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This is a due diligence checklist for Angel Investor / Venture Capital / Private Equity to invest in startups.
[Please note that this is a general checklist for Angel Investor, Venture Capital and Private Equity Investment and does not constitute legal advice. As each jurisdiction may be different, you may want to speak to your local lawyer.]
The following checklist assumes that there will be a Startup Company (“Company”) whereby one or more investor(s) will provide an investment and participate in the equity of the Company. This can be used by seed investors such as angel investor, venture capital, and private equity fund investing into a startup.
Checklist for Investing in Startup
1. Purpose of the Startup
First Things First - is to understand the purpose of the Startup for planning purpose:
who are the founders and the investors of the Startup?
what are the primary commercial objectives? is it confined to a particular territory or technological field? what are the key interests of the parties to protect? how do the parties expect to make a commercial return from the venture? what rights of control or participation do the parties expect? do the investors need or have an exit strategy?
Business plan can be a vital document to ensure that the Startup has a clear objective for the venture. It is common to identify the opening business plan in the investment agreement.
2. Ownership and Funding
Ownership. Ownership/voting shares of the parties will be vital:
will it be an equity, debt or convertibles investment? will economic ownership and voting rights be the same?
Funding. It is crucial to establish the legal obligations of the parties in respect of capital contributions, both at the outset and in the future:
will initial capital be provided in cash/non cash assets? initial debt/equity ratio? any obligations to contribute further capital (up to a maximum limit and/or in defined tranches)? shareholder loans convertible bonds? A convertible debt instrument is a loan from an early round private investor [Angel Investors and Venture Capital), with the debt being able to convert into equity ownership if the company is successful obligation to provide guarantees or counter-indemnities to support finance raised by the Startup? issuance of new shares by mutual agreement or by majority decision of the shareholders/ board of directors? pro-rata offerings? outside finance? project finance from the income stream of the venture?
techniques used to incentivise management?
3. Management
Management structure and corporate governance rights will usually be closely related to equity ownership. Each party will wish to ensure they are adequately represented.
how many directors/members/managers will the Company have and can be numbers be changed?
how are directors/members to be appointed and removed? will a deed of adherence be required?
how should key business decisions be taken? will they all be delegated to a committee/ board. will specific responsibilities be devolved to specific parties or committees? on what basis will decisions require simple majority, special majority or unanimous decision? any reserved matters that will require the approval of the investor(s)? how will appointment of agents be agreed/determined?
After determining the above, the Investment / Shareholders agreement should cover the following:
rights to appoint directors; who will appoint the executive management team? what authority is to be given to individual managers? what matters must be dealt with at board level? what are to be "reserved matters" for decision by the shareholders themselves - and/or will any "super-majority" vote be required for particular decisions at shareholder or board level? Matters which might be considered include:
changes in the Company's articles of association; new issues of share capital (including grant of share options); significant changes in nature of the business of the Company; major acquisitions or disposals;
capital expenditure or contract commitments in excess of pre-agreed limits; borrowing limits; dividend policy; appointment and dismissal of key management; material dealings with intellectual property; dealings between the Company and its shareholders (except arms' length dealings in the ordinary course of business).
Due Diligence should be conducted on directors and management to obtain the following information:
provide copies of all employment contracts and agreements with Directors of the Company including details of any change in the terms of the contract. have any of the Directors of the company ever filed for bankruptcy, have any outstanding convictions or ever held any government position? If yes, provide details.
did any of the Directors have any material interest in any business that filed for bankruptcy or been under investigation in the past twelve months? If yes, provide details. are there any Directors, employees, founder(s) or majority shareholders who have taken an interest in a business that is in direct competition with the Company? If yes, provide details. provide copies of all contracts signed with Directors, employees and other shareholders.
4. Investor(s)' protection
Investor(s) will wish to protect its interests in a number of areas. Objectives may include:
to participate in management through board representation; to be involved in major decisions (including, possibly, a right of veto); to protect against its equity stake being improperly diluted; to ensure proper distribution of profits; to establish adequate access to information regarding the Startup's affairs; to establish "exit" routes (including, possibly, put option rights or "tag along" rights).
The interests of the investor(s) will, of course, need to be reconciled with those of the founder(s). The latter will often have different objectives such as: to control management appointments; to minimise minority veto rights; and frequently, to establish "drag along" or other rights to enable it to deliver a sale of the Startup as a whole to a third party. A balance will have to be struck.
