On the Importance of Internal Due Diligence Before Approaching Investors

Doron Afik, Esq.
September 16, 2015

Almost as in the oldest and most basic love story plots: company meets investor, Company and investor sign a termsheet, investor commences due diligence review of the company (review of the legal and accounting documents and other issues), investor informs the Company that material issues were revealed in the DD process and "we need to talk ..."

One of the issues that starting companies encounter upon raising capital is the non-readiness of the company for the investor. When contact is made with a potential investor and the investor receives information from the company, the company's non-readiness can prevent an investor from proceeding with the investment or reduce the planned transaction target price. The company will usually not even know that the non-readiness is what caused the consequences, because only seldom will the investor, who sees many transactions every month, have the managerial time to give the company its comments (and if the investor wishes to consider investing despite the issues raised, the investor has no interest to have the company correct the issues as such corrections will raise the transaction price). At the stage in which the investor raises the issues discovered the company may already be in a cashflow distress and will be forced to agree to all the terms of the investor.

Many companies at their early-stage (but not only) are acting without on-going legal advice or with legal advice of attorneys who do not specialize in mergers and acquisitions. What reason would a company like that have for not getting prepared for an investment? No logical reason for it, but many companies prefer to save on the costs of legal preparation for an investments by attorneys specializing in mergers and acquisitions due to lack of comprehension of the fact that a relatively small investment at the early stage (and usually a company can reach an agreement with the lawyer that most of the payment will be postponed until after the closing of an investment) may produce value to the company.

In light of the above, it is recommended for a company seeking investment to carry out an internal review and a comprehensive overhaul of the legal framework in what is known in the professional jargon as an "offering preparation." This procedure includes review of all legal documents of the company and its other materials, all from a perspective of a prospective investor. Among others, the mergers and acquisitions attorney will review the corporate constitutive documents, labor agreements, all documents relating to intellectual property, material agreements with suppliers and clients, obligations towards third parties and other issues. It is recommended to integrate in such review also an examination of the company's marketing documents by an expert in such matters. This attorney can of 'course comment on documents that are lacking or missing and should be created or other issues that need attending to. Such mergers and acquisitions attorney can also assist in the correcting of the issues discovered.

It is important that not only will this review be carried out by an attorney with experience in mergers and acquisitions, but also that if other professional are involved, they will all be reporting to such attorney to ensure the existence of the attorney-client privilege. The attorney will later be able to assist the company in negotiations with potential investors, utilizing the knowledge collected in the internal review.