Tuesday, August 28, 2012

Pause Points for Diligence in Venture Deals

Last night Mark Suster wrote a thoughtful post on How Much Information Should You Give VCs During Diligence and, jet-lagged, I read it this morning and posted a comment.  As I thought more about it and realized I was about to commence both a new semester teaching Venture Capital and Angel Investing to MBA Candidates at Columbia University's Business School (my 7th year teaching this with my partner Dave Haber at Lowenstein Sandler) and a new vintage of www.FirstGrowthVN.com, with its  15 or so teams of founders, it might make sense to spell out my thoughts on the topic here.

Here then are my Pause Points For Diligence in VC Deals -- points in time at which the founders need to consider whether, how and to whom to disclose.  I think Mark did a fine job of talking about what to disclose during the initial getting to know phase, though I think it is fine to talk to more VCs and to simply get to know them and update them on your business. I'd set expectations about that being the purpose of a meeting before you arrive at the meeting, but building your network of investor relationships early is a very solid strategy.  It also happens to be very rewarding...many venture investors are really charismatic and insightful people -- they have to be, they're in the business of convincing really smart and creative people that the same amount of money from one investor is more valuable than that amount coming from another investor!

I give three pause points in the body of the article covering the time period after things have heated up with investors and before the closing but give 8 pause points at the end of the article from the start of the process (before you meet) to the closing.

Quick note: this isn't legal advice (and it isn't illegal advice) so don't sue me for it!

Years ago I had a friend and client who, sadly, perished in the twin towers on 9/11.  She taught me a number of things which still influence how I lawyer today.  One of them was "Bad news isn't wine, it does not improve with age."  That one applies here quite nicely.  Once you've passed the initial getting to know phase, there's a huge pause point (1) when your sponsor or deal champion at the fund is socializing the deal with her colleagues before the partner meeting. One good test for founders is to try to put yourself in the shoes of your sponsor at the fund and ask whether she is going to need to go back to her colleagues and say "hey, I either didn't do my homework or the founder didn't have great judgment about what and when to make disclosure but here's something we need to consider before we invest..." Investors will feel embarrassed and burned if they receive material bad news after they've greenlighted a deal. As an angel who has championed deals and brought others into a syndicate (as recently as this month), I certainly am sensitive to having egg on my face because it looks like I wasn't thorough or the founder didn't trust me enough to share potentially off-putting news. Sure, as angels we can ask the really hard questions, but we worry about giving off a bad vibe and/or impacting our own reputations ("Zimmerman, he's the creep who asks everyone if they've previously declared bankruptcy..." No thanks!). My view, as an angel, is that the founder should be forthcoming about negative info rather than waiting for me to ferret it out. How would you feel as a founder if, as an angel about to make a small investment and bring in a bunch of my friends, I asked you whether you had declared bankruptcy or been convicted of a crime? I think that burden should fall on the person with that in his or her past. Of course that is something the lawyers will need to tackle in legal diligence, which comes after there's a signed a term sheet but I'd argue that is way too late to first be learning about those two types of disclosure.
There's another pause point (2) before you sign the term sheet and again (3) before the company sends the investors the first draft of the disclosure schedules. The disclosure schedules get attached to the purchase agreement and modify the representations and warranties in the purchase agreement. For instance, "there's no litigation except the matters listed on schedule 3.7." If there's anything embarrassing (criminal, bankruptcy, resume inaccuracies) those usually get disclosed before the schedules go out either in a call or face to face - you don't really want your investor to read about the fact that you went bankrupt, tell her in real time (preferably shortly before she brings it to the partnership for issuing the term sheet, but that may be an over generalization of complex facts). The diligence process is an important prelude to setting the tone for a relationship in which bad news will inevitably get shared (even at great companies), usually in both directions (investors do, sometimes, have disappointing news to deliver to their management teams). Set the tone for honesty and openness early in the relationship. This also holds true for personal things (a dissolving marriage could, for instance, impact your whereabouts during the day and your focus at work; it could also impact stock ownership, and it has).  There are plenty of things that may not have any legal impact but that your investor should probably know about before funding because it might just feel awkward if they learned about it later.  Again, this is relationship/trust building as much as it is legal considerations. For instance, I'd expect a severe illness in the family to have an impact and it is something that a founder might consider disclosing at some point before the closing even though it may not be relevant disclosure from a legal perspective. Of course if you, as a C level executive, have had 3 prior heart attacks and are about to take the helm of a company into which investors investors have poured millions and you falsify your pre-employment questionnaire (by omitting to reference your heart attack), do expect that to bite you in the ass...and hard! (I mention this one because in putting miles on my odometer, I've had this actually happen...he had a heart attack during the first week in the new role!).
It is important to know that you will be held to the standard of having needed to disclose anything a reasonably prudent investor should have known before she made the investment decision. This standard requires foresight and judgment, the kind of judgment that only comes from having considered these decisions and then lived with the results...for years and years. If you're uncertain but think that disclosure might be necessary, run it by someone who has put a ton of miles on the odometer in these types of deals, there's no substitute for experience in terms of whether, how and when to make the disclosure.
As Mark's post indicates, people don't forget it when you've breached propriety in diligence, whether it was contacting people when you were asked not to do so or whether you shaded something the wrong way or exercised poor judgment about what and when to disclose. As a lawyer representing numerous venture funds, I've certainly spent time with clients noodling through whether I thought the founder who had messed up the timing, tone or decision to disclose was simply inexperienced and getting bad guidance or was not forthcoming. The first of those two categories can be a problem and requires fixing and the second can be worse. I've also spent way more time counseling founders on whether, how and when to disclose. It is important to note that lawyers shouldn't just have a knee-jerk reaction saying "disclose everything." I'm not suggesting that you hide pending lawsuits or felony convictions, but I'm not sure, for instance, that it is a good use of time and paper to disclose speeding tickets...that you paid.  On the other hand, having been fired for cause may end up in that middle category where the reasons and timing may well be important.  I mention that because I have been fired for cause...more than once (though not since law school).
While the odds of a bad outcome (the thing to be disclosed may never come to fruition) may be low, the odds of the investor finding out either not from the founder or after the closing can turn an honest mistake into a failure to properly respect a relationship. These can be pretty subtle judgment calls more susceptible to being talked through than to a 5 Simple Rules approach.

