Consequences of the startup prior to the entry of an investor

The arrival of investors in a startup usually involves a due diligence process, something for which the founders of the business must be prepared. In order to successfully complete this process, it is important that, from the moment the startup is formed, the founders are diligent in complying with all legal obligations and are well advised in this regard.

One of the experiences that any startup whose product generates interest will go through is the entry of an investor, of whatever nature (venture capital funds, family offices, investor groups, large companies, business angels, etc.). The common denominator among all these investors is that they are willing to assume a higher business risk than they would assume if they invested in a company with a consolidated track record. However, as in other types of investments, they are not willing to take certain risks or contingencies of the startup that are not visible to the “naked eye”, but that can be detected prior to the investment.

To detect these possible contingencies, investors, with the help of their advisors, start a review process of different areas of the startup in which they suspect that these risks could be “hidden”: legal, technical areas, etc. This process is called due diligence.

In this article we will focus on legal due diligence, although many of the notes I will address could be perfectly extrapolated to other types of due diligence.

Due diligence is carried out prior to the execution of the investment, within the period of negotiations between the parties, once the investor has already offered the founders (in a non-binding manner in most cases) the economic terms and conditions under which he is willing to make the investment, provided, of course, that the due diligence results in a satisfactory outcome for him.

To begin this process, the investor (or his advisors) sends the startup founders a more or less extensive list of the documentation and information they need to be provided for review. From that moment on, the startup founders embark on the thankless task of searching for papers and answering all the questions the investor asks them. Logically, the provision of all this information will have to be covered by a confidentiality agreement that the parties will have signed for this purpose.

It is very common for founders, before due diligence begins, to think that the process will be quick, so that the startup will soon receive the funding it needs from the investor, and that no significant risk will be revealed because they are convinced that they have done things right. And in many cases this is the case, but the truth is that at this point they may encounter surprises that could compromise the investment.

Firstly, the odious delays in the due diligence process. In most cases they are not so much due to the fact that the investor takes a long time to review the documentation, since his intention will also be to finish this work as soon as possible, nor are they usually due to the fact that there is a large volume of documentation to review, since the startup has not yet had many years of life in which, for example, it has signed numerous contracts with third parties that need to be reviewed. Rather, the speed of the process will depend to a large extent on the immediacy with which the founders can provide the investor with all the documentation requested and the solvency with which they can answer the questions asked. Therefore, it is essential that the founders, from the beginning of their corporate journey, are very diligent in knowing all the legal circumstances surrounding the startup and, of course, in the proper conservation of all the legal documentation related to the company, since it could depend on this that a future investment comes to fruition and at the time it is needed.

In addition, we cannot ignore the fact that throughout this process, as well as in the negotiations between the parties, the founders are projecting a business image to the potential investor that is providing information about their way of doing things, and there is no doubt that this can mark the relationship that will be established between the founders and the investor once the latter becomes part of the startup.

Secondly, let us start from the premise that it is very common for due diligence to detect risks or contingencies, of greater or lesser relevance, that the founders perhaps (surely) did not even suspect. Surely the founders will have had the will to do things right, and in many cases they will have done so, but in other cases they may have lacked advice and, through sheer ignorance, the startup may have incurred in certain risks that could have been avoided with proper advice.

And the detection of risks in the due diligence, unless they are risks that can be eliminated or mitigated before the execution of the investment or they are risks that are not very significant, will have consequences on the economic conditions of the investment. These consequences can be varied and depend on many factors, but they can be grouped as follows:

• If these are risks that are about to materialize or there are more than reasonable indications to believe that this will be the case and, therefore, that an effective loss will be generated in the company after the entry of the investor:
  
  • The investor could propose a price reduction, i.e., to take the same equity stake in the startup that was proposed, but investing a lower amount than initially offered.
  • The investor could propose that an indemnity commitment be included in the investment agreement, so that when the contingency detected materializes, already after its entry into the startup, the founders must indemnify the investor for the full amount of the loss that the latter has suffered in this respect in its capacity as a partner of the startup. However, this type of clause, which is very common in traditional investment agreements, tends to be more difficult to fit into the startup investment environment, since the founders often do not have the necessary liquidity to meet such an indemnification obligation, if necessary.
  • That the investment is not finally carried out because, due to the nature of the contingency detected, it has lost its economic sense for both parties.
• In the case of possible risks, which may or may not materialize in the future, and whose amount does not frustrate the economic sense of the operation, it is usual for the parties to regulate in the investment agreement a strict liability regime (limited in amount and time), so that the founders would be liable to the investor, within the agreed limits, for the damages that the latter, after making the investment and already as a partner of the startup, may suffer for the losses or damages that these contingencies generate in the company and that are caused by acts prior to the investment. This liability of the founders must be limited both in amount and time, both variables being subject to negotiation between the parties.

For all of the above, it is of vital importance that the founders of a startup are clear that if in the future they are going to open the possibility of the entry of an investor, they will almost certainly have to face a due diligence process, and that they can prepare for it from the very moment they constitute the startup, for which they must be diligent (as the name itself indicates) in complying with all the obligations of a legal nature and it is also advisable that they take appropriate advice in this regard.

All this will help to ensure that the funding required by the startup project can arrive at the time it is demanded and in the optimum amount, which can be key to the survival and success of the project.