Preparing for Due Diligence: Advice for Founders

Good afternoon, everyone. Welcome to our webinar, Because You Only Get One Chance to Make a First Impression: Preparing for Due Diligence, a Practical Guide for Founders. I'm Drew Futter. I'm a partner at the Ramon Law Firm. I specialize in venture capital and technology law. And every one of the M&A transactions that I work on start with a due diligence phase, and that's what we'll be talking about today. And I'd like to introduce my friend Aaron Spool, tell us a little bit about himself.

Sure. Thank you, Rohr. Aaron Spool. I'm a partner and managing director at Adventus Advisory Group. We are an on-demand CFO, controller, and accounting firm. So we help mid-sized firms with all their finance, accounting, operational needs, especially due diligence. So all different sides of due diligence from looking to acquire firms to looking to prep if you're being due diligence yourself.

Okay. Now, since this is co-sponsored by a law firm, you knew this was coming, the disclaimer. So anything I say today is not the viewpoints of Ramon. For all I know, they might not even be my own viewpoints. And if you do need legal advice, get a lawyer.

I'm just going to say in a great finance way, ditto.

Okay. So first, we're going to do a couple of of slides. I can talk to a couple of slides that deal with context. The first is, why are we doing this? What's the point of this process from the investor perspective, buyer perspective, or the target company perspective? And the way this presentation is set up is we talk about due diligence both in the context of a potential financing transaction or in the context of a of an M&A transaction. So Aaron, why is an investor or buyer subjecting the target to this kind of inquisition? Very fair.

And I think inquisition is, I like to call it a financial colonoscopy, but an inquisition is also good. So anyway, at a high level, due diligence is, it's a legal beagle term, which is more Deroit's world than mine, but basically means making sure you know what you're getting into. So an investor Anyone who is a sophisticated investor should be, or actually any investor should know what they are investing in, especially if it's big money. So we're talking about, this is not just, "All right, I'm going to buy a stock on the open market. I'm going to buy some Intel stock or something like that." You're talking about investing into a company and probably a large sum of money. And normally we're referring to companies that aren't with a ton of information out there. A publicly traded company, you can get a ton of information from because they're filing everything with the SEC. So you have all the financials that are— and there's certain specific regulatory rules with publicly traded companies, but for private companies, there's no filing requirements or very little. So if you are an investor, You're going to want to ask, I would recommend asking a slew of questions, both not only on the financials, but also with the business. So at the end of the day, an investor is trying to confirm that their investment thesis is correct in terms of the company that they're looking to invest in.

[Speaker:Ian Formigle] And what's in it for the target company other than obviously completing the deal?

Well, there's a few things. So if the target company, I find that when they go through a round of being due diligence, so I don't even know if that's appropriate syntax, but if you're going through due diligence and people are asking information, it lets you— very rarely do you ever— does a company ever take a holistic view of all their financials and all their strategy and put it all together and say, does this make sense side by side? It's tough to do that when you are running a company day to day. So the nice thing with this process is that it keeps you on your toes of how you're actually performing and making sure that, for instance, like, am I meeting the sales projections that I had originally planned? Do I have the evidence of that based off of my actual book of business? Will this close or will my things renew? It's easy to not— if you're doing internal reporting, it's easy just to— I hate to say lie to yourself, but it's easy to not take it as seriously. But if you are doing this for someone else, especially for a legal process such as a due diligence process, it becomes a lot more serious. So I think in the end, it helps you take a holistic view of your financial and actual just business performance and much more seriously than you would just on your own.

I think there's another piece to it, which is normally in reasonably well-run companies, due diligence kind of reveals issues inevitably. The question is the scope. But usually they're not deal-threatening, and in a large number of cases, they're not even economic deal economics threatening. But at the end of the day, it's an opportunity, I think, for the target company to get facts out there. And once they're out there, either have them addressed by some kind of adjustment in the economics of the deal or in a lot of cases, just having the buyer assume it or the investor assume it. And at the end of the day, every one of these transactions is going to have several pages of representations and warranties. So you're going to be held accountable for, for lack of a better term, bad things one way or another. And this is your opportunity to get them out there and hopefully try to get as much of it as possible as assumed ongoing risk. For the buyers. Okay. What does a due diligence checklist look like? So you're going to get from Buyers Council or Investors Council a due diligence checklist. They're going to vary in format. And level of detail. But in a lot of cases, you're going to get a due diligence checklist that has dozens of asks like the one I have here, which is just page 1 in this case of probably 20 pages of asks, a large part of which may not even apply to your company. But so the question then is like, why are the law firms doing this? Why are they torturing me? And from the buyer perspective, You want to make sure there's no stone unturned. So you want to get back a diligence checklist that has a bunch of stuff identified as not applicable, a bunch of stuff identified as none, as in it is relevant to me, but I have nothing to disclose in this regard. And then a bunch of actual disclosures. And so from the buyer's counsel perspective, there's no real penalty to be over-inclusive. And the penalty for being under-inclusive, in other words, not asking for a certain kind of piece of information that turns out to be relevant, is actually significant. So you're gonna very often get a frustrating request because of its length and detail, and you're gonna kind of recoil. But once you kind of go through it, you're gonna realize, okay, this is generic. A large part of this doesn't apply to me. And, you know, here are the 20 or so items where I really have to work at disclosure. And the reality is also most of these topics are, you know, they might be surprising in terms of the detail of the request, but a lot of these requests are not going to catch you by surprise. They're the kinds of things, you know, that are critical to your running of the company and that if you just pause for a second to think about it, you would assume a buyer would want to know about your company. Aaron, any thoughts?

