The Ins and Outs of Due Diligence
Insights from Locke Lord and Clean Energy Trust on how to tackle the due diligence process
Congrats, you signed a term sheet! You’ve come to an agreement with your lead investors on many key terms, but there are certainly more negotiations ahead. Term sheets are almost always non-binding (aside from confidentiality), but you’ve agreed to stop “shopping the deal” to other lead investors. This “lock up” period typically lasts 30–60 days, as dictated by the term sheet (push for 30!).
What comes next? Well, before funds will flow from your investors, you must tackle the due diligence process. And the key to successfully navigating the due diligence process is organization. Important for any startup, but especially critical for ones working on climate innovation.
Prepare Your Data Room for Due Diligence
You must know what information your investors will want to see, and what information your investors will need to see and where it is located. Early on, a data room is an important tool for organization. The effective use of a data room — a virtual “space” used to store and share sensitive files — protects the Company from future liabilities by preventing claims that the Company misrepresented a situation or failed to provide important information to investors. All information provided by the Company should be indexed and retained in the data room, so when questions arise, the data room is the definitive source on which everyone can rely.
Every data room should have an Index (find an example here). What you will notice is not only that the information is organized by categories, but also that the documents provided are listed with some specificity so that information is easily accessed.
Some climate technology companies express concern over the fact that if their corporate records are not pristine, a data room highlights that reality. Early-stage investors are accustomed to less than perfect corporate records, so no need to feel self-conscious.
Proactively rectify your likely imperfect corporate records by: (1) creating supplemental records (appropriately identified); (2) including a disclosure to investors with the facts of the situation and obtain waivers with regard to liabilities that arise as a result of incomplete records; or (3) (in the most difficult situations) obtaining written indemnifications from the founders for liabilities that might arise as a result of the incomplete or missing corporate records. Since this last option is the least attractive, a well-organized data room where omissions and supplemental materials can easily be identified, reviewed, and remediated is critical.
Due diligence, conceptually, can be separated into three categories:
1. Legal Matters: including formation documents, charter documents (articles of incorporation or operating agreement); bylaws; subscription agreements; SAFE agreements; phantom stock plans; equity incentive plans (and grants); convertible promissory notes; shareholder, joint venture or partnership agreements; mortgages, loans; qualifications to do business as a foreign corporation; assumed name filings (DBAs); franchise tax filings; employee lists (and classifications); employee tax filings; annual reports; consents and minutes of meeting of the board of directors/board of managers and shareholders/members (as applicable); litigation proceedings; notices, judgements or orders involving the Company;
2. Business Matters: including business plans/strategic plans; financial statements (including historical financial statements, quarterly and monthly financial statements and pro-forma financial projections based on the strategic plan); cash flow analysis; valuations; capitalization (both current and proforma to reflect the anticipated investment); customer contracts; customer lists; customer renewal and retention data; standard form agreements; material contracts involving the Company in excess of $25,000 or which are otherwise material to operations; insurance policies; confidentiality and non-disclosure agreements; and agreements requiring consent or approval in order to consummate the financing; and
3. Intellectual Property Matters: including patents, provisional patent filings; formulas, trademarks, trade dress, copyrights, service marks; sensitive items that may require additional consideration such as software and trade secrets. For companies developing “hard-tech” innovations, you may also consider including certain technical documentation such as renderings/schematics, relevant images, and 3rd party test data.
As illustrated in our data room example (found here), data room sub-categories are useful. The important element is to (1) organize the information that you have, (2) identify where there are gaps and, where possible, obtain supplemental information to fill-in those gaps before the investors begin their due diligence review; and (3) where the information cannot be supplemented, discuss the omissions including the specific risks that such an omission may impose on the Company, the investors or the Board of Directors and, where possible, obtain waivers from investors. Where material information is missing and cannot be supplemented, the Company will find itself primarily liable for any damages that result from said omissions. Ideally, over time such omissions become increasingly less important, and liability diminishes.