5. Non-compete
Many Startups will be between actual or potential competitors. Establishing clearly the scope of non-compete constraints is vital and will often be contentious in detail:
scope (territory/ field) of restriction;
exceptions (e.g. freedom to make acquisitions of businesses not significantly in competing field - possibly subject to offering the competing business to the Startup)
6. Distribution policy
The parties should have a common understanding as to the distribution policy to be adopted by the Startup. Particularly an investor will have little control subsequently and future dividend policy can cause considerable friction. Should there be a requirement to distribute a minimum proportion of distributable profits?
7. Exit and Termination
When, and how, should a party be able to exit or terminate its interest in the Startup? Parties are often reluctant at the start of their Startup to discuss the possibility of its break-up or termination. A well prepared Startup should, nevertheless, provide for that possibility. Basic exit or termination scenarios include:
Termination by notice will usually involve a right to sell to a third party purchaser subject to a right of pre-emption in favour of the continuing party(ies). Sometimes, it will not be feasible to permit transfer without consent of the other shareholder(s) (this simple formula at least reduces the length of the agreement!); the question then is whether a party should have a right to compel liquidation in certain circumstances;
Termination for cause or as a result of a "trigger event". If the parties agree that a particular event should trigger the right of another party to institute a call option or other termination procedure, the "trigger event" needs to be carefully defined, e.g.
insolvency of a party;
change of control? (inclusion of a change of control provision can be contentious if the Company comprises a significant part of a party's business); material breach? (relevant for a Company where funding commitments are significant); deadlock (see below).
Acceleration of Payment in relation to Convertible Bonds. Convertible Bonds are really loan notes if they have not been converted. If the Company defaulted on its payments, then the investors can accelerate the bonds and demand immediate payments. See below.
8. Convertible Bonds
Convertible bonds allow founders to receive loans from early investors, in exchange for promising to repay those investors with equity (stock) at a later time when equity could be determined. Normally, after a Series A funding round, the investors would convert the bonds into equity after a value is determined at a discount. There are a number of features that distinguish a convertible debt note from an ordinary loan or share.
The convertible holders will be able to convert at a discount to later investors. This is a feature that rewards early investors for taking larger risks. They can obtain shares at a lower price than that paid by Series A investors.
- The conversion cap similarly rewards early investors for their disproportionate risk, but in a different way than the discount. The cap sets the maximum value of a company when Series A closes, again giving an advantage to earlier investors.
Similar to loan notes, convertible debt notes contain an issuance date, interest rate and maturity date. In addition, there is a right to convert to shares at a discount. The convertibles will stay as debts if they are not converted.
The discount and cap are features that offer early investors two different ways to value their original investment. Investor(s) generally has the option to choose between the lower of either the discount or cap conversion.
9. Options
Sometimes the parties will agree at the outset that one party will have a right, at a specified time and usually at a specified price or at a third party valuation, to "put" its shares (i.e. an option to require the other party to buy that party's shares) or a right to "call" for the other party's shares (i.e. an option to acquire that other party's shares in the Company).
10. Right of Pre-emption
It is common for Startups to include contractual provisions whereby, prior to a proposed transfer of shares to a third party, the other shareholder(s) are given a pre-emption right. Points which arise include:
the price may be set by reference to a price which an identified third party purchaser is prepared to pay (the continuing party having a right to match that price - a right of first refusal); or a price proposed by the transferor before it finds a third party purchaser (the continuing party having a right of first offer at that price); or a price determined by a third party valuer (if the latter, it will be important to establish the valuation criteria to be applied
- including whether or not a discount/premium is to apply to reflect the size of the shareholding being sold); if a founder wishes to sell, should it be entitled to "drag along" the investor(s) (i.e. require the investor to sell its shares at the same price per share as that offered by the third party) so that it can deliver the whole Company to the third party?; should the investor(s) have the right to "tag along" or "piggy-back" by requiring that a third party purchaser must extend to the investor(s) the same offer price per share as it is offering to the founder(s)?
11. Deadlock
Startups carry with them an inherent prospect of management deadlock. Schools of thought differ as to the desirability of formal deadlock resolution mechanisms. Some parties require the certainty of outcome, leading to mechanisms such as a casting vote or a role for a third party non-executive `swing' vote. Deadlock can occur at different levels:
- Board level. A management deadlock can arise at board level where the directors appointed by the two founders take opposing views in a 50:50 shareholding or, if there are investor(s), where that investor(s) appointee exercises one of its veto rights.
- Shareholder level. Similarly, deadlock can arise at shareholder level in relation to matters which are withdrawn from the authority of the board of the Company and require shareholder approval and either it is a Startup where the parties have equal voting rights or a minority party has a veto right.