So, yeah, Sophia, so just from a practical perspective, you could get multiple due diligence checklists. There could be an auditor involved. There's problems, automatically going to be an attorney involved. Both could have separate checklists. Very rarely will they coordinate this effort. So, and they'll have, so what you're being asked for, you'll be probably be asked for again, if not a third time. The one, it is always okay to push back and say, I don't necessarily have that. There's, I think we'll talk about it a little bit later. I think the largest surprise that people have when they go through their due diligence process is how poor their record keeping actually is of, oh, you wanted employment contracts. And I can't tell you how many times I found contracts that someone's been employed for 2 or 3 years. They don't have a signed copy. So I can see Trevor's face like, what? It's— but it's It's very common. So it is— I would just recommend, if you can, just from your COO or head of HR, head of finance, should all take a— any one thing you could take away from this presentation is get a hold of like a classic generic due diligence list and make sure you can answer those questions today.

That's great advice, and I encourage companies to do that. We'll talk about timing later, but I encourage companies just to do that as a housecleaning. Housekeeping checklists, as you suggested. And the reality is that when you get the multiple requests, I just had that on a recent transaction where the two sides, it was even more frustrating because it was literally their finance arm and their legal arm both in-house that weren't talking to each other. And I helped firm. I said, no, Both from your perspective and from my perspective, there's value in having a shared diligence list because you're, you know, if I'm disclosing against two lists, you're going to have a problem judging completeness. And so am I. Go back and consolidate. You know, would I, would I threaten the deal over that? No. But at the end of the day, if you can convince the other side to consolidate, you're doing them a favor, even if they don't realize it.

Definitely agree. All right, so I can tackle this one. So how will the response to due diligence checklist be used? They're— so let's talk about follow-up due diligence requests. So I find it helpful if you've got a question asked to you from like an item description saying, what is this thing, ask. What they're attending— attempting to use it for. Some things will be easy, like give me your updated accounts payable, give me your updated accounts receivable, most recent as of this date. That's easy. You know what that— that if you don't know that, it's got other problems. But certain things you might not necessarily know what they're using them for. So realize that you're going to submit something, and then automatically there's going to be another question. Now, sometimes that question is They just don't understand what they got. Sometimes a question is because they're trying to solve for X and you gave them Y, even if they asked for Y on the list. The last part there is they might be doing what is a really good due diligence practice, is what I call triangulation. Is you will take— I'll take your deck and I'll take your current financials, then I'll take your book of business and I'll take all of this together and I'll look to see Does it all tie to prove out current financials? And does this also make sense? Do you have enough hard evidence to prove out your future projections? So that's where you'll get a lot of follow-up requests. And it also teaches you, if you've never been through one of these before, and even if you have, seeing your business through the eyes of an investor, it's fascinating because they're looking at things that you might not have even ever thought of would be an important KPI. And it might not be an important KPI for you, but it is for them. And it could be for a— maybe it could be for an abundant number of reasons, part of it which is just they have plans for your business. If they're— if they say they're buying the whole thing, and it could be these are very specific for those plans. Representations and warranties and disclosure schedules.

Aaron, before we move on, if you really closely monitor and track follow-up requests, As Aaron started to suggest, there is also a valuable source of intelligence buried there because one, it'll flag kind of areas of concern that are developing. And if you see a high concentration in a specific area, two, it'll give you a better insight into what is valuable to the buyer. And since due diligence process is usually done in parallel with the negotiation of definitive documents, that can be very helpful intelligence that you now know some of the levers you have to pull in terms of, oh, it's clear the buyer, you know, really views this as important. Uh, you know, I can use that fact in terms of some of the deal terms, uh, because I know this is important to them and something else isn't.

Yeah. And always, I always recommend ask why they're asking. It's not—

I find that that has, that has their limits, but just by sheer quantitative analysis of where, where the inquiries are coming in, uh, you'll have kind of an early warning for issues based on the quantity and the nature of the questions, or at least a sense of things that are critical to them.

And I guess, though, where I was talking about from the why perspective, not to be, oh, you don't need to see this perspective, but they may be asking for— especially once you find something's critical to them, they may be asking for pieces of information and they're trying to solve for an ask that they're asking the wrong question of you, of the documents that are needed. So you could probably prove that out to them by showing them something different than what they're asking, but that, that requires a longer conversation.

And by the way, one thing that's really important, if your response to any of these requests, but the original ones of the follow-up is none, be really sure that it's none. Because, you know, nothing kind of undercuts credibility because you kind of create this expectation of That's it, this subject's over, and then something turns up. So, you know, keep something in process if you're still hunting it down. But unless you're really confident that none means none, don't put something in the complete column unless you have the degree of confidence behind it.

