Investor Due Diligence Should Go Both Ways
Due diligence is a routine part of an investor’s decision whether to invest in a company. The company also should conduct its due diligence on the investor.
A couple of years ago, I worked with a company (“Client”) that provided e-mail security products. Previously, Client’s founder (“Founder”) had arranged for an equity investment by a company controlled by an individual in Southern California (“Investor”).
One of Founder’s huge mistakes was not seeking legal counsel to review the terms of the investment. Two of those terms proved to be disastrous for Founder:
- Investor was provided a majority of the shares of (i.e., control over) Client.
- Although Investor’s investment was to be made in a series of tranches over time, all of Investor’s shares were issued to him up-front – it is more customary, and more appropriate, for shares to be issued proportionally as investments are made.
Investor was dissatisfied with Client’s financial performance. In short order, Investor stopped making his investments, voted Founder off the board of directors, removed Founder from her position as President and CEO, and had Client liquidated. All of the time, energy and money that Founder had put into her company over a period of several years was lost forever.
This brings us to Founder’s other huge mistake: She did not conduct due diligence on Investor. Had she done so, she might have found, for example, a Wall Street Journal article stating that Investor had been subjected to a seven-year suspension from trading by the Alberta Securities Commission for selling unregistered shares in a limited partnership.
So if you have lined up a prospective investor for your company, (a) ask the investor to identify all of the companies in which he has invested, (b) talk to the CEOs of those companies to find out what type of working relationship they have with the investor, and (c) use online research (Silicon Investor, The Funded, etc.) to help determine whether the investor is reputable.
An interesting perspective on this topic is offered in a blog post titled Why Do “Asshole VCs” Survive?.
Related post: Investor Due Diligence Redux
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.
Dana Shultz is a business-savvy lawyer located in Northern California's San Francisco Bay Area (in the East Bay, near Oakland) who has in-depth knowledge of law, business, technology, and the needs of startup and early-stage companies.