A BlackCrest Guide To Investor Due Diligence For Startups In Nigeria
Introduction
Conducting due diligence is not only important in the preparation of an audited financial statement, public or private financing transaction, joint venture, bank financing, initial public offering (IPO), merger and acquisition (M&A) and general risk management.[1] In the securing of startup investment, from the preliminary discussions to the presentation of a term sheet, negotiations and the preparation and execution of the investment agreements, startup investors also carry out due diligence on the startup.
Due diligence refers to the process of gathering, comprehending, and evaluating information about the company’s operations to assimilate the legal, corporate status, and financial risks inherent in the investment.[2] Thus, a prospective investor undertakes legal and financial due diligence of the startup to thoroughly evaluate the possible risks associated with investing in startups.
Typically, the amount of information required to be gathered and presented to potential investors varies according to the stage of fundraising; the bigger the investment, the greater the obligation relating to due diligence.[3]
In most cases, pre-seed or seed investors do not require extensive information before investing in a Startup and where the funding round is being facilitated through Simple Agreement for Future Equities (SAFEs) or convertible notes, it is at the investors’ discretion to decide the course of due diligence to follow.[4] On the other hand, if the fundraising adopts a priced round at the seed stage, the due diligence process will closely resemble that of other priced rounds viz series A, Series B, etc.[5] However, irrespective of how a startup runs its seed round, there is basic information that is required to be provided. They include;
- Founder profiles (qualification)
- Company incorporation
- Intellectual property document (if applicable).
- Company employment and partnership Contracts
- Market research
- Company financials
Below are the different types of due diligence that startup investors undertake for startup investment.
Legal Due Diligence
The startup’s legal due diligence involves collecting and assessing all the legal documents and information relating to a startup to scrutinize and ascertain any legal risks and potential liabilities such as lawsuits and intellectual property details before executing the investment.[6] In conducting legal due diligence, the relevant information is gathered and may involve a review of
- Company’s Organizational Structure
- Pending and potential lawsuits
- Intellectual property
- Property and tax liabilities
- Environmental law
- Contracts (customer, supply, operating, and employee contracts and licenses)
- Organizational documents
- Representation and Warranties
- Insurance Coverage[7]
These processes enable an investor to understand the Startup and its operation, obligations and issues to make informed decisions. Importantly, legal due diligence does not only benefit the investor(s) but the company as well because it enables the Startup to identify the company’s worth, potential risks and necessary steps to take in rectifying all issues and ensuring a higher value deal.[8]
Legal Due Diligence Checklist for Seed Stage Startups
| S/N | LEGAL DUE DILIGENCE INFORMATION | POSSIBLE QUESTIONS |
| 1 | Company’s Organizational Structure | ● Does the company’s corporate structure foster growth?
● What is the structure of the company’s current and potential market size? ● What is the structure and composition of the company’s board of directors (BODs)? |
| 2 | Organizational Documents
|
● Where are the articles of incorporation?
● What is the nature of the shareholder’s agreement, list of shareholders and percentages owned? ● Where are your share transfer forms and share certificates? ● List of company by-laws and amendments. ● Where is the limited liability agreement? ● List of licensing revenue and expenditures. |
| 3 | Intellectual Property | ● Do you have patent clearance documents?
● Summary of claims or threatened claims on intellectual property. ● Are there any consulting agreements, invention agreements and licenses of intellectual property to and from the company? |
| 4 | Property and Tax Information | ● Are there any undisclosed taxes?
● What are the federal, state, local and foreign tax returns including net profit or loss for a specified period of time? ● Are there any tax liens on the company’s property? ● Where are the income and employment tax filings for a specified period of time?
|
| 5 | Environmental Issues | ● Are there any environmental contingencies or liabilities?
● Copies of notices and filings with the Federal Environmental Protection Agency (FEPA)? ● List of environmental investigations and pending litigations affecting the company. ● Are there hazardous materials used in production and what disposal methods are adopted for recyclable and hazardous materials? ● Does the product or service line address any sustainable development goal(s) (SDGs)? |
| 6 | Material Contracts | ● What is the company’s monthly manufacturing yields (Where applicable)?
● What are the operating and employee’s contracts and licenses? ● What is the nature of distribution, sales, marketing and supply agreements? ● Are there operations and stock purchase agreements affecting the company’s operation? |
| 7 | Litigation | ● Is there any pending and potential Lawsuit(s)?
● Are there documents injunctions or settlements? ● Is there any history of problems with regulatory bodies such as the Securities and Exchange Commission (SEC) etc? |
| 8 | Insurance Coverage
|
● Are there any insurance claims over a specified period of time and copies of such claims?
● What are the schedules and copies of insurance coverage for general liability, errors and omissions, product liability, personal and property etc.? |
| 9 | Products and Services | ● Lists of products and services offered by the company.
