Legal advice for entrepreneurs: the ABCs of Due Diligence

Investor funding can be the lifeblood of a start-up. However, most investors will want to conduct a due diligence investigation on a business before investing any funds or taking up an equity share.

Due diligence investigations take the proverbial “pulse” of a company in order to measure a company’s legal, financial, and tax health.

What does this mean for your business if you are looking for funding? These tips should assist…

What is a due diligence investigation?

A due diligence investigation examines the structure and operations of the target company, its assets and liabilities, as well as any potential risks that it faces in the market.

In short, are there any skeletons in the closet, or risks around the corner? The scope of a due diligence investigation will vary from case to case. Generally, the more significant the investment, the more detailed and probing the due diligence investigation.

Due diligence investigations typically comprise a legal, financial and tax review.

This is done by performing a comprehensive analysis of the target company often including commercial, banking and finance, litigation, employment, environmental, insurance, tax, intellectual property, and real estate law aspects.

The assets and liabilities of the target company and how the business functions are scrutinised. Often various legal, financial and tax teams will work in tandem.

Due diligence investigations take the proverbial “pulse” of a company in order to measure a company’s legal, financial, and tax health.

How is a due diligence investigation undertaken?

The company under investigation will typically be required to make important documentation available to the reviewers via a virtual or a physical data room.

The nature of the documents and information required will have been set out in an information request.

These documents will depend on the specific purpose of the review, but are usually a mixture of company secretarial documents, constitutional documents, client and supplier agreements, employment agreements and human resource policies, payroll schedules, business licences, trading terms and conditions, business plans, financial statements and tax filings amongst others.

What are reviewers looking out for in a due diligence investigation?

Generally, reviewers are looking out for any potential risks faced by the target company such as existing debt obligations in the form of unpaid tax or potential administrative fines as a result of statutory non-compliance, as well as any restrictive or unusual clauses in agreements, particularly those which trigger adverse consequences in the event of a change of control of the target company (for example, if an investor takes up a majority stake).

Depending on the particular sector in which the business operates, there may be a specific focus on certain aspects of the target company’s operations (for example, an emphasis on evidence of environmental legal compliance in respect of a waste management company).

How is a due diligence investigation ultimately relevant?

Ultimately, the reviewers will compile a due diligence report which will give a full picture of the target company.

This report will enable the investor to gauge the commercial viability and performance of the target company and make an informed decision as regards the investment.

It will also inform the nature and extent of the warranties and indemnities that the investor may want to include in the investment agreement so that any risks identified are adequately mitigated.

The due diligence report is typically pivotal in an investor’s ultimate decision (and on what terms) to invest.

How can the target company assist?

Statutory compliance (or non-compliance) is a key consideration.

Review your basic company secretarial and other statutory records, founding documents, employment contracts and human resource policies, supplier and customer arrangements, trading terms and conditions, business licences and tax filings and, to the extent that these do not comply with legal requirements, correct these as soon as possible.

Ensure that the company keeps a comprehensive paper trail and, to the extent possible, as the business concludes key contracts, carefully consider whether they would be attractive to a potential investor.

Businesses that are structured correctly from the outset, and which keep up-to-date records, are more likely to lend themselves to investment.

This article is written by Justine Krige, Director in the Corporate & Commercial practice at Cliffe Dekker Hofmeyr (CDH)

Feature image: RF._.studio via Pexels

Read more: Cybersecurity is more than a tech issue – it’s a business problem too

Read more: Expert tips for SMEs this tax season