Due Diligence: Everything you need to know about this practice to raise money
How can this tool help you to close an investment round for your startup?
If you are an experienced entrepreneur who is in search of venture capital for amounts greater than one million dollars, such as the rounds that Softbank will offer for startups located in Latin America, you have to know how the Due Diligence process that the fund will carry out works. venture capital before granting financing to your company.
In general, this process is carried out before the interested parties carry out a transaction or business relationship and can make informed decisions, such as investing in a startup.
For this type of advanced investment rounds, from Series A onwards, the Due Diligence process is extremely important due to the types of investors and the amounts of capital to be invested. On some occasions the funds come to request it, even when they invest with SAFE's (simple agreement for the acquisition of shares in the future for its acronym in English).
“Due Diligence is an audit process that is normally carried out between private parties. This has the purpose of informing one of the parties about the current state of the company in different aspects: legal, accounting, financial, commercial and others. If an entrepreneur wants to participate in an investment round, he must know how they work and be prepared to face it ", says Víctor Aguirre López, founding partner of the firm BlackBox Startup Law , specialized in providing legal advice to startups in Mexico.
Due diligence step by step and cost
For the Series A investment rounds onwards, these processes focus mainly on financial, accounting and legal issues. The first two areas are well known to entrepreneurs; however, the legal aspect is often a problem due to its specificity and the breadth of topics it covers.
According to the BlackBox specialist in legal Due Diligence , beyond the financial and accounting health of the company, corporate issues are addressed, such as the structure, the company's corporate books, labor contracts, civil lawsuits or the tax situation of the company.
Some peripheral issues are also considered, such as the analysis of the company's occupational risk (and social security), the status of intellectual property in terms of trademarks, patents and copyrights, as well as the company's environmental impact and its legal responsibility. .
This disclosure must be accompanied by the signing of a confidentiality agreement between the parties to protect the entrepreneur when sharing sensitive company information.
The lead investor is in charge of requesting and contracting the law firm in charge of carrying out the Due Diligence . The firm, in addition to reviewing all the documentation provided, will also inquire into various public records in order to detect factors that may compromise or modify the transaction.
This process can take from two to six weeks, depending on the complexity of the case and is held in parallel with the negotiations between the entrepreneur and the lead investor.
The cost of this kind of Due Diligence (financial, accounting and legal) is variable. It can range from a fixed amount (approximately $ 20,000) to a percentage of the value of the transaction, depending on the case.
What can delay the closing of an investment round?
The objective of Due Diligence is to find information that may represent a risk for the startup itself (and its operating model) and consequently for investors. Therefore, entrepreneurs are generally asked to solve the problems identified before the end of the investment round. According to BlackBox Startup Law , the nine most common issues that are typically identified are the following:
- Not keeping the corporate books updated.
- Not having the titles of the shares issued.
- Not having notified the SAT or the competent authority on foreign investment of capital increases or having reported it improperly.
- Not being the proper owner of the domain ( domain name ) or internet domains used by the startup.
- Not having the trademark registered, having it registered in an inappropriate class.
- Not having registered industrial property (patents and industrial designs) or copyrights (specifically programs and software) that prove the ownership of the intellectual property by the startup.
- Not having a clause for the transfer of intellectual property rights in the respective employment contracts, both for co-founders and employees.
- Using outsourcing services incorrectly, that is, with companies that are not registered in the REPSE.
- Failure to properly keep the accounting, nor the withholdings applicable to employees for Income Tax and employer employee fees.
In this sense, these are seven keys that BlackBox Startup Law shares to be successful in Due Diligence :
- Before the Due Diligence , a legal checkup must be carried out with a specialized law firm that helps the entrepreneur to make the necessary modifications and improvements to comply with the legal requirements of investors.
- Carry out a correct control, update and maintenance of the corporate books before, during and after the Due Diligence has been carried out: mainly having the books of changes in capital and shares updated and the respective titles of shares issued.
- Notify the SAT, in a timely and correct manner, about a capital increase in the startup, as well as the competent authorities in the case of foreign investments.
- Acquire by the main founder all internet domains used by the startup.
- Start or conclude with the trademark, patent, industrial design and copyright application procedures.
- Modify the labor contracts that are necessary and include a clause for the transfer of intellectual property rights in favor of the startup, mainly for all those co-founders or employees who develop intellectual property of the product or service.
- Temporarily suspend the outsourcing services that are being used and preferably hire all staff directly.