So you’ve just received a Letter of Intent for a company to acquire your startup or for VCs to invest a round of capital into it. Congrats. But before you get to deal close – 30 to 45 days if you’re lucky – you have to slog through an intense period known as due diligence, where the acquiring (or investing) company will examine, probe, and question every part of your business.
I’ve been the diligence lead on two deals (selling SiteAdvisor to McAfee and more recently selling Hunch to eBay) and have learned a ton in the process. I’d say that in both cases our business procedures and document organization were good – probably even very good – but they weren’t perfect, and there are things we could have done better.
I’ll outline a few tips here about what to expect and how to prepare for diligence, and how to successfully get through the process once it starts.
What to expect
* The first time you see a diligence request your jaw will probably drop. The ones we’ve received have been in the range of 400-500 initial line-item requests, with dozens more as follow-ups. A single line item could be as simple as a yes/no answer (“Is your company currently involved in any litigation?”) to something requiring hundreds of pages (“Provide all patent filings”, “Provide every employee invention agreement”, “Upload every material vendor contract currently in force or recently completed.”) In our recent deal we provided about 800 documents comprising 9,000 pages in response to diligence requests.
* You will be asked to put supporting statements and documents in a secure “Data Room”. User access is controlled and you can set individual permissions for different folders. For example, you can grant access to salary or options-related information to only certain people with a need to know. I used Merrill Datasite (no connection to Merrill Lynch) on both deals and am generally happy with them. Only gripe is that Mac compatibility could be better.
What you can do to be ready for due diligence:
* Use a well-known, big name law firm to provide you with a standard set of company formation documents, employee agreements, stock plan agreements, etc. We use Gunderson Dettmer. The key is to negotiate a low initial package price for these stock agreements (somewhere between $5,000 to $10,000) with the gentleman’s agreement that the firm will make the real money during subsequent financing rounds or an ultimate acquisition. As trying as the diligence process is in the best of cases, it will be exponentially worse if the other party’s counsel is questioning every core document because it was prepared by some unknown law firm or individual.
* Keep meticulous employee records for offer letters, stock option agreements, and especially PIIA (Proprietary Information and Invention Assignment) agreements. The PIIA in particular applies to EVERY current and past employee, contractor, or intern. The best control procedure for this is probably to ask your finance or accounting team to require a full employee checklist/document list before anyone can be brought on board or paid.
* Ideally you should have those docs already scanned and electronically organized. Hardcopies should be in a fireproof filing cabinet, with a copy given to your law firm.
* Ensure that all your documents and contracts are:
1) dated and signed by the other party, with a place for printed name as well. (you’d be surprised how often a document gets misfiled and it’s impossible to decipher the signature to reveal who it belongs to)
2) dated and signed by your own company’s representative (this is one of the things we often forgot, although fortunately it’s an easy fix)
3) when it comes to responding to diligence requests, contract signature pages aren’t enough. At a minimum, the entire agreement needs to be included when requested. Ideally, each page before the signature page would also be initialed by the outside party.
* Keep all your vendor contracts in one place. Again, try to have them already digitized. Periodically ask around your company if anyone has started new vendor arrangements and not provided contractual paperwork to whomever is the central manager of that.
* Be mindful of formal vendor agreements that you let lapse, yet then continue under their current terms, thinking “let’s just keep going as we have been.” You’ll be asked for current, properly-executed contracts for all your current vendors. Try your best to always keep them up to date, formally extending them as needed, so you’re not caught scrambling for paperwork while the clock is ticking.
Getting through the process
* Assign one primary administrative executive who will lead the due diligence process, respond to requests from counsel, and coordinate resources to get everything answered quickly and accurately. You should generally pick an exec in your company who thrives on organization, has a substantive history with the company, and who has a good overall perspective about multiple functional areas. This process requires meticulous detail, patience, and follow-through.
* I find it helpful to create a Google spreadsheet with all the diligence requests, and then categorize them in one of 3 ways:
1) A straightforward question which can be answered with a simple statement or one sentence explanation. This can be answered right on the Google doc, a copy of which you’ll upload to the Data Room from time to time.
2) A request which is primarily satisfied by uploading existing documents.
3) A request which requires more substantive explanation and the creation of new documents/content.
-> Also assign each requested item to one core person in the organization who is responsible for completing it.
* There will be cases where essentially the same information is requested by different functions or departments. For example, HR and legal will have separate line item requests for employee/consultant invention agreements. But never duplicate uploads; provide the requested information in only one section and then refer the other request to that section. This both saves you money (you pay the Datasite based on every page you upload) and it means you need only update one area if you find a new document or need to correct something.
* When responding to requests – particularly requests that require the creation of new documents and content – think “explanation”, not “dissertation”. You want to address everything with adequate thoroughness but not go into exhaustive detail. The idea is to disclose and explain, thus shifting responsibility for the knowledge of the item to the other party.