And rather, just to give an example of that, let's see something easy. Pending lawsuits. If you write none, there better be no pending lawsuits. Doesn't matter the materiality of such. So that's just— and if you don't know that they're pending lawsuits, well, then once again, it goes back to record keeping.

Exactly. You want to tackle reps and warranties?

I'll say it in a high-level business perspective, and we're probably going to follow up with the legal definition. You're basically signing off that this stuff is true. So you're representing in order— you're saying this is all real. So realize when you submit something to a due diligence list implicitly, and sometimes they even have you sign things, you're saying this is the true representation of the company and you're giving them the actual facts. It has legal ramifications if they're incorrect.

And from the buyer perspective, what they learn in diligence may drive very specific tailored representations beyond those in the first draft of the purchase agreement or the investor document they give you. In other words, if they see an issue or they're uncomfortable with an issue, they may layer on representations and warranties around the situation to make sure they fully understand it. And then on the disclosure schedule, right, when you give representations and warranties in an investor agreement or a sale agreement, your representations and warranties are normally made subject to a disclosure schedule. So, you know, if I said that, except as set forth in Schedule X, the company has no contracts above $10,000, right? Presumably your data room will have all the contracts that are above $10,000, and that will become the basis upon which you draft the disclosure schedule. So the diligence room will have a second life in creating and feeding the information flow that goes into your disclosure schedule, which is going to be, as I said, in any investment or acquisition document. Aaron, you want to take this one? Prep for due diligence?

Sure. Okay. When you are— so let's go through each one of these things and see what it says. So assembling documents. Here's some tips and tricks there. It says— and we're going down for data. So let me— so assembling— I'm going to go through all these high level and then explain how to do it. Assembling documents is you put a whole bunch of stuff together. Usually, and I always say this, it's like we could talk about when to prepare for this. So let's assume that in this scenario here, you are entering a due diligence process. So assembling the documents, so I would first say what you should solve for is actually at the end, is figure out where you're going to save these things. This is all highly, highly confidential information. So you need a place to drop these documents. That's what— in the colloquial term, it's called a data room. It could be as simple as a shared drive that you have very locked-down access to that you can give outside people access to. So I would say get yourself, get yourself a shared file system, whatever it is you decide to use. There's software out there if you really want to get like hardcore data, Data Room software. I don't recommend it for someone who's only going through this once. Have an index. So there should be a— it could be a Word document or whatever you want to have that says the file nomenclature of what this is. You should have every document labeled in a particular way with the first beginning of the document having some sort of code which therefore ties back to the due diligence. It could be like 001_4, 002_3, something along those lines of tagging. And what you want to do is that— so get yourself a place to save it. Um, the second— I'm going in reverse order here— figure out who can get into the data room and what they can see. Uh, I would be very careful giving full access to everything in a data room, uh, to anyone. So you got to figure out what do you want to have disclosed to certain types of roles and certain types of people. Uh, uploading documents to an online data room that there's a few things you have to worry about. First, version control. So you don't want to add something and then there'd be another version of it. Uh, so you have to very carefully only have one version of that. Uh, two, make sure you don't accidentally delete something that's in there. So sometimes you can overwrite something. You gotta be very careful about what you're uploading. Uh, this is the same stuff. Uh, and then the last two from the AssemblyDocs, so verify completeness and signatures. Whatever you're uploading, make sure— actually open up the document first. A lot of times, there's like a list of 100 things or more you have to upload. So what you'll end up doing is you'll say, HR, hey, can you give me all the employee documents? And they'll send them all to you. And you'll just upload them. I mean, I've done that in the past. Actually open up each one. Look for completeness. Make sure that everything is signed. And if not, get it signed. Work with HR, guess, is it just like an employee contract? You'll be surprised how many share agreements. Do you have the board minutes that have signed off on equity being issued to your employees? Things like this, you have to make sure you— you should have this already, but if you don't, make sure you have everything signed and complete before you upload it. And then assembling the documents kind of go back to their bidding, and this is a huge gathering, so there's more to talk about this. We'll talk about who you reach out to. The circle is probably going to be very small, who you reach out to, and we can talk about best practices of that before. But there should be owners for, like, for instance, your CFO should own assembling the finance documents. Your head of HR should own the the employee agreements, depending upon if you have internal or external, internal, you know, general counsel or on-demand general counsel, they're going to need to be involved as well, maybe the COO, but each one, each person should own very specific parts, and they need to make sure that these are the accurate and most up to date. That's what I got there.

