Investor Due Diligence Should Go Both Ways

Due diligence is a routine part of an investor’s decision whether to invest in a company. The company also should conduct its own investor due diligence.

A couple of years ago, I worked with a company (“Client”) that provided e-mail security products. Previously, Client’s founder (“Founder”) had arranged for an equity investment by a company controlled by an individual in Southern California (“Investor”).

First Mistake: No Legal Counsel

One of Founder’s huge mistakes was not seeking legal counsel to review the terms of the investment. Two of those terms were disastrous for Founder.

• Client issued a majority of its shares (i.e., control) to Investor.
• Investor’s investment was to be made in a series of tranches over time. However, Client issued all of Investor’s shares to him up-front. (It is more customary, and more appropriate, to issue shares proportionally as investments are made.)

Investor was dissatisfied with Client’s financial performance. Investor stopped making his investments, voted Founder off the board of directors, removed Founder from her position as President and CEO, and liquidated Client. Founder lost all of the time, energy and money that she had put into her company over a period of several years.

Second Mistake: No Investor Due Diligence

This brings us to Founder’s other huge mistake. She did not conduct due diligence on Investor. Had she done so, she might have found, for example, a Wall Street Journal article reproduced at Silicon Investor stating that Investor had been subjected to a seven-year suspension from trading by the Alberta Securities Commission for selling unregistered shares in a limited partnership.

So if you have lined up a prospective investor for your company, here is what you should do.

• Ask the investor to identify all of the companies in which he has invested.
• Talk to the CEOs of those companies to find out what type of working relationship they have with the investor.
• Use online research (Silicon Investor, The Funded, etc.) to help determine whether the investor is reputable.

An interesting perspective on this topic is offered in a blog post titled Why Do “Asshole VCs” Survive?.

Related post: Investor Due Diligence Redux

Image credit: Biz Blog

Dana H. Shultz, Attorney at Law +1 510-547-0545 dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.