For arbitrary and unjustifiable reasons, start-up entrepreneurs fear (and try to shun) a legal due diligence of their company before receiving any express interest from investors and when they receive an interest from an investor.
Image Credits: ShutterstockThe reasons for a due diligence for an investor or an acquirer are simple: to ensure everything is in place from a legal perspective. Hence there is a necessity for any transaction to include an exercise of due diligence at the initial stages as a manner of routine investigation of corporate matters of the company.
For an entrepreneur, the following are the various categories that are given a thorough assessment to determine risks, if any, at its different levels:
Each company is required to be in compliance with the provisions of the Companies Act, 2013 and the Companies Act, 1956 where applicable, and other acts relating to SEBI for example, if it is listed. Under the Companies Act 2013, the company is required to submit various forms with the Ministry of Corporate Affairs from time to time. What an investor or acquirer mainly focusses on is to see if the company has adopted the right incorporation process and the company’s objects. A routine check involves examining the statutory registers, minutes of shareholders meetings, and meetings of board of directors, annual return, consent of persons to act as directors in case of increase of share capital/members, registration of resolution, creation or modification of charges, return of allotment, share transfer form, among others.
This is given maximum scrutiny for most start-ups especially in the IT space. Labour and Human Resource related registrations include having the Provident Fund and Employee’s State Insurance in order. Depending on the type of company, additional registrations would include Importer Exporter Code, Software Technology Parks of India, and the Special Economic Zone.
Material contracts and employment contracts of executive and non-executive directors, consultant and other key employees are scanned to check important clauses like termination, transfer, confidentiality clause, and other restrictive covenants. The necessity behind reviewing employment contracts is to just highlight the terms of the appointment to the acquirer to gauge terms of employee benefits like provident fund, gratuity and any kind of union activity, restrictive covenants, term and termination, etc. Studying material contracts like commercial agreements and licensing agreements highlight aspects of assignment of the agreement and validity of the license. Loan documentation is also reviewed to study the nature of charge, overlapping charges, the breach of covenants of loan agreement (invariably in the nature of insurance covenants), etc.
IP includes patents, trademarks, copyrights and designs. The check on the entity that owns the IP is one of the main conditions preceding an investment especially among start-ups. The important issues that are sought to be answered through the exercise are whether the IP has been registered, and/or transferred, and/or licensed from someone or to someone. What is also checked is if the company is infringing on an existing IP.
Has the company been involved in any court cases, have any of the promoters been involved in any legal tussle? To answer if there any court matters that can legally impede the potential investor or acquirer is the primary purpose. In any case, these matters are protected through a clause on representation and warranties and the disclosure schedule in the transaction documents. Note that a check on the promoter’s personal litigation is out of the scope of the due diligence.
The other areas that are scanned in a due diligence exercise include real estate, insurance, and environmental licenses. A quick check is also done to see if the intended acquisition or investment could fall under the meaning of combination under the Competition Act. However, most of these are not given a high level of importance for start-up companies.
If everything is in order, an entrepreneur has nothing to fear.