – after the go/no go and after demands for plastic surgery or therapy on the cat – is a long (often 10 pages or more) section of the share purchase agreement which contains a set of representations and warranties. Those representations and warranties, taken together with the specifics of the disclosure schedule that accompanies them (another 10 pages or more), describe the company and everything about it at a high level of detail. If the representations and warranties and the disclosure schedule have absolutely everything there is to say about the company in them, the investor will never be able to claim that the company misrepresented something, that the investor was damaged by the misrepresentation and that the company needs to pay the investor for its losses. The bottom line is that full disclosure is your friend.

It should be obvious already, that a company that is well organized before it begins due diligence is going to have an easier time of it. Keeping carefully filed (electronic and hard copy) signed copies of everything about the company as an ongoing practice isn't much work and the obsessive compulsives among us actually derive joy from it. By doing it ongoing, you will save yourself a tremendous amount of hassle when the time comes for due diligence.

What's the due diligence procedure?

First off, you are telling someone all of your company's most closely guarded secrets. Obviously, before you make the first disclosure, the investor needs to be signed on an NDA. The NDA is often part of the termsheet or annexed to it. Sometimes, investors go through the first stages of due diligence prior to signing a termsheet. They should be signed on an NDA right at the beginning and then the NDA can be incorporated in the termsheet or supplanted by a new one.

Next, the investor's lawyers will send a due diligence letter asking for the information required to take the cat out of the sack in a highly structured way (for example, a question about employees who have worked in universities and hospitals might be numbered 6.4 in the intellectual property section numbered 6). The due diligence letter is usually a combination of document requests and questions. The response is organized in the same way, with the same numbering scheme, as the due diligence letter.

Sometimes, it is not just the investor's lawyers who are involved. Sometimes, there are accounting due diligence, patent searches and business analyses of the company.

Do not try to prepare the response to the due diligence letter by yourself. Your lawyers need to be involved at every step of the preparation of the response. They need to review with you every document being disclosed, and every response to a question to make sure that they are complete and accurate and ultimately can serve as a basis for the representations and warranties and disclosure schedule. Remember, disclosure is your friend and your lawyers are the ones making sure that your friendship is deep and rewarding.

Finally, due diligence is not a one way street. This is obviously true when your investor is giving you shares in a company as part of the consideration for your shares or when there is a merger. Then, there is full due diligence in both directions. But even a straight cash investor should be checked out. Google the investor. Ask for other companies that the investor has invested in and ask the founders there what working with the investor is like. See if the investor has added value in terms of being able to make connections for the company or provide technological guidance. And lastly, be concerned if an investor is too easy – giving in to your requests too readily. That can be the sign of a con or a sting.

Back to the beginning: the due diligence process is not fun. It is very demanding on your time, energy and patience. But when you are well prepared for it and understand its importance for you as well as the investor, not only will it take the cat out of the sack for the investor, it will buy you a lot of insurance against post-closing claims against the company by the investor. It is a process that you have to go through. But by going through it carefully and well, you can make it work for you too.

Written by Narda Ben Zvi, Adv., Partner and Head of High tech and IP department at Yaacov Salomon, Lipschutz & Co.

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