This article is written by Akansha Srivastava. This article has been edited by Ruchika Mohapatra (Associate, Lawsikho). 

This article has been published by Sneha Mahawar.

Introduction

The start-up industry has seen a boom in 2021. Several startups have come up with proposals and funding requirements, and we have seen venture capitalists like Accel and Sequoia invest in these businesses. The process of due diligence is a very crucial step in  Venture Capital financing as it determines the prediction regarding the success or failure of the investment. The Investor always makes sure that it conducts sufficient verification before making a final investment decision. The venture capital firm always wants to invest in a company that has a good future and will sustain future competition. Venture capital is the capital invested by a wealthy investor and the investor gets benefits from the same in different forms like equity shares, conditional loans, etc.; all of which will be discussed further. There are various steps involved in the process of raising venture capital financing and due diligence is one of the steps. There are various steps involved in the process of due diligence such as Screening Due Diligence and Business Due Diligence. There are various areas of due diligence such as management team, product, legal, etc. we will discuss legal due diligence in detail and the role of legal counsels in the legal due diligence in the article. 

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What is venture capital

Wealthy people invest their money into businesses and those businesses return a profit to those investors.  The capital that such investors invest is known as Venture Capital. Such investors are known as Venture Capitalists. Such investors invest in the business which they believe in and find to be capable of growing and making profits in the future. Some Venture Capital firms are Sequoia Capital, Accel, Blume Venture, etc. 

Methods of venture capital financing

Equity financing

A new company is not capable enough to return the money to investors on time as it is still at the stage of a growing startup. Thus, they take money from the investors via equity financing through which they give a certain percentage of the equity to the investors, which cannot be more than 49% of the total stake. Thus, the company manages to retain its ultimate power and get finance from investors in return for the equity shares of the company itself. This is the most used method in Venture Capital financing. 

Conditional loan

They are different from bank loans. There is no fixed rate of interest attached to these loans. There is no predetermined schedule for payment. When the venture capital undertaking starts making revenue, they repay the finance provided by the investor in terms of royalty, which varies from 2% to 15%.

Income note 

Venture Capital firm gets payment in terms of both royalties as well as interest as it combines the features of both traditional and conditional loans.

Participating debentures

The firm pays the interest to the investor firm on distinct rates for different stages of its operations. The interest is nil before the commencement of business, low-interest rate after the commencement, and higher interest rate after a particular level of operations. 

Convertible loans

A time is fixed for payment of interest on the loan and in case it is not paid within that stipulated time, the loan gets converted into equity shares method in which the investor is given a certain percentage of equity in the Venture Capital Undertaking. 

Process of raising a venture capital financing

The process of getting funds from a start-up is very complex. There are various steps involved in the process of financing which is discussed below:

Term sheet 

It is a technical document that is not always binding but acts as a guideline to be followed by both startups and investors. They do have certain clauses like exclusivity and confidentiality which are binding as they are a very crucial element of any deal.

Due diligence 

Before going to the next step of entering into a definitive agreement, the company does prior research to analyze the risk involved in such investment and growth expected from the company. There are various steps involved in this which we will discuss in the next part of the article.

Definite agreement 

It is binding in nature and it can be explained as an elaborate form of the term sheet. It contains the detailed mechanism for the implementation of the terms made in the term sheet. 

Condition precedent

It contains the key items which need to be fulfilled before the investors wire the amount into the company’s account. 

Closing

This is called the last stage of the transaction in which the amount of investment is wired and the certificate of confirmation regarding condition precedent is given to the investor. 

Post-closing

It is an internal process of the company where the meeting is held and various compliances of RBI are completed by them. 

What is due diligence

Due diligence is a precautionary measure taken by the investors before deciding to invest in a particular startup or business. They conduct detailed research to evaluate the risk involved in such investment and understand the prospects of the company. Any investor would prefer to invest in a company in which risk is minimum and profit is maximum because the ultimate purpose of an investor is to make money. To prevent loss incurred due to the failure of startups, investors conduct a prior evaluation of the potential of such occurrences. 

Process of due diligence

This process is conducted by the investors before moving forward to other stages of valuation and deal structure. There are two types of due diligence i.e. Screening Due Diligence and Business Due Diligence. 

Screening due diligence 

There are certain criteria of investors which need to be fulfilled to proceed with the funding process. Screening of business proposals is done on the prior stage if the business meets the criteria of the investor. All the investor firms have a different approach toward the screening process criterion for investment. It is subjective. They look into the factors discussed below:

Investment fit 

There are various factors involved that help to determine if an investor would want to invest in the business or not. Such factors include the Stage of the business, geography location, Size of the business, and the sector of the industry. It depends on the philosophy of the investment firm. There are two types of investors:  Generalists and Specialists. Generalists invest in various sectors in different geographical locations and different stages of operation while the specialists have certain specified one or two sectors in which they prefer to invest. Specialists prefer to invest in a business at a particular location as it helps them to easily manage the investment and take part in the strategic decision-making of the business. 