- Inadequate Quorum. Sometimes a deadlock arises because one of the parties refuses to attend meetings (whether at board or shareholder level) and it becomes impossible to conduct the affairs of the Company.
Methods of resolutions:
Casting vote - Giving the chairman a casting vote unlocks deadlock at board level but it does so by giving one party an advantage which negates the concept of joint control. Independent Director - Giving an independent third party a swing vote as an additional non-executive director will unlock deadlock at board level. The attractiveness of this will depend upon whether a suitable person with appropriate business expertise can be found.
Alternate Dispute Resolution - Startup parties sometimes provide for any dispute or deadlock which arises in relation to the Startup to be referred to an independent third party. This could be an expert in the relevant field or an arbitrator or could involve some form of alternative dispute resolution procedure.
Reference to Parties' Chairmen or CEOs - A common formula is for any deadlock/dispute to be escalated to the chairmen/ chief executives of the parties Russian Roulette - allows one party to offer to buy out the shares of the other party at a certain price - but with the other party having the right to decide either to accept and sell its shares or, instead, to buy out the first party's shares at the same price;
Texas Shoot-out - where both parties wish to buy and a sealed bid procedure takes place to determine who is the higher bidder.
Ultimately these mechanisms may not be applied but their uncertain outcomes may act as an incentive for the parties to reach a commercial solution before they are implemented. This will hopefully minimise the inherent continuing damage to the Company of a prolonged deadlock will create.
12. Accounting Policies
Important for the parties may be to establish the accounting principles and policies to be adopted by the Company:
A party should recognize its interest in a jointly controlled entity using either: Proportionate Consolidation
Equity Accounting - associated undertaking with significant influence
Full Consolidation - subsidiary undertaking with control
What reporting information will the parties require from the Company?
What should be the Company's accounting policies and who will be the auditor?
Is it clear what constitutes profits and losses of the Company?
What provisions should apply regarding the distribution of profits and gains of the Company?
What provisions are needed relating to the maintenance of books and records, access to them by the parties and the supply of management accounts or other financial information on a regular basis to the parties?
What provisions are needed for the preparation of annual audited accounts, accounting principles to be applied and the appointment of auditors?
What, if any, services (such as payroll, computers, personnel) will be provided by the parties to the Company?
13. Law, Jurisdiction and Arbitration
The governing law should be established early. Arbitration will often offer the advantage (in addition to greater privacy of proceedings) of more effective enforcement internationally of awards under the New York Convention. Other jurisdictional issues to consider:
Registration requirements? Requirement for local ownership/control?
Local governmental consents/licences required?
Effect of local employment laws?
Taxes: duties on share capital or loan capital? withholding tax on dividends? availability of capital allowances? corporate tax rates? any tax holidays or incentives? import duties on raw materials/goods?
Any capital or currency restrictions? Any restrictions on repatriation of profits and/or payment of dividends?
What rights in land will the Startup parties obtain?
Any special intellectual property rights protection required locally?
14. Due Diligence on Parties and the Transaction
Legal, commercial, tax and financial due diligence on the parties entering into the transaction.
Identify risk areas along with any necessary consents and further ancillary documents will be required as part of the Company. Any material contracts/assets/properties which require third party approval prior to vesting in the Company?
Tax/transfer duty considerations affecting method and timing of contributions.
Method of valuation of contributed assets? Accounting policies to be applied?
Any equalisation payment required as between the parties? Method of calculation and payment?
Any subsequent profit-related adjustment as between the parties?
Warranties and/or indemnities to be given by either party to the Company/other party regarding assets contributed.
15. Due Diligence on Assets
Legal, commercial, tax and financial due diligence investigation into assets/business of the Startup.
Provide details about all hardware, software and equipment owned by the Company. Also provide the annual maintenance contracts or arrangement for all of them. Provide details about the assets owned by the company but currently not in its possession.
Provide details of any stock of goods that are damaged or obsolete.
Provide details of all assets that were acquired and disposed of by the Company in the past five years.
Provide details of all assets that the Company uses but is not its legal or beneficial owner. 6. Provide official copies of any property formerly owned, used or occupied by the Company or real estates which can be a liability for the Company.
Provide official copies of registered titles and documents mentioning the unregistered titles with respect to Company’s real estate ownership.
Provide details of changes in the real estate ownership of the Company or the changes in which the Company used its real estate assets.
Detail any contingent liabilities with respect to any real estate or interest in land (even if not owned by the Company). Include any residual liability on a property formerly owned by the Company.
Provide details of all rent, service charge or any other monetary sum paid by the Company in terms of lease or license pertaining to any real estate asset owned or used by the Company.