Yeah, this is where the, One chance to make a first impression really is critical. This is definitely one of those where it's form over substance and looks matter. It's one— when you're doing diligence on a company that's unfamiliar to you, the first impression of the organization of the diligence room has really outsized weight. And you want to make the diligence room as organized and as easy to identify documents as humanly possible. You don't want the buyer or the investor to have to scramble to figure things out. So even kind of seemingly stupid things like have file names that actually tell you what's inside the document, critically important. You just get people irritated when they have to go hunting and you just don't want that. You want to make it as easy as possible you want to show that it's crisply done. If you haven't been through this process before, work with, you know, with the financial resources or the legal resources, anybody who's been experienced with this process, and make sure it's staged properly. You know, I've had particularly with some of the early stage venture financings kind of say, oh no, we'll take care of it, we'll set up, you know, our Dropbox. And, you know, the logic they use for why they put certain documents in certain folders. I'm sure there is one, but it was totally lost on me. And more importantly, you know, knowing what their counsel has probably done a whole bunch of these is going to be looking for where they're expecting to see documents. You know, the only thing you're going to do is kind of irritate the investor or buyer early on, and there's no reason for it. On the other hand, everything's crisp. All the documents are fully executed. They're sitting where they're supposed to. They're nicely labeled. Now you're messaging to the investor, to the buyer, hey, this is a well-run shop. And so if they find issues, their initial presumption is going to be, this is a well-run shop, let's figure out what we're misunderstanding. On the other hand, you telegraph early on that you're a mess, you get no benefits of the doubt and every diligence finding becomes an issue and it goes downhill from there. So I cannot stress enough the need to kind of get this right and get this set up the first time you open up the data room. And the other thing is, You know, you'll always have some documents you need to supplement, but view this as a one-shot deal. Don't pretend— don't, you know, I have clients are so anxious to get going with the disclosure process and move the deal forward that they start doing partial uploads. Nobody wins. Document traffic tracking becomes a mess. And, you know, there are repeat repeated requests, then more documents come in. The buyer, the investor doesn't know documents come in. The process becomes much more difficult when most of the documents are being dribbled over time. So, you know, view yourself as targeting kind of an initial disclosure that's gonna be 80 to 90% complete before you even let the buyer or the investor into the room.

Agreed. And get yourself an index. It should be a simple form that should have at least 3 columns: document number, document name, and then description of document. It should be for everything that should tie directly to everything that's in there.

Okay. Ensuring confidentiality. So NDAs are kind of mythological creatures that a lot of people believe have superpowers. At the end of the day, an NDA is basically a ticket to go in front of somebody in a black robe when confidential information is disclosed. And in a lot of cases, by that point, you know, the damage is done. So yes, you need to have an NDA in place. You need to make sure it's going to be covering everyone who has access to the information. But the most important part of the NDA process is who is the other party signing it. You want to, you know, and it sounds ridiculous, but you want to make sure you're dealing with Trustworthy people. And if the relationship isn't deep enough yet for that and you do have questions, consider tiered disclosure. So identify kind of things that are hypersensitive, whether it's pricing information, which also may have some antitrust issues to it in the case of competitors, whether it's kind of secret sauce on the IP side, critical customer names, and phase disclosure so that you're only disclosing the most sensitive things as your confidence that they are for real and they're going to be doing this deal grows. I just closed a deal which was an acquisition of a competitor. My client was a competitor to buyer. We actually did not disclose customer names till 2 weeks before the end of closing, 2 weeks before closing when the deal was looking very certain and they did their customer reference calls. Very late in the game because of the sensitivity. And in general, if the counterparty is not a financial entity, but a strategic one, there's a potential competitor, you really should be giving thought to kind of how you stage diligence because they're going to be learning about you. And even if they have an NDA, they can't kind of forget what's in their heads. And that information becomes things that can be used against you if the deal deal financing falls apart. So you really want to kind of stage diligence and identify what are the most critical jewels that you want to keep for the end, so that you're disclosing matches kind of your deal confidence.

Yep. And on that, not just from a confidentiality perspective, this is a huge effort. So understanding how serious this investor is, will also help you out from saving time. And why are they interested in you? And do your own due diligence on the person putting money into you.

By the way, we— I should have said this at the start of the program, um, you know, unfortunately we can't really do this as an interactive program, but there is the chat functionality. And if people have questions, uh, we would love nothing more than be able to respond to your to your very specific questions. So feel free to post them. We're monitoring it and we're happy to answer any questions you have along the way. Okay, what kind of disclosures are you going to be making? So kind of inevitably, almost in any kind of M&A or financing diligence list, the first bucket is going to deal with corporation, make sure you're properly set up, that everything you everything you've done has been properly authorized, what subsidiaries you have, corporate minutes, resolutions. They're going to want to know your cap table really well and how every person or entity that's on the cap table got there. And by cap table, I mean a kind of summary of who owns what and who has what rights, shares, preferred shares, warrants, options. Particularly for companies that are first time going through due diligence, getting this right often is a lot more than they thought because this process of getting it done, especially the first time, really identifies a lot of holes and things that hadn't been documented properly. But at the end of the day, right, if a company's investing for 25% of your company, they want to make sure that they have a full understanding of the other 75%. And who owns it and that there isn't anyone who's going to surface with a claim once the dust is settled. And if they're dealing with— if it's a buyer and they're dealing with 10 shareholders, they don't want an 11th to come out of the woodwork. So it's hard to imagine something that's almost more critical in either of these scenarios than making sure your cap table is accurate and fully documented. And if there are major misses here, Easy, easy way to blow a deal.