Investment potential 

The investors check the viability of the deal they are making. There are several factors with the help of which the investor decides if they will invest in a particular business or not which are as follow:

  • Management 
  • Market
  • Product/Service
  • Business Model

Business due diligence 

The investor makes a verification about the potential of the deal. The factors which are investigated during initial screening are looked into in-depth at this stage. The investors check if the business has the potential of surviving by investigating in depth. They conduct research in detail. They look into the market, product, team, and business model. 

Management 

The management team must be capable enough to survive in the competition and changing environment. They look into the questions like:

  • Who are the founders and their backgrounds?
  • Their previous track record and experience?
  • How good are they in evaluating risk and survival?
  • How much capacity do they have and sustained effort?

Market

They look into the kind of market the business is going to target and how effective a plan they have as mapping out the competitive landscape is essential for the development with minimum competitive threats. They look into the questions like:

  • Who are the people that are going to use the product/service?
  • What are the existing boundaries in the market?
  • What is the existing competition?
  • What are the regulatory measures of the market space?

Product/Service

The product must deliver some additional value to the user and possess a sustainable differentiation. . Technological advancement and excellent user experience are required to sustain in the market. They look into questions like:

  • What problem will be solved by the product/Service?
  • What are regulations related to Intellectual property protection for that particular product?
  • How is the technology creating additional value for the customer?
  • Why is the product superior to the existing competition in the market?

Business Model

The investor will check if the company has the required potential for high gross margins and potential for recurring revenue streams. They will look into questions like:

  • Whether the business model is scalable or not?
  • What are the margins anticipated by the company?
  • How will the company sell its product/service?
  • What is the exit strategy of the company and whether it is feasible or not?

Area of due diligence

There are various aspects of a company responsible for success or failure and thus due diligence is required in all such areas which will be discussed below:

Management team 

At the early stage of a startup, investors make sure that the team of the startup is good as the future of the startup depends upon that. There are various significant factors such as the track record of the members, their credentials, and experience which indicates to the investor if the management team is worth investing in or not. 

Market 

They check the type of market in which the startup is going to work in. They check if the market is large or small, growing or still, etc. 

Product 

They look into the product or service that the startup is going to offer as it should have the potential to survive in the current competitive market. The product must be differentiated from the other similar products already available in the market. The differentiation must also be sustainable which means that even if the product is copied by others in the future, the company can provide some uniqueness which may be due to exceptional user experience or another technological advancement. 

Traction 

It is the measurement of the progress of the company. The investors measure how far the company has progressed so that they can decide if the company has such potential for growth or not. It also helps them to decide how much the product is mature in the development cycle of the product or service. 

Legal 

Both investors and the owner of the company want to get more power in the company in matters of right to take business decisions. Thus due diligence in legal terms is necessary to evaluate the investment’s legal worthiness with the matter of control. A rigorous investigation is required into the legal aspects of the company to identify if there exist any outstanding liabilities and legal claim against the company as such aspects helps the investor to make a wise decision as to whether to invest or not in the company. 

Financials 

The investors need to investigate the financial metrics of the company to evaluate the worthiness of the deal. They look into the current revenue, revenue growth rate, type of revenue, free cash flow, product margin, etc. 

Process of legal due diligence and the role of legal counsels in the process

The company informs the legal aspect of the company to the investor but the investor must verify those legal terms and confirm the same before making any investment decision. They make sure that the contracts of the company are matching with the information provided to them at the earlier stage. They look into the outstanding liabilities of the company and check if any competing claims exist to the company. It is generally done by the investor’s legal team but in cases where the legal aspects are complex, a third-party law firm is hired for conducting the process of legal due diligence. 

Legal Counsels are also appointed by the companies and startups to anticipate issues that might arise later and guide them in the correct direction. They help the companies to ensure that such terms are made with the investor so that the power of the owner is retained in his hand. Common Legal Issue that arises in due diligence in the legal area is related to certain agreements and documents which are mentioned below:

  • The start-ups must have Service agreements, Employment Agreements, or Manager Agreements.
  • Transfer of full ownership of the Intellectual Property under the Intellectual Property transfer agreements and they  must not be restrained as to how the IP can be used in a case such a loophole exists, the agreement gets renegotiated which is time-consuming in the process of due diligence
  • The structure of the company must not be complicated. This refers to a situation in which a founder sets up different companies and merges them with other companies. In such cases, they must provide an overview chart and information like a financial statement to make the process of due diligence convenient for the Investor company. 
  • Negotiation relating to the shareholder agreement between investor and startup company. 

Conclusion

Venture capital requires the process of due diligence so that investors can minimize the risk that is generally very high when an investor invests in a company especially when the company is at the seed stage. Legal due diligence is very important to make sure that the company is complying with all the compliances that are required by the agreement between them and the company has terms that are beneficial for them and they have some power and control in the decision making of the business. They try to acquire such power to ensure that the business in which they are investing grows and provides them with certain benefits.  All the investors want is profit and power and they want to avoid any loss and failure. 

References

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