Allens Accelerate
Preparing for investment
So you've reached that pivotal point in your startup journey where you (and your startup) are ready for investment. By this stage, you will likely have spent a long time thinking about, perfecting, and presenting your pitch to investors.
It's natural to want to jump straight into negotiating the terms of a potential investment. However, the period between a successful pitch and finalising an investment is crucial, as investors will use this time to validate everything that you have told them by conducting 'due diligence'.
Think of due diligence like a housing inspection when purchasing a property – before you make any significant investment you would want to confirm there are no structural issues, verify ownership details and ensure that there are no hidden skeletons that could cost you down the line. Similarly, when an investor is doing due diligence on a startup, they are looking for any red flags that could potentially jeopardise their investment.
A good investment will be beneficial for both the investor and the startup. As a result, it is also critical to conduct your own due diligence on prospective investors to confirm that they have the capacity to provide the support you need and ensure alignment of values and growth objectives for your startup.
In this Insight, we explore some of the key areas that investors will scrutinise when conducting due diligence and provide you with a roadmap to help you get your house in order from a legal perspective. We will also delve into what you should be looking for in an investor and why we recommend conducing your own due diligence before an investment.
The value proposition check
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When engaging in a due diligence process, it is helpful to remember that investors are looking to invest in your startup for (primarily) three core reasons:
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Together, these inform what the startup world refers to as your value proposition.
Your idea provides the innovative core, the IP offers protection and exclusivity, and your team ensures effective execution and roll-out of your business. These factors create a compelling opportunity for an investor. However, an investor will need to be able to see that your idea cannot be easily replicated without your IP and that your team is uniquely positioned to bring the idea to life. They will also want to make sure that the startup they are investing in owns and has protected its valuable IP.
The 'make or break' red flags
While a value proposition lies at the heart of the success of a startup, there are a number of areas that investors will focus on as part of their due diligence. This is because red flags that are identified in these areas have the potential to make or break an investment. These include:
Practically speaking, an investor is looking to buy a stake in your startup and will therefore want to investigate its legal structure and ownership and ensure that all the appropriate governance guardrails are in place to protect its potential ownership. In practice, verifying that a startup has all of the expected governance documentation in place (e.g., a constitution and shareholders agreement) is a crucial first step in an investor's due diligence. We have provided more information below on how you can establish strong legal foundations and ensure that your ownership and governance frameworks are not a 'red flag' for investors.
As flagged above, if your startup is dependent on its IP (as many startups are), investors will be eager to confirm that the entity they are investing in actually owns or has the necessary rights to exploit, commercialise, develop and use the IP that it relies on. An investor will also be keen to understand whether you have, where appropriate, protected your IP and confidential information from competitors with:
- non-disclosure agreements with key suppliers, customers, employees and contractors;
- written IP assignments from founders, employees and contractors involved in the development of this valuable IP; and
- registration including, for example, trademarks and patents (but only in circumstances where it makes commercial sense to obtain such registration).
If your IP is crucial to your business strategy, we suggest that you consult with experts about what you can protect and how best to do so. Not everything can be patented and understanding the nuances will help safeguard your innovations effectively.
Investors will want to see that the arrangements that form the commercial basis of your startup are formally documented (for example, customers contracts, supplier contracts and terms of use) and that you are doing what you can to extract the most value from these arrangements. Investors will scrutinise available material contracts to understand your startup's revenue security and risk management. An investor will typically be on the lookout for key contract terms, such as:
- termination rights – what rights does a customer or supplier have to terminate their contracts;
- limitations of liability – what risk exposure does your startup have under the contract and what ability does it have to protect itself from the other party; and
- exclusivity arrangements – are there any restrictions on your startup's growth due to exclusivity promises made to certain customers or suppliers.
Ensuring that a startup is complying with its regulatory obligations will typically also be a core focus for investors. This is particularly relevant for startups operating in heavily regulated industries like healthcare or fintech. Investors will want to confirm whether your business has obtained all necessary approvals and licenses required for legal operation in its market. Compliance ensures that you avoid hefty fines or operational shutdowns due to legal issues.
Another cornerstone of investor scrutiny during due diligence, investors will look into your startup's financial arrangements. This includes any loans, liabilities, cash flow statements, and repayment terms to assess the financial health of your startup. High levels of debt or unfavourable repayment conditions can strain cash flow and hinder growth potential, posing significant risks to future profitability.
Investors will want to examine the team and employment relationships, often with a focus on the key personnel who are essential to the day-to-day operations and fundamental to executing your business plan successfully. Investors may also be doing a 'vibe check' to make sure that there are no culture and conduct issues that may result in grievances down the line. Generally, investors need confidence that a startup's team members are committed, capable and adequately incentivised to align their interests with company goals. They will also want to ensure that your employment agreements have appropriate IP assignment, confidentiality and non-compete clauses in place.
Our tips for surviving a due diligence
With all of this in mind, there are a number of pre-emptive steps that startups can take to ensure that they are ready for due diligence by an investor.
Create a smooth process
Make the due diligence process smoother by anticipating investor inquiries and providing all relevant information and documentation upfront.