I'm going to add a little bit to this. So everything that we mentioned from a disclosure perspective, even if you're not thinking of getting an investor or not thinking of selling or anything, you should be able to answer now. So for the organization side of the house, taking the cap table out, which I'll talk a little bit afterwards, you should be able to show an org chart. To show if there's an ownership structure, should show all the incorporation documents. If you don't have those, make sure you have them. The second this webinar ends, make sure they're saved somewhere. Every major— your leases, any major agreements that you have from suppliers, all that stuff should be saved and updated in a regular fashion. And easily accessible and also make sure they're complete. So actually, when you have these documents, it can't just be an excerpt, it can't be a boilerplate document, it actually has to be signed not only by you but also by the counterparty. If you don't have that, get that fixed today. On the cap table, one thing that happens is that you, especially if you might have done a fee-for-service saying, oh, I'll give you equity if you do the service for me, for me. Try— and odds are you never documented that. It doesn't mean that you don't have exposure to that. So make sure that you have, from a cap table perspective, not only everyone recorded, but also the supporting documentation behind it. So if you've issued shares to your employee base, do you have a record of that? Do you have a counterside document of that? Do you have that? Do you have that mentioned in the board minutes and has it been approved? Talk to, talk to an attorney about the types of things you have to have to prove out your cap table. And then talk to Durore about all the horror stories that could happen and make sure that—

Nightmare scenario here is, you know, you start up, a couple of founders, uh, Jane the web developer is brought on board, uh, founder sends email to Jane, yeah, we'll pay you $10,000 for this, or nothing at all for this, and we'll give you 3% of the company, right? Nobody knows about it, right? Then Jane reads that your company did this big financing, or Jane reads that your company just got acquired and there's a lawsuit. Now you've breached your reps and warranties and you're going to pay the consequence for it. I just realized we might have blown past the slide, so I do want to pause for a second and talk about this. Which is the timing of when you should be preparing for due diligence. And I know Aaron has particularly strong thoughts about this. I mean, he would basically say at birth, but maybe you can, maybe you can provide a little more clarity.

Sure. So from a timing perspective, you should— so if you notice, the theme of what I'm saying is, no, you should have all this stuff saved anyway. So there is a and I'm not talking like having a— you could have a formal data room, but you should at least know where all these documents are saved and make sure that they're well recorded and they're easily accessible and that they're accurate. That should be automatic from day one. If you are— but let's say you don't have that. And let's say that you're not thinking about due diligence. The latest point you should start prepping is the second you think you need capital. Once you realize that, hey, I'm probably going to need to do a raise or I'm going to look for a buyer or something along those lines, once you know that you have an intention to do this type of transaction, start prepping for due diligence. Another pro tip is at the end of that process, let's just say that you took on more investors, you still own the company, you're still— and let's use some VC terms. Let's say you just raised the Series A and you have every intention of raising a Series B in 12 months, 18 months. Start— have a minimally a quarterly process where you continue to update that data room that you did for Series A. It is going to save you time. So, and luckily the majority of work has already been done. Just, just keep refreshing those documents. You want to be able to be prepared at any point in time. You go to a cocktail party, and I, I guess people still do that in the days of, you know, viruses and the like, but— and you're talking to someone and you're thinking about getting some capital, but you haven't really started the process yet, you have no idea. Someone might say, actually, I run a fund and I'm looking for— we just raised it, we did raise a new fund, and I'm looking for a couple of good companies. I'd love to talk to you more. Well, you got to be prepared and prepared to move quick. So that's where, that's where a lot of the stuff is coming from. Just think about at any point in time, someone could be asking for this information. Do you have it? Off my soapbox.

Okay, um, okay, this is your world. You're going to go back on your soapbox.

Fun. Okay, uh, I would like to say this should be easy to get. So if you don't have this, blame your finance team. This is the one place you're going to blame someone else. You need to blame somebody like me. Let's get— this is the bare minimum. So take this slide. At the end, we'll send it out to folks. Send this— these items here you should have ready access to no matter what. You should be saving these no matter what. The first are just your regular monthly income statement, balance sheet, statement of cash flow. I said monthly. You really should have them on a month-by-month basis. If they're just sitting in your general ledger, that's okay too. But you should have those audited financial statements. If you're not audited, okay. Don't be surprised if you're going to get some sort of audit request pre or post investment of other folks. These next things, if you don't know your current accounts payable and you don't know your current accounts receivable, you're in trouble from an operating entity anyway. So that is— you should be doing that. Just like with bank statements, you should be doing monthly bank reconciliations at least. So that should be easy. A fixed asset roll forward. So let's say if you don't have fixed assets, then this doesn't apply to you. You should know if you have fixed assets. Do you own something physical? Do you own something that you've capitalized? Do you have depreciation on your income statement? Do you have assets on your balance sheet? That if any of those answers are yes, you should have a fixed asset roll forward. And if you don't know what that is, we're not going to discuss that now. Talk to your accountant or your finance people. Cash runway analysis.

Thank you for that. Not discussing it now.

Yes, yes. We're not talking about it now. Cash runway analysis. Just think about this way. Do you know how much money you have and do you know how much you're burning per month if you're not profitable or how much runway you have? That is, that's what this is. You better have that. We're not going to discuss this now, but if you don't know when you're running out of money, you could have run out of money today. You don't even know. It's bad. You have to know this. And this should be— you should mandatorily be hounding your finance people to have this. Taxes. This could mean a lot of things and you can get into a lot of trouble if you're not careful. And so taxes is either your corporate taxes, You're paying your income taxes. You also mean sales tax and your sales tax exposure. Also, do you have exposure to different states that you're selling in? Call that a— talk to your accountant, make sure you're buttoned up, talk to your attorney.

