By DShen on February 14, 2013 9:02 AM

In two past posts, I talked about doing due diligence on startups. The first one was The Lack of Due Diligence is Appalling and Foolish where I lamented that most investors I met out there did virtually no due diligence whatsoever. Then I talked about how simple and easy doing The Due Diligence Customer Call was, and some suggestions on what to ask. There are two more topics I would like to tackle in the due diligence area. Last year, John Lanahan in our research team tackled research due diligence in Efficient Research: The Lean VC Way. The last part of due diligence that I will post about today is corporate due diligence.

In my Lack of Due Diligence is Appalling and Foolish post, I give a short list of documents I ask from the startup before investing. I have expanded that list slightly, adding debt obligations, business contracts, and then I modify it based on the situation and startup in question, but it has essentially been the same over the years. Most of the time I collect all this into a Dropbox folder and send it to my lawyer for review. It has always amazed me that it takes him only 1-2 hours to go through this- I guess when you look at a lot of this stuff, you get used to reading it and picking out specific stuff to look for. Every now and then, I get the opportunity to do corporate due diligence myself and yes I can definitely say it can take you only an hour to do this!

Generally, the corporate due diligence step I leave for the last step, after doing customer calls, reference calls, and research on the market. I don’t want to ask for corporate documents unless everything has checked out up to this point, since those documents are confidential to the company and I want to respect that.

Note that I am ONLY talking about early stage startups: companies that have been only in existence for less than a year and have not had many business operations. Corporate due diligence can grow exponentially when the company has been in operation for years and then there are tons of documents and contracts, which can take teams of lawyers weeks to review. So feel lucky that at early stage, you don’t have much company history to go through! But sadly, there could be a lot still to worry about.

So yes it can take only an hour! Just a few months back I did just this with a startup and zinged a bunch of questions back to them for inconsistencies and missing items. How does one do this? Some tips:

1. Do this often. Get used to reading legalese and understanding it quickly.

2. Learn to recognize standard legalese in corporate documents and when they diverge.

3. Learn to read and scan text quickly.

4. Take notes in a separate notepad or document while reviewing, so you can come back to important points or questions.

OK those are the preliminaries; now what to look for? Some common things I’ve learned to look for are:

1. Which items in the list are missing and why?

2. How many shares are authorized in the Articles? It is better to see 5M or 10M authorized. I would raise a flag if only 10K or similar shares were authorized. Lower numbers authorized also can indicate that someone incorporated by themselves at some online easy incorporation website — not the best option.

3. Scan through the board meeting minutes, assuming they exist. Identify any inconsistencies in personnel, consultants hired, stock granted to individuals and why, business dealings, operating directions, and information in the minutes and the other documents.

4. In the stock purchase plans, are people vesting or do they own stock?

5. If there have been previous financings, what do the terms of those financings look like? Do any have any effect on your money coming in at this time?

6. If there are any contracts, are there any problems with those contracts relating to future business?

7. If there is any debt, are there any liabiltiies to be aware of? Any liens on the assets of the company? Who gets paid back first and when?

8. Who is the lawyer? Be wary of lawyers who are not familiar with early stage startup work. Their lack of experience can cause all sorts of unwanted trouble — doesn’t mean they aren’t good lawyers, just means that lack of experience on what is acceptable and what is not can be a barrier to getting things done.

9. How much is owned by founders, employees, and, if any, previous investors? Is this acceptable to you?

10. Go to the site of the state in which they are incorporated and search for them in the incorporation database. Make sure they really exist there!

11. Write down all people and companies you encounter in the documents. Did they get money or stock? Or were there contracts that were entered into? Are they accounted for in other documents? Check the cap table — is anyone missing? Check on why anyone would receive money from the company.

There are many more that come up, but those are ones that I’ve encountered in previous deals. I also asked my lawyer for a broader set of Top 10 things to look out for, from his perspective, listed here:

1. No Organizational Resolutions (after Articles, to set up the company, appoint officers, etc.), or they are incomplete.

2. No qualification filed in state of domicile (e.g. DE company located in CA, no filing made in CA).

3. Docs are provided, but they are unsigned.

4. Company is set up by an Incorporator, but there is no Action by Incorporator adopting the Bylaws and appointing the initial Board.

5. Stock Options granted, but a Stock Option Plan was not adopted by the Company.

6. More stock issued than is authorized by the Company’s Articles/Certificate of incorporation.

7. No Board Consent or Minutes approving the current financing.

8. Notice of Stock Transaction (in CA, a 25102(f) Notice) not filed with the State for the sale of stock.

9. No Cap Table.

10. Founders acquired stock but did not sign a Stock Purchase Agreement.

My list and my lawyer’s list provide a great starting point. These lists are not, by any means, exhaustive. My best recommendation is always to collect the information and then send it to your lawyer for review and spend the money for it to be done by a professional. In lieu of that, it is always educational and interesting to go through these documents by yourself and try to spot potential problems. I always scan the documents, even when I send them to my lawyer, for practice, and also to double check his work because sometimes I may find something that he may miss, or I may care about something due to the nature of the company and situation but he won’t know it’s important since he isn’t as close to the deal as I am.

The next step is to then decide whether you’re OK with what you found or not. At early stage, it is common to find lots of corners have been cut to get to where they are now. Many early stage rounds are completed with big discrepancies in the corporate documents unfixed. If an institutional investor comes in, they will most likely demand clean up. I have often asked to clean up, even at low levels of investment. Rarely do I find that an entrepreneur won’t clean it up; most of the time he/she knows it has to be done anyways, so why not now?

Other red flags:

1. I have asked for corporate due diligence documents and the entrepreneur has refused to provide them.

2. The entrepreneur doesn’t want to clean up the documents, or constantly backpedals when you ask.

I have walked away from deals, after doing all sorts of other due diligence and then got to corporate due diligence and either one of those red flags pops up or I find something that I cannot live with. Do not skip this step!

Doing corporate due diligence is a necessary step no matter what the level of investment. It is best done by spending a little bit of money getting a professional eye to look them over. And it can be done on the cheap by doing it yourself.

Thanks to Mark Edwards of Edwards Law Group for contributing to this post.