Provide details of any or all permission or planning notices given or received by the Company with regards to its properties.
16. Due Diligence on Financials and Liabilities
Legal, commercial, tax and financial due diligence investigation into the financials and liabilities of the Startup.
Provide names and contact details of Company's bankers
Provide details of all accounts held by Company along with the current overdraft or any borrowing.
Provide details about Company’s debt securities along with mortgages and any property belonging to the Company that has been used as a Collateral. Include copies of all relevant certificates.
Provide details of any loans given to the Company by any third-party including loans given by any person or entity associated with Directors or Shareholders of the Company.
Provide copies of budgets, financial forecasts for the last five financial years.
Provide copies of any grants received or applied by the Company in the past five years. Also include details about whether the Company has to make any future payments for the received grants.
Provide copies of all credit sales, hire purchase agreements, leasing and/or rental contracts.
Provide details of any off-balance sheet commitments of the Company.
Provide details of any guarantees, indemnities or sureties given in favor of the
Company. Provide details of all distributions paid and declared by the Company since the date of last accounting audit.
Provide details about the capital commitments and capital expenditure. Provide details of the Company’s debt schedule.
17. Competition Issues, Regularity consents and Licences
Will the Startup result in a significant market share in any particular market or jurisdiction? Will there be any issue with Competition Laws/ merger control? Consider the following:
Are any industry-specific regulatory approvals required? Identify whether any regulatory or other consents (e.g. Bank or Regulatory) or licences are required.
Any tax clearances, third-party consents or registration formalities required to establish the Company or to enable the parties to participate in it?
Any major supply contracts, client engagement arrangements and the ability to transfer these.
Make provision for co-operation between parties in the event of subsequent regulatory action?
Any concern that the Startup (eg. crowdfunding or P2P lending) might be a collective investment scheme under the relevant financial regulations?
Are regulatory approvals required in any foreign jurisdictions? Should any such approvals be made conditions precedent of the Company?
18. Tax
Tax considerations may play a major part in structuring the Startup and varies greatly across different jurisdictions (consider seeking local tax advice):
Any Capital Gain Tax on the establishment of the Startup?
Need to transfer tax losses?
Stamp duty/transfer taxes cost?
Is ongoing consortium or group relief required?
For cross-border Startup, consider the structure in light of: need for efficient repatriation of profits? controlled foreign company rules? thin capitalisation? transfer pricing?
Identify clearances to be obtained; will any be conditions precedent of completion/ establishment of the Startup?
19. Employment
Employment issues should also be considered:
Is there a restructuring and a transfer of employees? If so, does the employee who works in the undertaking that is the subject of the transfer will have additional legal rights? Would a dismissal connected to the transfer attract liability for unfair dismissal?
Will it be necessary to harmonise employment terms and conditions?
Will employees be seconded to the Company - or employed by the Company? If so, on what terms? How will terms be aligned across employees from various employers? Are there existing share option or other incentive arrangements? How will they be affected?
Are employees members of an existing pension scheme? Will there be a need for a new Company scheme?
Will service contracts be required for key employees?
Are secondment letters or new service contracts required?
The following employment documents should be obtained for the purpose of due diligence:
Provide an organizational chart and list of all employees. Include part time employees and employees in overseas offices.
Provide copies of all job contracts and contact details of all employees. Also include details about any increase in bonus/remuneration/pension benefit provided.
Provide a list along with contact details of all contractors, consultants, agents that work for the Company. Also detail their remuneration and provide a copy of their contract agreement.
Have there been any disciplinary actions taken against any employee? If yes, provide details.
Are the employees of the Company part of any trade union, staff association or any worker’s representation body? If yes, provide details including copies of agreements or arrangements.
Provide copies of all contracts/agreements signed with agents and state whether there has been any change in the terms of the contract or agreement.
Provide a copy of the standard form of contract used by the Company and a copy of the disciplinary rules or procedures used by the Company.
Provide details along with copies of any employee stock option plans, profit sharing plans, bonus, commission or any other benefit the Company is providing to its Directors as well as employees.
Provide details of all perks/benefits the Company will provide to its employees such as company car, life insurance and health insurance.
Provide details of any loans or guarantees made by the Company for or on behalf of any of its employees.
Provide details about any compensation payment or any redundancy payment the Company made or has the provision to make to its former employees or the next kin/ dependent of former employees. Disclose details of payments made in such a case in the past twelve months.
Provide details of any agreements with the Directors or employees of the Company where they get paid for losing their job in the event of the Company getting acquired.
