5 Things Found in Diligence

1. Company IP. For technology companies, IP is very often the company's most valuable asset, yet we’ve seen instances where ownership of that asset is suddenly called into question. In one case, a very early co-founder had worked on the company's product years before and subsequently left the company to pursue another career altogether. Although he was no longer involved with the business, the company’s documents left open the possibility that he could claim he helped develop core technology and therefore was entitled to participate in the company's success. In another case, a founder had received an early research grant from a university. Buried in the grant agreement were provisions giving the university certain co-development rights over a piece of technology that had become critical to the company's product. Gone unchecked, these issues could have materially reduced the value of these investments or jeopardized a future financing or acquisition.  

2. The cap table. Verifying the cap table should not be a perfunctory task. It requires careful, detailed review to ensure the numbers actually tie out to the company’s documents. For example, we’ve found option pools that were not properly reflected in the share price, resulting in incorrect ownership calculations; an investment that was never properly recorded and remained off the cap table through several subsequent financing rounds; and many instances where a single incorrect formula threw off the calculations for the entire cap table, skewing the ownership percentages for investors and founders. Even small errors or oversights can have outsized consequences in a company’s cap table, yet they often go unnoticed.  

3. The often overlooked "miscellaneous" section. Some of the most consequential provisions we've found are hiding in the least exciting part of an agreement. For example, a specific investor had consent rights over any amendments to a key agreement, giving them the ability to hold up future financings due to an effective veto right over the proposed terms. In another instance, “majority approval” actually meant only one shareholder who could make changes to a critical agreement unilaterally. We also often see issues with amendments to the provisions granting board designation rights. In those cases, former founders could have retained the ability to control their seats after leaving the company, giving outgoing founders outsized influence over the company and serious leverage in exit negotiations. Needless to say, seemingly boilerplate provisions in the miscellaneous section of an agreement can have major ramifications.  

4. Supervoting rights. Founders often receive special voting rights in the early days of the company. That's not necessarily unusual, but investors should understand exactly what those rights mean. We've encountered situations where a founder's stock carried multiple votes per share, giving that founder substantially more voting power than their economic ownership would suggest, even after the founder’s ownership rights had been diluted in subsequent financings. Investors cannot assume that ownership percentage equals voting power. It is imperative to look at the company's different classes of stock and calculate who actually controls shareholder votes. 

5. Personal relationships within the company. Sometimes the relationship between co-founders isn't just a business relationship. That isn't inherently a problem, and many successful companies have been built by people with close personal relationships. But it is something investors should know and understand, as a personal dispute can quickly become a business dispute, and startups are highly dependent on their founders. A breakdown in the founders' relationship can create instability at exactly the time when the company needs focus and leadership. Investors should understand whether there is a relationship that could materially affect the company's stability and ensure the company is prepared for that possibility. 

Due diligence isn't about finding reasons not to invest; it’s about identifying problems when they are still fixable. Some issues can be solved with a simple closing condition, while others require a much more complicated cleanup. Either way, the earlier you catch these issues, the better.