The three common mistakes made in due diligence are:
1. Omitting Documents
Founders occasionally cannot find documents prepared from the Company’s earliest days. Documents that cannot be found need to be replaced, or amendments or waivers signed by investors need to be obtained. Failure of a Company to provide a copy of a material agreement or omit to inform investors of a material relationship can result in investors being able to demand their money be returned or to sue the Company for three times the amount of the investment, plus costs.
Duplicates of some documents, such as copies of Certificates of Incorporation and franchise taxes, can be ordered from the governmental authorities from whom they were originally obtained. Copies of these documents will be satisfactory and free from liability.
2. Misunderstanding the Capitalization Table
Providing and organizing the information pertaining to your Company is of critical importance. Of equal importance is to have an understanding about what it means. Posting your Certificate of Incorporation but not understanding the difference between Common Stock and Preferred Stock is a critical error. Providing copies of your Capitalization Table, but not understanding the relationship between Equity Owners, SAFE Agreements, Convertible Promissory Notes and, ultimately your Investor Documents (discussed in our next article) puts you and your management team at a great disadvantage as you negotiate valuation and dilution.
If you have promised restricted stock grants, options or phantom stock to employees, directors, or consultants, you must understand how the exercise of each of those instruments will affect your Capitalization Table. You must understand, at all times, how much of the total equity of your Company the founders own and how much will they own once all convertible instruments (such as SAFE Agreements, Convertible Notes and Options) and other dilutive arrangements, including Phantom Stock Plans, are issued and converted or paid.
The above is key to not only understanding the Company but also to understanding how the issuance of Preferred Stock or other instruments will affect the ownership and governance of the Company.
Example: Recently, a client informed us (Locke Lord) that they had transferred the assets of the Company to another entity controlled by the client. However, the Company had previously issued Convertible Promissory Notes which provided that any sale or transfer of the Company’s assets triggered, at the election of the noteholders, a conversion of the Convertible Promissory Notes into a cash payment equal to three times the balance of the Convertible Promissory Notes.
While full disclosure allowed the Company and its new investors to move forward (after obtaining waivers from the holders of the Convertible Promissory Notes), this experience illustrates how important it is that management have a full understanding and awareness of the terms of all instruments to which the Company has agreed and what restrictions those instruments directly or indirectly place on the activities of the Company.
3. Amending Documents
Documents are in full force and effect until they are formally terminated either in accordance with their terms or, in writing, signed by all the parties to the (original) document. Documents do not disappear. Documents are not superseded by the passage of time. Documents do not just cease to exist.
Example: Recently, a Locke Lord client remarked that the SAFE Agreements he signed several years ago had “terminated” because the Company had subsequently offered and sold Convertible Promissory Notes to subsequent investors. Instead of consulting with other team members or legal counsel regarding his confusion, the client instead made the assumption that because the Convertible Notes were entered into after the SAFE Agreements, that the SAFE Agreements were no longer of any force or effect. In other words, the client believed that because the Convertible Promissory Notes were signed after the SAFE Agreements, the Convertible Promissory Notes superseded most of the terms set forth in the SAFE Agreements.
The client was shocked to learn that the SAFE Agreements not only continued to be in full force and effect, but since the SAFE Agreements contained a provision which gave the holders of the agreements the choice of continuing to invest through the SAFE Agreements or to become Convertible Promissory Noteholders, depending on which instrument had the better economic terms, the investors who originally invested through the SAFE Agreements were now, in fact, by their own choice, holders of Convertible Promissory Notes.
The entire Cap Table was affected by the CFO’s blunder based on his belief that one instrument followed by another “cancels” the first instrument. Cancellation or change in any document only comes as a result of the execution and delivery of explicit written agreements, which detail the prior and revised terms — signed by all parties!
