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Startup due diligences prior to the entry of an investor: what are the consequences and what preparations are needed

Maria Luque, Senior Associate, Garrigues Corporate Law Department

The arrival of investors in a startup tends to involve a due diligence process, something that the founders of the business must be ready for. To pass the process with flying colors, it is important to ensure that the founders comply diligently with all their legal obligations and obtain advice in this regard from the time the startup is set up.

One of the experiences that any startup whose products generate interest will go through, is the entry of an investor, which can be of any nature (venture capital funds, family offices, groups of investors, large companies, business angels, etc.). The one thing all these investors have in common is that they are prepared to assume a higher business risk than they would if they invested in a company with a consolidated track record. However, as with other types of investment, they are not willing to take certain risks or face the contingencies involved in the startup that cannot be detected "at first glance", but which can be detected prior to investment.

In order to detect these possible contingencies, investors, assisted by their advisers, launch a review process of different areas of the startup in which they suspect that these risks could be ”hidden”: legal area, technical area, etc. This process is known as “due diligence”.

In this article we will focus on the legal due diligences, although many of the aspects that we will address could be perfectly extrapolated to different due diligences.

Due diligences are carried out prior to the execution of the investment, within the period of negotiations between the parties, once the investor has already offered the founders (in most cases the offer is not binding) the economic terms and conditions on which it is willing to make the investment, obviously provided that the result of the due diligence is satisfactory for the investor.

To begin this process, the investor (or its advisers) sends the founders of the startup a more or less extensive list of the documentation and information with which they need to be provided for review. From that moment on, the founders of the startup start the thankless task of “looking for papers” and answering all the questions that the investor asks them. Logically, the supply of all this information needs to be covered by a non-disclosure agreement that the parties will have signed for this purpose.

The founders often think, before the due diligence begins, that the process will be fast, and that the startup will soon start to receive the financing it needs from the investor. They believe that no relevant risk will be found because they are convinced that they have done things well, and in many cases they have, but the truth is that at this point they maybe in for a surprise that could jeopardize the investment.

First of all, the detestable delays in the due diligence process. In most cases they are not so much due to the investor taking a long time to review the documentation, since its intention is also to finish this work as soon as possible, nor to the fact that there is a large volume of documentation to review, since the startup has not been around for long enough, and therefore has not signed numerous contracts with third parties that need to be reviewed. Rather, the speed of the process depends to a large extent on the immediacy with which the founders can provide the investor with all the documentation that they have requested and on the solvency with which they can answer the questions they are asked. Therefore, it is essential for the founders, from the beginning of their corporate career, to make sure they are fully aware of all the legal circumstances surrounding the startup and, of course, to safeguard all the legal documentation on the company, since whether a future investment comes to fruition and when it is needed, could depend on this.

In addition, we cannot ignore the fact that throughout this process, as in the negotiations held between the parties, the founders are projecting a business image to the potential investor that gives it information on the way they are doing things. This too may undoubtedly affect the relationship that will be established between the founders and the investor once the latter becomes part of the startup.

Secondly, let's assume that the due diligence very often detects risks or contingencies, of greater or lesser importance, that the founders perhaps (probably) did not have the slightest suspicion of. The founders intention was no doubt to do things properly, and in many cases they will have done, but in other cases they may have lacked advice and, due to sheer ignorance, the startup has run certain risks that could have been avoided with proper advice.

Detecting risks in the due diligence, except for risks that can be eliminated or offset before the execution of the investment, or risks that are not very significant, will have an impact on the economic conditions of the investment. This impact can vary and depends on many factors, but  can be assembled into the following groups:

  • If they are risks that are about to emerge or there is reason to believe that this will eventually be the case and, therefore, that an effective loss will be generated in the company after the entry of the investor:
  • The investor could propose a reduction in the price, that is, take the same stake in the share capital of the startup that had been proposed, but investing a smaller amount than the figure initially offered.
  • The investor could propose that an indemnification undertaking be included in the investment agreement, so that as soon as the contingency detected emerges, after joining the startup, the founders must compensate the investor for the entire amount of the loss that the investor has sustained in this regard as a partner of the startup.
    However, these types of clauses, which are very popular in “traditional” investment agreements, tend to be more difficult to include in the startup’s investment environment, since the founders often do not have the necessary liquidity to, if necessary, pay indemnification of these characteristics.
  • That the investment finally does not go ahead because, due to the size of the contingency detected, the operation has lost its economic sense for both parties.
  • In the case of possible risks, which may or may not materialize in the future, and which are not so substantial that the transaction does not make sense economically, , usual practice is for the parties to regulate in the investment agreement a system of strict liability (limited in amount and time), whereby the founders are liable to the investor, within the agreed limits, for the damages that the latter, after making the investment and already as a partner in the startup, may sustain as a result of these contingencies resulting from steps taken prior to the investment. This liability of the founders must be limited both in amount and time, and both variables must be negotiated between the parties.

For all of the above reasons, it is vitally important for the founders of a startup to be aware that if they intend to possibly allow entry to an investor in the future, they will almost certainly have to undergo a due diligence process. They must therefore prepare for it  from the very moment that they set up the startup, must be diligent (as the name itself indicates) in complying with all the legal obligations and furthermore it is advisable that they receive appropriate advice in this regard.

All of this will help to ensure that the financing that the startup project will require arrives when it is needed and in the optimum amount, which can be crucial for the survival and success of the project.