Introduction
Generally, investments are a significant source of capital for startups, and a startup's ability to attract investments is often the difference between growth and stagnation. This ability also aids the transition from being a bootstrapped entity to a venture-backed company, as a number of significant decisions that impact the startup's growth revolve around this ability. Startups never exist in a bubble and investment decisions are anchored on a number of questions which revolve around the actual or potential viability of a startup. Due diligence is the task of determining what questions to ask and what the right answers are based on the applicable regulatory requirements and lifecycle of the startup.
Legal Due Diligence Across Board
What is Legal Due Diligence?
Legal due diligence is the comprehensive review of the material information and documents of an entity to ascertain the extent of the entity's compliance with regulatory standards and requirements.
Within the context of an investment, legal due diligence is the audit of a potential investee startup ahead of an investment decision. Beyond viable products and well-crafted pitch decks, the due diligence process creates a lens through which an investor can accurately assess the investible state of an entity.
While the evolution of innovative technologies has improved access to startups across jurisdictions, this advantage has extended the borders of the due diligence process as investors are also required to review the business models and extent of compliance of global startups with relevant regulatory standards as each due diligence process has to consider the regulatory nuances of the jurisdiction.
When Does Legal Due Diligence Start?
The legal due diligence process often commences with an informal interaction between the startup and a potential investor. In 2021, Mr. Sahil Lavinga disclosed that his first interaction with the founders of Cowrywise, a savings and wealth management startup had happened via a direct message on Twitter, an interaction which culminated in an investment in the startup's preseed $3 million round.1
The due diligence process often commences with the submission of a due diligence checklist to the founders of the entity being reviewed. The due diligence checklist requests for disclosures which inform the final decision of the investor.
Why is it important?
Startups are largely focused on product development and scaling, investors are focused on the viability of a business and returns on investment. By virtue of this, each investment decision secures an investor's buy-in to the business model and operations of a start-up. The importance of conducting legal due diligence before investing in an entity cannot be overemphasised.
Legal due diligence largely serves as a compass which guides the investor through the business and operational model of the startup, exposing and assessing risks along the way and advising on next steps. By asking the important questions, legal due diligence ensures that an investor does not jump headfirst off a cliff.
For startups and investors, legal due diligence is a coin. For startups, legal due diligence creates an opportunity for startups to improve and raise their standards. On the investor side of the coin, legal due diligence ensures awareness of risks and moderation of expectations ahead of an investment decision which may go one way or the other. These double-sided advantages stem largely from the fact that due diligence focuses on the following crucial areas:
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Footnote
1. Exposure to risk: What tech investors fear and find interesting about Nigeria's Twitter ban | TechCabal https://twitter.com/razaqahmed1/status/1354985823834402822
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