Provide details of any former employee whose termination or resignation led the Company to lose any customer/supplier contracts or led to a decrease in revenue. Specify the circumstances of the termination/resignation and state whether the former employee has now joined a competitor firm.
Provide details of all offers of employment currently sent out by the Company which are accepted/not yet accepted.
Provide details of all notices of termination given by the Company to its employees/ contractors/consultants.
Provide details of any employment disputes the Company currently has or had in the past twelve months involving the Directors or senior management of the Company.
20. Intellectual Property
Key Intellectual Property issues are:
What brand will the Company trade under? Will trademarks of the parents be licensed to the Company for its use - including in its name/logo? How will existing IP/brands be protected?
Is it preferable to vest ownership in the Company - or to license?
Will material technology be provided by the parties to the Company? Is it protected by Intellectual Property Rights?
Will the parties need ongoing access to, or rights over, confidential information, knowhow and other intellectual property rights concerning or accruing or belonging to the Company itself?
Is technology predominantly in the field of the Company - or is it used in the separate operations of the parties? Is there a risk that such information can flow from the Company into competing or potentially competing parts of the parties‟ other business? Need to consider the position of rights to IPR in the event of termination.
21. Information Technology
Which Information Technology systems will operate in the Company? Consider:
Which systems will transfer
Regulatory constraints on access
Support arrangements
Maintenance
Protection of data
Ownership of systems and data created
Major IT supply contracts – ability to use existing arrangements of the parties or will new contracts be needed? What will the consequences be?
Will there be any need for information to be in formats that can be “read” and integrated into existing party systems – consider data protection issues.
Any cross-border transfer of data? Any customers in the EU? Consider GDPR.
The following information technology documents should be obtained for due diligence:
Provide details of all computer software and hardware used by the Company. Include details about software licenses or mention the owner of the software.
Provide details of information backup and security in the event of a system shutdown. Also include details of the disaster recovery.
Provide copies of all licenses and equipment owned by the Company with respect to the hardware and software used by the Company.
Provide a copy of all software and hardware maintenance contracts signed by the Company.
Does the Company have any copyright of any software that it uses. If yes, provide details.
6. Provide details of any Copyright owned by the Company in its websites.
Provide details of any source code, software developed or owned by the Company and the date of its creation.
Describe the circumstances in which the Company might lose its access to its softwares or hardwares.
Provide details (if any) of any past dispute or ongoing dispute with respect to the usage of the Company’s IT infrastructure with any third-party.
Provide details of domain names registered in the name of the Company including details of the email provider used by the Company. Include copies of agreements pertaining to hosting, maintenance and operation of websites.
22. Data Protection
Has the Company carried out any processing of personal data according to the relevant data protection laws applicable to the Company? If yes, provide copies of data protection notification certificates.
Does the Company use any data pertaining to any minors?
Is the Company compliant with the latest data protection acts?
Does the Company employ any third-party to process personal data? If yes, provide copies of contracts with such third-parties and show whether the contract is compliant with the applicable data protection acts.
23. Compliance Information
Describe the events, acts or circumstances or omissions that might make the Company non-compliant with any law, regulation pertaining to health and safety of workers, environment or asset that the company uses.
Provide a confirmation along with copies of registration of the Company as per the relevant Companies Registration Act of the country in which the Company is registered. Confirm that no officer or employee has ever failed to perform any statutory duty with respect to the Company.
Are there any disputes or potential disputes with existing employees, customers, suppliers? If yes, provide details of past disputes along with the remedial action taken by the Company.
Provide details of any pending, actual or threatened litigation, arbitration or an assertion on the Company that any of its employees or the Company itself is non-compliant to any of the laws or regulations it is subject to. Include details of any such incidents in the past along with the remedial action.
Provide details about any judgements that can affect either the Company or its assets.
24. Regulatory Information
Provide details about all regulatory bodies the Company is subject to.
Describe the situations where any of the Company’s permits or licenses can be suspended, revoked or not renewed.
Provide copies of all licenses, approvals, permits, certificates, authorizations, any application of registration or declarations obtained by the Company or applied by the Company (even the ones the Company applied but didn’t obtain).
Provide details along with copies of any relevant documents about any non-compliance condition pertaining to permit. Include details about any failure of the Company to remedy a non-compliance action.
25. Insurance Information
Provide copies of all insurance policies take for or out by the Company and receipts of all paid premiums.
Provide a history of any claim made on any insurance policy or any outstanding claims.
Provide details of any withdrawal or refusal of insurance cover in the past five years. Describe the situations where a claim under an insurance policy can be made in the next twelve months about which the insurer is not notified about.