It is— your attorney is going to send you to your accountant.

Yeah. Yeah. All right. So talk to your accountant.

Can't hand this one off to us.

Oh, I tried. Make sure you're buttoned up from— and if you need to do a SALT, which is a sales tax, uh, um, study, you would be surprised at how many states you actually have to pay taxes in, uh, and you have to be registered in to do business in. And odds are you're not doing any of that. This will come up in due diligence, so it's better to be prepared beforehand. That's it. Okay.

Well, that was, you know, much less painful than I anticipated. Okay. Personnel. You know, there, there, there are a couple of pieces to this. First, the buyer, the investor kind of wants to know your, your compensation structure, you know, what, what payroll looks like. They want to make sure that everybody, you know, they want to understand what benefits, what other promises have been made. To employees, particularly for early-stage companies when they don't have processes in place. This, this is often a big mess, uh, and a decent chunk of my early engagements with companies is just cleaning up these kind of messes, particularly with equity grants. And the trick with equity grants is that there are tax consequences to going back and documenting after the fact in a lot of circumstances. So this is an area where often, you know, I don't have great answers to give companies, and not just because of my deficiencies as an attorney, but because you really can't do it. It turns out the IRS doesn't have a sense of humor on a lot of these issues. Another really big one here is confidentiality, and more importantly, assignment of IP. I had a transaction a few years back where the company had used some developers in the Ukraine for some of their early-stage development. Didn't have assignments of IP from them, and the deal was held up for 2 weeks, and we had to send somebody to the Ukraine to hunt them down. You know, hopefully easier to document your equity plans and make sure that all the grants are documented and that all the supporting board resolutions that are required for ISO and grants are in place. Benefit plans— a lot of companies use PEOs, you know, Trinet, uh, uh, Experity, companies like that. Make sure they have the plain, the plan documents. You know, for a lot of the venture investments, that'll get minimal attention. Uh, in the M&A context, they will get a lot more attention. Um, history of employment disputes— don't try to hide anything. Uh, if you've had problems, um, you know, disclose them. But, uh, your disclosures to the other side are not covered by the attorney-client privilege. So, and this is by the way, a general, uh, point. If you're about to disclose something controversial, if it's a document, it is what it is. Um, unless it's correspondence from an attorney, in which case you should never be disclosing that to or from an attorney, in which case you should never be disclosing that without talking to your attorney. But if your disclosure is narrative. In other words, if you're going to write an answer to the diligence question, um, and it's a controversial point, a potential point of liability, make sure to run the point by your attorney. Um, what I advise is on litigation or employment disputes, I will just give the most, in terms of the formal disclosure document, the most general description so that I can clearly show that I disclosed the dispute to the buyer or to the investor, but I will pretty much have no other narrative either for it or against it. In other words, I won't say, but we think the claims are meritless, or we believe we have exposure here. That I'll leave to talk through as much as I can, because those documents are discoverable in the future litigation. And so there's kind of a, you know, a joint interest both on the part of the company as well as the investor or buyer to keep disclosure on those sensitive points in the formal disclosure documents as lean as possible.

And to add to this, everything should be countersigned. So you should have it right now at the end of— save this screen too. Go to your head of HR and say, do we have signed offer letters for everyone that's here? Do we have signed employment agreements for everyone? For everyone who's here with— and the rest of this. And it's signed by both the company, you or someone in your company, reps in your company, and the counterparty is whoever the employee is. That should be mandatory. Yeah. By should be, I mean is.

Yes. Okay. Financial commitments. So, you know, this is kind of a grab bag and we could argue calling these financial commitments, but, you know, they're going to want to know the company's indebtedness and where the company has guaranteed third-party obligations. To the extent assets have been pledged in any context, they're going to want to know what's out there. In a lot of cases, they're going to run their own lien searches, but your disclosure of the liens will kind of give them information in terms of where they should be running the lien searches. If you're, you know, if you're in a business that's regulated in any way, you have all the consents and permits in place. Are they current? Are they up to date? It is, you know, it is depending on the industry, you can almost count on the fact that some permit has expired somewhere and this process surfaces it and then everyone's scrambling to renew it. And sometimes consequences of that are pretty insignificant and sometimes they're not. So get ahead of that process. Don't make your first disclosure the time, minutes after you've realized that you didn't have to sign. That's what Aaron was talking about in terms of starting the process ahead of your need for actual disclosure. Clean up that stuff beforehand. It just makes you look sloppy. Insurance. What's nice is in due diligence, particularly for early-stage companies, often it's a prompt to think about insurance for the first time because a lot of companies don't have it. So if nothing else, before you put down none in the box, which might raise some concerns, might be a good time again, if you take Aaron's advice on lead time, to actually line those policies up. And in litigation, again, if there's litigation, give the briefest description possible that kind of makes the straight face test of disclosure. That will invite questions back from the counterparty. That's fine. And then you can jointly discuss kind of how and what the subsequent disclosure needs to be. But keep disclosure lean and always around litigation, make sure your counsel has seen something before it's gone over to the other side.

