If your startup company receives a legitimate offer from a qualified investor in an email to make an investment in the startup company, what happens next? My following answer can cover situations that might originate by the due diligence request by an investor from an initial round of investment, developed in the process of a M&A or even the preliminary preparation for an IPO. The analogy is not much different from buying a house — you make an offer, then prior to closing on the real estate, you follow with steps to due diligence: who really owns the house, any history regarding repairs, damages, etc.
First, comes the “Term Sheet” that will articulate further the investment framework. It will include phrases that restricts you to shop around for other potential investors and allow the investor access for the materials required for due diligence on the company. And this sheet comes with a deadline, between 30 to 60 days. The term sheet is the prelude for an army of lawyers and accountants to look into your company’s legitimacy of its business process statements and existence.
Second, lawyers will ask in a standard document various pieces of paperwork regarding the company, its clients, and service providers — in order to determine the legitimacy of the statements made to the investor regarding the company. The initial document relates to the company’s existence — where was it incorporated, its corporate books, and current verification of its “good standing.” Actually, I had a client who did not a have company, and the term sheet included wording that the founder had to create that company within a specific time frame prior to releasing the funds and a corporate bank account. As the investor was located in Massachusetts, we incorporated in that state to expedite the funding. And then one orders a stamped, official copy of the articles of incorporation. Copies will not do.
Then corporate wording has to be prepared to show the purchase of the equity (if the investor is going directly to control the company.) The lawyers know now the quantity of outstanding shares out there. If the investor puts in $1.5 million for half of the company, the new valuation is $3 million. And, if the shares outstanding are 1,000, then the investor receives 500 with each share valued at $3,000 per share. The corporate minutes have to reflect the value of the shares to the company, and who has acquired those shares. And where appropriate, the corporate paperwork must be prepared to show whether the investor is also a member of the board. All of the corporate documentation must be drafted and executed by the company’s officers and directors.
But that is part of the due diligence process. If the company has ongoing operations, there can be office leases, employment agreements, customer contracts, insurance premiums, other accords and/or any other documentation evidencing relationships with clients, partners and landlords – to prove that your source of revenues and expenses. And if there is advertising or promotion, those collaterals must be delivered to the investor. In other words, your claims as to the company’s operations must be validated by paperwork. Those documents must be copied and delivered to the investor’s counsel. (And, by the way, at closing date, the company must pay the investor’s counsel its legal fees. The company must be aware at all times that the legal fee meter is running for opposing counsel’s time.)
The investor’s other team to knock on your door will be the accountants. They will ask for the company’s financial history, bank accounts, balance sheets, and audited reports. They review and, if necessary, organize the numbers to be within the GAAP accounting standards for the investor’s investment team. For any minor discrepancies, the accountants will make the adjustments. On the other, if the accountants identify major variances, the investor will be wary.
How seriously are the documents inspected by the investor? I have witnessed one leveraged buyout investor take the set of company’s documents, insert them in large black binders, place dividers and labels on each set of documents, and make several copies for his team – one box full of documents then becomes 5 boxes. In other words, the more documents you deliver to the investor, the higher you raise your confidence level in his eyes. And organization is key. If the company’s filing system is a disaster, it will slow down the due diligence. And remember, not until the check clears does the final closing becomes a reality. At any point during due diligence, the investor can walk away for whatever reason. One San Francisco entrepreneur related to me that his $ 1 million investor pulled out on the day of closing, claiming that he announced that he was getting divorced. So the faster one expedites the due diligence process, fewer problems will surface prior to closing. Anything can go wrong during due diligence. Again, think of what it takes to buy a house, and consider that the closing of an investment undergoes similar processes.