Corporate Law

Author: Andrew Hennigar & Mike Weber

For many growth-stage business owners, securing an investment requires weeks or months of invasive due diligence of your business.  During the process, usually the investor asks the questions and the business owner promptly and “happily” provides answers, hoping that each question will be the last and the answer will lead to the investor cutting a cheque.

So focused on securing that investment, many business owners may overlook performing their own due diligence of the investor with potentially perilous consequences.  Below are just some of the reasons why conducting your own investigation must be a crucial part of the investment process.

  1. Securities Act Compliance. Canadian securities administrators continue to increase the onus on companies to ensure that investors meet the requirements set out in the various prospectus exemptions in securities law.  For instance, it is no longer sufficient for a company to simply rely on an investor checking a box in a subscription agreement indicating that they are an “accredited investor” or other qualified person.  Companies must now take steps to verify the representations made by investors or risk penalties from securities regulators.
  2. Regulatory Compliance. For companies that operate in regulated industries or are subject to conditioned cultural grants, it is imperative that they know all of the details of their investor base to ensure that they do not inadvertently face consequences from a change in residency of their company resulting from the location of their shareholders.  For example, for Canadian small and medium sized businesses, maintaining requisite Canadian ownership and control to qualify as a “Canadian controlled private corporation” has a direct and often substantial financial impact on a company.
  3. Value-Add. For growth-stage companies, it is important to understand that part of the bargain for many companies is that an investor, through its network, experiences, or skills, offers far more than simply dollars in your account.  When faced with two interested bids from investors, experience, reputation and goodwill obtained by association with one investor may offer more long term value to your company than a more favorable valuation offered by another who does not bring those intangibles to the table.  The only way to make an informed choice is to conduct proper due diligence.

Conducting due diligence of an investor should look similar to an investor’s due diligence of the target company.  How does that happen?

  1. Make it a Priority. It is okay to openly discuss at the beginning of a relationship with a potential investor the importance of finding not only a source of capital but also the right strategic relationship for your business, which may also need to check certain legal or regulatory boxes.  Savvy investors will expect you to perform some level of due diligence on them and may be wary of your sophistication if you do not.
  2. Always Be Thinking About It. Pay attention to the investor’s conduct and behavior through the process of negotiating their investment in your company.  Ask yourself whether the manner in which they conduct business and the manner in which they treat you (and others in the negotiation) jives with your style and the manner in which you desire your company to be perceived.  Consider whether your interactions engender trust or give you pause about a longer term relationship.
  3. Financial Disclosure. Depending on the profile of the investor (individual vs. well known firm), you may need to conduct some financial due diligence of a proposed investor to determine whether they have the financial wherewithal to make the investment they are promising. Establishing their financial qualification under securities laws for the reason noted above is also important.  You should consult with counsel and other advisors to get a view on what they think is required and then do not be afraid to ask the investor if it is something you need.
  4. Check References. Ask an investor for introductions to leaders/owners of other companies in which they have invested – including one that failed – to learn about their track record.  Call those people and ask tough questions about their relationship with the investor:
  • Have they provided any value-add intangibles?
  • Have they delivered on promises with respect to subsequent investment rounds?
  • Have they been a hands-off critic or a hands-on problem solver?
  • What did the business owner not know about the investor that they know now, or wish they had known prior to taking the investment?

Seeking investment may be new territory to many business owners.  With so many elements to consider in the process, investor due diligence is an area where your accounting, financial and legal advisors are a good source to help coach you through the process.

This post is for informational purposes only and does not constitute legal advice or an opinion on any issue.  If you are interested in receiving additional details on the topic above or advice about specific circumstances, please contact MEP Business Counsel at 604-669-1119.