Again, key to any data room, is the management understanding what is in the data room and how the agreements posted there inter-relate to each other — BY THEIR TERMS!
It is not a matter of what may or may not seem to be “logical” but rather it is the precise language and meaning of the documents that is important. If you read a document and are lost or uncertain as to what it says, consult with legal counsel so that you understand the meaning and impact of the documents in your data room.
Best Practices for Confidential and Sensitive Information
There are some documents that climate tech companies are hesitant to provide immediately to potential investors including employment agreements and financial information. While those documents are sensitive, they will need to be produced before closing. However, they can be produced after an initial due diligence review has been completed so that the Company is confident that the transaction is moving forward with a particular investor.
It is also common to offer data room access to interested investors prior to a term sheet being signed. However, in such cases it is very important to be selective about which documents are included.
Climate tech companies often request that investors sign NDAs. Some investors, most specifically investment funds, generally will not sign NDAs because they are concerned that doing so would embroil them in disputes if they chose not to invest or invest in a similar enterprise.
Software codes, formulas, and trade secrets should never be provided, even under the strongest NDAs. Those disclosures are best made in consultation with legal counsel.
Work Swiftly and Efficiently
As mentioned earlier, once the Term Sheet is signed, due diligence will begin. Climate technology founders will want to move quickly. However, moving through due diligence quickly will require focus, attention to detail and self-discipline to be sure that you explain to investors, in detail, the Company’s history, financial condition and contractual commitments as well as your understanding of the agreements that you are taking on with your new investors.
Moving so fast that you fail to disclose important details to investors puts the Company, and yourself, at risk — as well as your future relationship with your new investor. Stay focused, ask lots of questions and do it right!
By following these steps after you’ve signed a term sheet, you and your climate tech company will be better prepared for what comes next. And you’ll be able to work more efficiently with your legal counsel by knowing what questions to ask during the due diligence process.
Join us back here for another blog post in this ongoing series.
Mike Malfettone is a corporate, M&A and transactional attorney with an expertise in the energy sector, particularly renewable power, clean energy and energy transition technologies. Mike’s practice focuses on representing public and private companies, entrepreneurs, and venture capital, private equity and strategic investors with debt and equity financings and M&A transactions. Clients also look to Mike to help with corporate formation, structuring, governance and commercial contracting matters.
Kathleen Swan focuses her practice on venture capital, venture debt, private equity, and institutional private placements representing both portfolio companies and investors and lenders. Kathleen has represented clients within a number of diverse industries including energy, health care, retail, pharmaceuticals, manufacturing, and utilities operations. She has worked with angel investment and impact investment groups in connection with their formation and investment activities. Kathleen is active in the venture capital and private equity communities and serves as a judge, coach and mentor for several incubators, forums and business plan competitions.
Paul Seidler serves as Managing Director at Clean Energy Trust overseeing the organization’s investment activities, including deal sourcing, diligence, negotiations, and tracking and supporting portfolio companies. He has participated in over 30 transactions totaling over $5 million since joining Clean Energy Trust in 2014. Paul serves as a board director or observer for numerous portfolio companies. He is also responsible for managing structured fundraising initiatives on behalf of portfolio companies seeking to raise institutional capital.
Clean Energy Trust is a Chicago-based nonprofit that supports early-stage startups in the Mid-Continent region of the United States working on solutions for clean energy, decarbonization, and environmental sustainability. Clean Energy Trust helps high potential entrepreneurs scale and succeed by providing capital and hands-on mentorship and programming. To date, Clean Energy Trust has invested in 35 portfolio companies. Learn more at www.CleanEnergyTrust.org.
Locke Lord LLP disclaims all liability whatsoever in relation to any materials or information provided. This article is provided solely for educational and informational purposes. It is not intended to constitute legal advice or to create an attorney-client relationship. If you wish to secure legal advice specific to your enterprise and circumstances in connection with any of the topics addressed, we encourage you to engage counsel of your choice.