* Once most requests have been submitted and the other company has had some time to review, there will generally be a period of in-depth phone calls or in-person meetings to review follow-up questions. I find it helpful before each call to see which documents the interviewer has accessed from the Dataroom, so I get a sense of the starting knowledge the person likely has. The Datarooms have functionality to generate reports with this info.
* If you think nobody is really reviewing what you submit, think again. Counsel from the other company will be thoroughly reviewing absolutely everything to ensure you’re in compliance with their requests. I can’t tell you how many times I received an email at midnight saying something like: “Page 3 of 2007 intern John Doe’s employment agreement is not readable; please resubmit in full.”
Intense (and sometimes exhausting) as it is, the diligence process is also an incredible learning experience. It causes you to review everything about your company’s history and get a bird’s eye perspective of every department and function. And hopefully, everything will go smoothly and you’ll end up with an on-time and successful deal closing.
Kelly, Leave it to you to create an authoritative, strategic, concise and , yes, amusing guide to the due diligence process. Insightful and analytical, as always. With perfect grammar, of course. You should blog more often. Best – Sam B
Excellent guide. This is getting bookmarked and uploaded to my startup FB page. A couple follow on questions, if you’re game:
+What did you do in the event a file or contract could not be located or a request could not be filled? (I assume with 400-500 requests, a handful were not do-able)
+What items were scrutinized the most, or had the most (potential) to cause heartburn? IP? Employee agreements? Cap table stuff?
+Also, how closely did they review or pick apart your financials– both historical, and projected? Any tips on “managing” forward-looking parts of the discussion?
+Finally– did you compare any other data rooms? (I ask because it seems there are a ton out there now, and Merrill is on the pricier side if I’m not mistaken…wondering if anyone’s got equivalent bang for less buck)
Thanks! Awesome post. Nathan
Thanks for the kind words. To answer your questions:
* When something couldn’t be located, we disclosed that and attested to what we thought the core follow-up question might be, basically trying to reassure the lawyers that there’s nothing to worry about. This sometimes required a bit of back and forth explanation but it was generally sufficient. For example:
-> “we are unable to locate the personal invention form for intern Jane Smith from the summer of 2008. Note that her sole tasks were routine data entry, she had no access to proprietary information or systems, and she did not contribute any intellectual property of any kind.”
* A few items were scrutinized the most:
-> IP-related items (including patent filings, use of open-source code, employee PIIA forms)
-> Cap table info. They wanted to see what I’d describe as both the cap table ‘balance sheet’ (exactly where things stand now) and also the full transaction-level history of how it got there. That meant supporting documentation and dates for every stock grant, options issue, dilution event, option exercise or forfeiture, etc.
-> Financials: Lots of detailed follow-up questions on everything from depreciation schedules to tax treatment to timing of revenue recognition.
* Financials: They dug deep into historical financials and we scheduled several calls between the acquiring company and our accounting firm to go through details. For projections, I basically took our trailing 12 month income statement, and next to each line item provided a semi-quantitative assessment (ex: trending +10%/quarter, trending towards zero, increasing proportionate to revenue) of how the item was trending on an as-is basis (assuming no acquisition) and then assuming the acquisition closed. They then used that to build their own forward-looking model.
* Data rooms: I didn’t compare others; I had used Merrill so was comfortable with them. As you note, they are pricey. I will say that their customer service is outstanding. From the time I first contacted them I was up and running in 2 hours, and they have well-informed customer service people ready 24/7. Any request I had was taken care of immediately. I guess they’re used to having stressed-out investment bankers call them at 2am expecting quick service!
Kelly– thanks for the follow up! Great, detailed info…I’m very slowly putting together a collection of “exit hacks,” tips and techniques so this level of detail about the process is awesome. Now how about a blog post on the pre-DD negotiation phase? 🙂
Very nice and comprehensive post Kelly. With regards to datarooms, please give Firmex a try. Elegant product with a flat rate pricing model that is much more budget friendly to startups and dramatically undercuts the archaic per page pricing model that Merrill and other big players use.
@Nathan: I think I’ll leave it to Chris Dixon to post about negotiation tactics- he was the guy who made both the deals I referenced (SiteAdvisor and Hunch) actually happen.
@Peter: Thx for tip on Firmex.
One other thing I’ll add: 1099 contractors raise huge flags and you’ll find yourself explaining over and over why Dan or Nancy or Tim is 1099 and not a regular PT or FT employee. There may be great reasons that your company uses 1099 contractors, and I’m not going to go into the complicated rules and pros/cons of one way or the other, but just be ready to get a lot of skeptical questions and provide lots of explanations for why you’ve chosen a 1099 labor designation.
Great article, thank you for sharing. I am currently working several regional VC associations in Asia, advising start ups on due diligence. Merrill datasite are the preferred supplier of most and offer good pricing for pre-revenue and early stage companies.