● Correspondence relating to regulatory approval of product or service line. ● What is the profitability and cost structure? ● Summary of complaints and warranty claims |
Financial Due Diligence
In addition to the legal due diligence, the investor also has to conduct an investigative analysis of the financial performance of the startup of interest, to gain a better understanding of the startup’s financial situation and its prospects for the future.[9]
It is similar to an audit but conducted by outsiders to uncover issues that may not be readily apparent in financial statements. The financial due diligence provides the investors with overall insight into the company’s financial performance, its unit economics, balance sheet, cash flow, and profit and loss statement in order to ascertain liabilities, possible irregularities, and threats.[10]
Financial Due Diligence Checklist for Seed Stage Startups
| S/N | FINANCIAL DUE DILIGENCE INFORMATION | POSSIBLE QUESTIONS |
| 1 | Financial Statement | ● List of the company’s financial statements including cash flow and balance sheet for a specified period of time.
● Auditor’s Correspondence evidence areas to improve efficiency and profits. ● Unaudited financial statement for comparison |
| 2 | Outstanding Debts | ● Are there clauses that increase company’s debts?
● Are there parties that have loaned money to the company? ● List of collateral for debts.
|
| 3 | Projection, Capital Budgets and Strategic Plans | ● What is the company’s financial projection including revenue by product/service type, customers and channel?
● Company’s balance sheet, cash flow statement and cash-on-hand. ● Analysis of projected expenditures and depreciation. |
| 4 | Public Filings | ● Is the company listed on relevant boards of the Nigerian Exchange Limited (NGX) or a similar stock? |
| 5 | Revenue Streams | ● What is the company’s pricing and estimating philosophy?
● What is the nature of the recurring revenue stream? |
Technology Due Diligence
Technology is a key component of all startups. Investors are therefore very interested in knowing what technology the startup will use and how it can help them retain a competitive advantage. The technology due diligence for a pre-seed startup is not a very technical-oriented audit. At that stage, the investor is more interested in knowing the platforms and digital processes that distinguish the startup of interest from its competitors.
| S/N | TECHNOLOGY DUE DILIGENCE INFORMATION | POSSIBLE QUESTIONS |
| 1 | Software choice | ● List of the company’s programming language and reasoning choices.
● Can the current software accommodate scale in the short term? |
| 2 | Digital Partnerships /Integrations | ● What is your startup’s choice of payment integrations partners and why?
● How many digital partners does your startup require to run efficiently? ● Does your startup plan to build its own payment infrastructure?
|
| 3 | Innovations | ● What in your market vertical does your technology seek to disrupt?
● How will your startup manage the software in the short term and the long term?
|
Conclusion
A comprehensive due diligence list enables a potential investor to obtain unbiased information on the startup’s major operations. It allows an investor to understand the Startup and its operation, the potential profit margins, obligations, and issues to make an informed investment decision. At BlackCrest, we understand the uncertain nature of startup prospecting and have successfully helped investors of varying nationalities make informed investments in Nigeria. We believe legal and financial due diligence does benefit not only the investor(s) but the startup as well because it enables the Startup to identify its worth, potential risks and the necessary steps to take in rectifying these issues, thereby ensuring a higher value deal.[11] No investor should invest in any startup without undergoing a form of due diligence. This process will help the investor assess the market potential, the financial statements and forecasts, the legal aspects, and other related risks in the startup. Undergoing due diligence before investing ultimately helps the investor determine if the startup and its founding team are worth the investment.
[1] Upcounsel, ‘Due Diligence Checklist: Everything You Need to Know’ (Upcounsel, 28 June 2020) <https://www.upcounsel.com/due-diligence-checklist> accessed 15 May 2022.
[2] Thought leadership, ‘How Startups Can Ace the Due Diligence Process’ (19 March 2021) <https://vazilegal.com/resource/how-startups-can-ace-the-due-diligence-process/> accessed 10 May 2022.
[3] Stefan Nagey, ‘How to Prepare Your Startup for Due Diligence’ (Capbase, 21 February 2021) <https://capbase.com/how-to-prepare-your-startup-for-due-diligence/> accessed 15 May 2022.
[4] Ibid.
[5] Ibid.
[6] Ansarada, ‘The Legal Due Diligence Process’ (Ansarada Group Ltd, 2022) <https://www.ansarada.com/due-diligence/legal> accessed 15 May 2022.
[7] Ibid.
[8] Ibid; Upcounsel (n 1).
[9] Kison Patel, ‘How to Conduct Financial Due Diligence = Checklist’ (DealRoom, 2022) <https://dealroom.net/blog/how-to-conduct-financial-due-diligence#:~:text=Financial%20due%diligence%20is%20an,its%20prospects%20for%20the%20future.> accessed 15 May 2022
[10] Ewa Chronowska, ‘Startup Fundraising: Due Diligence’ (Vestbee, 1 December 2021) <https:www.vestbee.com/blog/articles/startup-fundraising:-due-diligence> accessed 15 May 2022.
[11] Ansarada, (n 6).