So now that I've said I can't give you 5 simple rules, I can give you a handful of pause points when you need to strongly consider whether to make additional disclosures -- and it is a bad idea to be forgetful when trying to figure out if there is something important to consider, which is why overly inclusive diligence lists that ask whether you've been arrested or gone bankrupt are important and helpful:

1. When introducing your business by email, especially through a middle person (friend of a friend) or cold

2. At first meeting -- if you aren't shopping/pitching, manage expectations about that and figure out in advance what you want disclosed

3. Before investors do a deep dive to figure out whether this is something they might want to fund

4. When your internal champion/sponsor at a fund or in an angel group is about to socialize your business with her colleagues/friends before greenlighting a term sheet or investment

5. Before signing that term sheet

6. Before sending the first raft of diligence materials -- call or do a face to face if there's anything icky or sticky to disclose

7.  Before sending the first draft of the disclosure schedules -- I hate seeing something that the founders knew about and just didn't want to disclose when I get a blacklined second or third draft of the schedules.  The junior lawyers and junior people at the fund will always read the blacklines and the senior folks often do as well.  Adding something negative that just arose is okay (of course, it may be so negative that it impacts the deal, but at least you won't look like a liar...unless it is a perjury conviction in which case, there's not much I can do to help you!), but a late addition of something material that was clearly known about previously is worth noting and not in a good way.  I'd want to understand why it had not been disclosed sooner so be ready to explain.

8. Before closing.  This is why lawyers for the company often do a "knowledge group call" with the management team members in the so-called "Knowledge Group" to go through the reps and warranties.  These calls aren't always done and in a cost-cutting/cost-conscious environment, people in seed and venture deals often omit them.  I'm a fan of doing them, especially in M&A and larger venture deals.

Hope that helps.  Please share your experiences and pose your questions!  Thanks.

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