Don’t hide bad news – address potential issues early on. Investors appreciate transparency and are more likely to work with you if you’re upfront about any challenges. Remember, the larger the investment, the more thorough their scrutiny will be. Surprises can derail deals quickly.
The due diligence process will require sharing sensitive business information. Consider what confidentiality arrangements you can put in place to protect your interests or how to you might deliver certain information (for example, withholding certain information deemed too sensitive to share at an early stage).
It is typical for prospective investors to ask that startups disclose materials (i.e., documentation such as, standard form customer contracts, governance documents and internal policies such as privacy policies and employee codes of conduct) as part of its due diligence process. For this reason (as well as simply ensuring overall good governance), it is vital for a startup to ensure that it documents all material arrangements and processes and is ready to deliver up these materials when asked.
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That doesn't necessarily mean that your team needs to spend hours poring over contracts. A well-oiled startup often leverages template agreements tailored to its specific circumstances. Adopting a similar practice will also ensure consistency and protection of your startup's interests. Examples of the different types of agreements that you might create standard form contracts for include:
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Startup due diligence is targeted and founders and investors alike do not want to be trawling through reems of information. Ensure that the materials you provide are truly relevant to your startup and your investors decision to invest (for example, the 'make or break' items we have identified above). The same goes for your startups' legals – invest your money on the areas most crucial to your startup in the early stages (for example, registration of key IP, strong protective customer contracts etc). Utilise free templates such as the Allens Accelerate A-Suite for areas which do not require bespoke legal advice – it is much better to have an off-the-shelf document than none at all!
Laying strong foundations
Your startup should have a strong legal foundation and appropriate governance processes in place. While startups can adopt a variety of company structures (eg proprietary limited companies, companies limited by guarantee and pubic companies), a proprietary limited company is by far the most common structure adopted and is generally best suited for a startup looking to take on external investment. Ensure that your company has been properly incorporated with a clear ownership structure.
Shares should be appropriately allocated among founders, early key employees, and/or investors and recorded in an up to date and accurate register of members. Additionally, notify ASIC of all company details and shareholders promptly to avoid penalties.
Define how day-to-day operations are managed and how critical decisions are decided. Establish whether certain decisions are reserved for shareholders or if they can be made unilaterally by a CEO or executive team. All of these issues should be dealt with in the constituent documentation that you prepared when you worked out what structure was best for you. For a proprietary limited company, this will be a shareholders agreement.
| A shareholders' agreement plays a critical role in formalising these arrangements. This document outlines each shareholder's rights, obligations, responsibilities, and share distribution within a company and serves as a governance tool that regulates how decisions are made. The Allens Accelerate Corporate Bundle includes a template shareholders' agreement that can serve as a starting point for drafting your own agreement, if you do not have one in place. |
An investor will also be interested to understand whether you are bound by any earlier arrangements that may restrict or prevent you from receiving investment. If you have bootstrapped your company from the get‑go you might not need to worry about this. However, many startups get off the ground with a little help from friends, family and angel investors, usually in exchange for shares in the company. You will need to consider how those investors will be impacted by any new investment – and conversely how the rights attaching to their shares might affect the new investment (eg do your existing shareholders have the first right to provide additional equity funding to your startup, or a right to approve future fundraisings?).
Do your own due diligence
The way that you engage with prospective investors during the due diligence period will not only determine whether you attract investment at all, but will set the tone for your relationship going forward. As the old saying goes, there is no such thing as a free lunch! Your relationship with your new investors will be critical to the success of your startup.
Before you sign on the dotted line, it is important that you have carefully considered all the elements of the proposed investment, including crucially, what type of shareholder the investor will be. Although the prospect of receiving investment is exciting, in order to ensure the longevity of your startup, it is important to ensure that the investor understands and is aligned with your goals and objectives for the startup, as well as your values and boundaries.
This is a particularly important consideration at this stage as you have the opportunity to include certain protections in your investment agreements that can help manage your relationship with the investor, safeguard your interests and control over your startup and essential business decisions, and reduce potential conflicts down the line.
Your due diligence checklist
Make sure you understand:
- the degree and type of involvement your investor intends to have. Are they taking board seats? Do they provide mentoring and network opportunities?
- their expectations regarding information and reporting (will you be spending all your time on monthly investor reports, or will they provide you with some freedom to get the job done)?
- how their other investments have performed? Don’t be afraid to ask for references from other startups they have invested in.
- their ultimate goal for your startup and whether it aligns with yours.
- whether they are supportive of you raising further capital in the future (would dilution of their stake in your startup negatively impact them and can they prevent this).
- what is their expectation regarding liquidity (will they put pressure on your startup to 'exit' before you are ready).
The arrangement that you reach with the investor should reflect the type of investor you want – do you want active investors who have a say in day‑to‑day decisions, or do you want someone more passive, who will just provide their money and let you run the show? You and your investor should be clear about their role, and your agreement with them needs to reflect that.
So what next?
Allens Accelerate can help get your startup ready of investment. As a first step, we suggest downloading the Allens Accelerate A-Suite, our free foundational legal documents for startups. Then when you are ready for additional help, reach out to us via email and we can discuss how our startup experts can help set your startup up for success.