I'm going to add one thing before you flip, and that's on loans. I've seen multiple times that startups, they've they've loaned out money to the, the founder. Sometimes it's, you know, in lieu of salary. Make sure that's documented and also, also know, are you planning on having— you as the founder, are you going to pay that back or will it be forgiven? If you're going to pay it back, it better be documented and you better have a payment plan. There's tax ramifications. If the company forgives that, you as a founder, you as an owner, you as whoever has significant tax implications, because it's basically you've just been given free money. You can't get away from that. So make sure that especially if it's on the books and records somehow, like, oh, I just put that down as employee loan or loan to founder, be prepared to know exactly what that is and what to do about it. That's it.

No argument here. Okay, assets. Um, so particularly if IP is important to the company, whether it's tech company where that's kind of self-evident, or brand where the trademarks are important, um, make sure you have your house in order before you go in. So if it's patents, make sure any fees are up to date. Trademarks. Again, the same thing. You're, you know, you're, you want to run the reports and spot issues and hopefully address issues first. And also make sure that all assignments are in place. So the way patent law works, right, the inventors are the owners of the technology from a patent perspective at the point of filing. That's why they need IP clauses in their agreements with the company that require them to assign it to to the company. You really don't want a situation where it turns out the individual investors still own it and haven't turned it over to the company. Make, make sure those, those ducks are lined up. Make sure, you know, you have all internet domains identified. And again, on trademarks, you know, make sure you're, you're current with the process and that your disclosures accurately reflect where you are in the process. So include not just issued patents and trademarks, but pending patents and trademarks as well. In terms of— I suspect that Aaron is going to have a lot to say about inventory, property, plant, and equipment, so I'm going to yield to him on that.

So property, plants, and equipment. There's a couple things. It's do you legally own something? So make sure it's legally documented. Is it reflected on your general ledger at all? Means is you have property, is it on the balance sheet? If it's not there, you technically own it, but it doesn't exist from a finance perspective, meaning that it's— I've got this, I got a series of laptops and they were under a certain dollar amount threshold, so I didn't capitalize. And these are all financey words. So you own them all. But they don't exist in your books and records anymore because you've expensed them. It's like I bought a shirt. I own the shirt, but it doesn't exist in the company general ledger because it was an expense. That's all okay. But you have to have— if it exists in the general ledger, and you'll know it because you'll see some sort of evidence, whether you have depreciation, whether you've done some sort of capitalization, the sales— that's, you know, the various different tax credits that you can get for, you know, from research and development or anything along those lines. You need to have all the documentation of that. You also need to have it evidenced in your current financial documents, your balance sheet and your income statement. Inventory. It's— have a good inventory process. You probably don't. No one does. I wish they did. They don't. You need to be able to know— you have to evidence not only what you have from an inventory perspective. You got to be able to assign it appropriately to the cost of goods sold. You've got to have that process documented and followed well. You also need to make sure that your inventory— you don't have anything obsolete. If you have inventory, what will happen? One, your due diligence process will be longer. Is it just— there's a lot of things you might be audited on an inventory account. Be prepared that if you don't have this process buttoned up now, there it will— it one makes you look really bad to an investor. And two, don't be surprised if you get a haircut and sometimes quite a large haircut on, on your— on the purchase price.

And related point, right? The working assumption when you put assets out there, physical assets, is that they're, you know, they're usable to run the business tomorrow, you know, so that they— if they're damaged, it's kind of subject to ordinary wear and tear. So be careful that, you know, assets that you put on the list either meet that criteria or you flag deficiencies. Similarly, you know, with IT infrastructure, If you've got some outdated computer hardware, almost better not to have it on the list than to list it, to include it on the list. And depending on the transaction, right, you could have a buyer come in and post-closing doing the matchup and that becomes the basis for a claim. And particularly if you haven't been particularly good about managing your physical assets and during COVID physical assets first, you know, do the physical inventory, match it up to what your records are showing, and make sure the stuff is there. I, I suspect in kind of mid-sized M&A deals with the— with COVID and things kind of walking outdoors, there's going to be a fair amount of disputes around, you know, missing assets.

Yeah, don't fall into the trap of like every little thing I should capitalize, because it's a bear and a half to manage. If you have a whole bunch of laptops, we have a whole bunch of like office furniture, I don't, unless it's, as long as you have an accounting policy of we don't capitalize under X amount, which if you don't have one, get an accounting policy. Don't go crazy on, these are non-core items. Well, I use my laptop all the time. It's a freaking laptop. It's not like a physical plant or a machine you own that is fabricating, you know, a product for you. I would say keep your capitalization lean to, as Drew said, actually important things to the running of your business, not ancillary items.

