Immediately after signing the LoI (term sheet), your startup will receive a request for a substantial list of documents and information that the company wants to see. So begins the due diligence process.
This stage can often feel onerous, but it is important for founders to understand how necessary it is. Fundamentally, if one company wants to buy another, the purchasing company needs to know what it is buying. Note that phrasing — it needs to know.
A company cannot spend millions of dollars to acquire a startup without having a very clear understanding of what it is getting in return.
The due diligence request will take the form of a list with up to two hundred separate information requests. Don’t balk at this. Companies tend to use a standard form, so a five-person startup will receive the same list of requests that a hundred-person company does and many items can simply be marked “Not Applicable”.
At a high level, the requests will be grouped into Legal, Financial, and Technical sections with personnel or HR matters being included in one or all of those groups. The company will provide a link to a virtual “data room” that the startup can use to share the necessary documents.
Founders should be aware that responding to all these requests will require no small amount of effort.
For a start, founders need to be sure that signed copies of the required documents actually exist. While this might seem obvious, the consequences of sloppy paperwork, taking shortcuts, or failing to chase up signatures will now become painfully apparent. The documents then need to be located and scanned or otherwise converted into a format that can be easily shared.
I strongly recommend that the founders dedicate the most business-orientated member of their team to this task. Alternatively, this is a good time to think about tagging in some help from someone else they trust with good business acumen — perhaps an investor, board member, or advisor.
When it comes to legal diligence, the company needs all the formal documentation associated with the startup. This includes the company incorporation documents, employee agreements, intellectual property (IP) assignment or licensing agreements, customer agreements, supplier agreements, and leases.
Typically, the legal items that get particular interest are the employee agreements, anything associated with IP assignment or licensing, and customer agreements. The company needs to understand who its employees are (and were) and whether or not they explicitly assigned the IP of the work they created to the company.
The company is trying to determine whether or not the startup legally owns all the relevant IP. Presumably (other than the team), this is the key asset that is being acquired. If the employees haven’t already signed IP agreements, this leaves the actual ownership of the IP in question.
If this is the case, the company will ask the startup to chase up all their old employees and contractors and ask them to sign a retroactive IP assignment form. This is an unpleasant chore, and one every startup should take steps to avoid.
The customer agreements are also of particular interest. Assuming that the signed contracts exist and can be produced, the next problem is that all too often, large enterprise customers make startups accept amendments to their “standard” contracts. Startups often have no option other than to accept these amendments, even if they seem over-reaching.
This can be problematic for the company, especially if the amendments include clauses like “unlimited liability,” “unlimited licenses,” or agreeing to a level of service that the acquiring company can’t commit to.
The good news is that if there are any troublesome contracts, usually they can be re-negotiated or terminated before the deal closes.
On the financial side, the company will need to know how much cash is on hand and the bank accounts’ current state. They will want to understand how much money is scheduled to come in (the receivables) and how much is scheduled to go out (the payables).
They also need to learn what these numbers have been historically and how predictable or consistent they usually are. The startup’s capital structure (i.e., the cap table) is also important to understand. Who owns how much equity, and which shareholders will the startup require formal approval from before the deal can be completed?
The tax situation is an area of interest as well. Startups are notorious for taking their eye off the ball for what is due and when. Commonly, they will not have taken advantage of all of the discounts or itemizations that are available and that a larger company might utilize.
The company will also want to understand the startup’s financial processes. Who on the team has access to the startup’s bank accounts? Who has a company credit card? What precautions are in place to ensure that fraud doesn’t occur?
On the technical side, one of the core activities will be for the company to make sure that they understand the startup’s product and its architecture. What does the product do? What does it not do? What technical choices have the founders made, and why?
This part of the process can be a source of concern for the startup. Founders can feel like they are exposing their core asset — opening the kimono, as it were. It must be remembered that this is a necessary step.
The company cannot acquire the startup without fully understanding the product they’re acquiring and how it works.
So, this is something that ultimately, the startup founders are going to have to get comfortable with. The risk taken by showing the company what the startup has done and how they have done it tends to be overestimated. Unless the startup has some secret algorithm, then a couple of senior engineers could probably make a pretty close guess on how to recreate the product.
More importantly, before starting this stage of the process, you should know (or at least be able to find out) what type of reputation the company has. A simple google search should reveal if any other startups feel like their IP was “plundered” during an aborted acquisition process.
This can happen, but it is extremely rare. If a company were to do this, then no other startup would want to engage in a deal process with them, so they would lose the ability to grow via acquisition. So frankly, for larger companies, it’s just not worth the effort nor the bad press.
The due diligence process can normally be completed in two to four weeks. One of the things startups can and should do in advance is to have good housekeeping. At the very least, founders should make sure all formal documents actually get signed before being scanned, sorted, and stored.
Just doing that will change this process from the world’s most un-fun scavenger hunt to a simple drag-and-drop exercise to whatever secure box/Dropbox folders the company is using for their data room.
Insofar as it is possible, founders also need to do everything they can to maintain momentum in their startup’s core business during this time.
I know this might be hard and they’ll likely feel pulled in different directions, but due diligence is a key stage, and it is one where many deals fall apart.
If this happens, it is a lot better if it is an inconvenience. A bump in the road. A learning experience for the founding team. Not something that arrests the startup’s momentum and potentially causes an existence-threatening disruption.
Click here to see the previous blog in this series, which brings some much-needed transparency to the M&A process for startup founders.
If an acquisition is a potential exit for your company, you should check out my book — “How to stick the landing: The M&A handbook for startups.”
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