What Investors Look for During the Due Diligence Process

6 Mar

By Danielle Silva, Director of Research, Life Science Nation

For life science investors, conducting thorough due diligence on potential investments is critical, especially because many investors in the sector invest in pre-revenue companies that do not have sturdy financial positions from which to court investors. There are many misconceptions that life science firms have about what will make or break an investor’s decision to provide capital. It is extremely important for life science firms to understand what factors will come into play during the due diligence process, and what they will need to demonstrate to a potential investor. It is also key to have a checklist of all the due diligence materials that they will need to have readily available to provide to investors.

Investors in life science companies have become increasingly cognizant of intellectual property (IP) issues, which often times are addressed during the due diligence process. If IP issues are ignored, it can ultimately decrease an investor’s return on investment (ROI), and cause legal issues for them in the future. Thus, potential investors will expect that startups be very transparent about their IP portfolio and will expect companies to disclose all information regarding the IP, including if the IP is protected (for instance if the firm has patents), what products or services are covered by the IP, if there are potential competing technologies, as well as regulatory and legal implications that could potentially affect the IP. Investors may also expect to be provided a number of documents pertaining to the IP during the due diligence process.

Often times, emerging firms will believe that if they are backed by a well-known incubator, the due diligence process will be less exhaustive than for startups which do not have this kind of relationship. If anything, investors will expect firms that work with an incubator to be even more polished than startups that do not have a relationship with this kind of firm, because incubators often provide startups with many resources to help them create a solid infrastructure.

Although business incubators are known to be selective in terms of the firms they work with, they typically do not conduct deep due diligence themselves (they typically just want to ensure that a firm will not be a liability in the long term). Thus, investors will still need to conduct deep research on the firm themselves, and speak with references that are not associated with the firm’s incubator. Working with an incubator, however, is still beneficial for startups, and may illustrate to a potential investor that the firm has a unique product or idea and that they’re putting in some extra effort grow the company and get a solid infrastructure in place.

Another myth that many entrepreneurs believe is that if their firm is registered as a Delaware corporation (DE corp) it will shorten the due diligence process. Although registering a firm as a Delaware corporation will certainly add legitimacy to a company (around half on the Fortune 500 list are registered as DE corporations), it unquestionably will not convince an investor to immediately give a firm their stamp of approval and make an investment. Firms can easily and inexpensively register as a DE corporation online (sometimes for as little as a several hundred dollars), so investors may be wary about a firm’s validity even if they do obtain this registration. Registering as a DE firm, however, is beneficial to small firms and should be taken into consideration because Delaware does have very favorable business laws. Thus having a DE corp registration will not make or break an investor’s decision, but it may help a firm demonstrate to an investor that the management team does have a level of business acumen.

Many life science firms recognize that they must spend a good deal of time and resources putting together their marketing materials and focusing on branding their firm to attract potential investors. Many firms, however, do not realize that in order to complete a deal with a potential investor, they must also have their due diligence materials in order. Accordingly, it is vital to put just as much time and effort into drafting due diligence materials as it is to spend valuable resources on putting together marketing materials.

Investors will expect that entrepreneurs will provide a number of documents during the due diligence process, regardless of how young the firm is. This will generally include all of the companies financials (including future forecasts), lists of employees, investors, and advisors (including legal representation), stock purchase agreements (as well as stock option and agreements and plans), articles of incorporation and by-laws, product plans, as well as a business plan and investor deck (if not already provided to the investor previously). This is not an exhaustive list of all the due diligence materials that investors may ask for, but these are the most common documents that investors will ask that a company provide.

The most important thing to keep in mind during the due diligence process (although quite obvious) is that honesty is always the best policy. If certain numbers are provided to an investor over the phone by a company during their initial correspondence and these figures do not match up when an investor is going through a firm’s financials during the due diligence process this will be a huge red flag for the investor. Thus it is imperative for entrepreneurs to be open and honest with investors from the get go, and to be as transparent with investors as possible. This will not only ensure that an investor is comfortable during the due diligence process, but will also help the firm develop an open and solid relationship from the very beginning. Thus, the more transparent and candid life science firms are during the due diligence process, and the more willing they are to provide the necessary documents to investors, the smoother the due diligence process will be for both the life science firm and the investor.

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