Okay. You know, it goes without saying, the buyer, the investor is going to know your important commercial relationships. As I said earlier, there's some sensitivity when when you're dealing with a competitor. But at the end of the day, you can kind of expect they're going to want to see the contracts. Things that they're going to be concerned about: does your transaction trigger prohibitions in the contract on assignment or change of control? And, you know, do your contracts have exclusivity that might prevent you from entering the market? Do they have kind of minimum requirements or you know, that you have to buy a certain minimal amount? Are your customers locked into a certain level of purchasing, or is it really, you know, when and if they order? So they're going to want to understand the nature of your commercial relationships, and they're going to want to be about— and they're going to be evaluating it both from a what obligations are unavoidable, what, uh, what, uh, sales volume is guaranteed or semi-guaranteed by the agreement, and will this transaction impact the relationship from a contractual perspective. They'll also probably want to see your form agreements. And depending on your stage, if you don't have form agreements, would not be a bad time to consider doing them, though I wouldn't rush to put in form agreements in place in anticipation of diligence because saying I have form agreements that are going to apply to one contract out of hundreds probably wouldn't be your best look. Aaron, do you want to discuss kind of the IT and security disclosures?

Sure. So first and foremost, your CTO is going— your CIO, whichever— your head of tech is going to be able to— is going to answer all this. Really what it comes down to is identification of policy and identification of proof that you do this. So each one of these 4, you better be doing somehow. Well, the infrastructure description, this goes to, you know, each one of these, careful of trade secrets. So I'll give you tips and tricks on this. Careful of trade secrets, careful disclosing this, the more, like I wouldn't disclose code unless you had to and be very careful with that. Cybersecurity means a lot of things to different people. But for instance, if you had a customer data breach, you better have an ability— you better like make sure you're buttoned up from a legal perspective on the post of that. Also make sure that you have that fixed for the future. Like you have to have processes for each one of these. You have to basically— so think about it this way. The buyer is going to look at this and say, does this company— is there any exposure here? The SOPs and process maps, That's really from— for key— so SOPs, standard operating procedures, these are for key processes. Not like, hey, how do I book a sale? That's not what they're talking about. They're talking about very, very key to running the company, delivering the product, delivering the service. So each one, if you don't have these, the process maps might not necessarily be as necessary. But your infrastructure description will be cybersecurity is a must, and privacy, how you protect the privacy of your client base, is incredibly important. So if you happen to have what they call PII, personally important information, Social Security numbers, credit cards, addresses of people, all this stuff, blood type, if you're a healthcare company, this is going to be, even more important, from HIPAA protection. Make sure that this is locked down, and if you can, try not to actually store it yourself. If you can get a third party that is approved to store, like you don't have to collect credit card information, you don't have that anywhere, that would be good. The second you have, the second you have this stuff saved somewhere, you can have a potential for a data breach. If you for some reason have a client list and it's got important information about that client list and something that's used for like a financial forecast, and there's a tab in that spreadsheet that has all this excess data. I've seen it as well for employees. So you'll have Social Security numbers of your employees that happen to be part of like a data file, and you as a finance person are trying to forecast out salaries and you just use that data file from HR. Well, Now you've got Social Security, once again, super confidential information, like lying around in a financial file. That should automatically be a no-no. So if you don't have a personally important information, PII, process, get one. And at least, at least at a bare minimum, the documents that you upload to the data room should not have any of that in there. So that should be your bare minimum standard.

Yeah, and again, it's hard to stress enough how much privacy has become part of the diligence process because everybody's sensitive to it. And if you're kind of in healthcare or finance, you know, it's probably too late if you haven't been talking to a privacy professional, but do it yesterday. But even if you don't, even if you have minimal exposure to it, everyone is, you know, it's funny, even in situations where the company really handles minimum amount amount of privacy information. It's kind of a check-the-box drill on the part of the parties performing the diligence, and they want satisfaction that, you know, this is an issue you've thought of, analyzed, and addressed. So, you know, just anticipate this part of due diligence. You're going to be asked about this, and either you have robust processes in place and have consulted with privacy counsel, or you have a good— you've consulted with privacy counsel and concluded that there's no real exposure And that's why you don't have anything to really say on this front. So we are coming up on the hour, and we're mindful of everyone's time. We will be sending out both this deck and a full white paper that deals with these subjects in greater detail. The deck has our email addresses, and I can be presumptuous and speak for Aaron, but both of us are are more than happy to answer any follow-up questions you might have. And with that, I'll turn it over to Aaron for any final thoughts.

Ah, Theodore, definitely reach out to us if you have questions. We may be reaching out to you just from a survey perspective. I— there's two— if I could give you two final thoughts. First is, goes back to the title, you get one chance to make a good impression. This is— think about that from any type of interaction you do with, uh, within the due diligence process. Always, always make sure that you're— everything is tied and it's clean, there's no spelling mistakes, and all the data is accurate and it all makes sense. Uh, this— the second is throughout this process, you are going to see what the what the buyer is like. And it's going to be just like when you interview a candidate, you get to see like a specific side of them. You will never know as much about the buyer as through this process. If you have any concerns, make sure that they're addressed. And if you're really nervous about how they're behaving now, when they're technically courting you and wanting to invest, imagine how they're going to treat you once they own you. So just keep that in mind and don't be afraid if you have the financial luxury to walk away from a deal that you're not comfortable with. We could, we could talk for hours on this, but in the consciousness of time, that's— I'll leave it at that.

Okay. So thank you everyone and have a good rest of the day. Take care.

Take care.