Due Diligence Considerations for Entrepreneurs and Investors

Representing clients seeking to invest in a venture or finance a new business opportunity is a challenging experience for the lawyer as it routinely involves outlining the steps and various issues that are involved in the process of either type of transaction.  The discussion would involve addressing equity and non-equity financing structures and the types of entities that are appropriate, as well as the advantages and disadvantages when determining the corporate form to be pursued. The review would also include discussing the different types of investments that are available and how each vehicle impacts short- and long-term goals for the investor or the entrepreneur.

During the process of developing a strategy for investing or raising funds, it is paramount to protect the client from personal liability which involves determining the most appropriate corporate structure for the opportunity. The failure to be diligent in this exercise could expose the client to financial liability or adverse tax consequences. The forms of entities that should be explored would include general partnerships, limited partnerships, C corporations, S Corporations, limited liability companies and limited liability partnerships. The lawyer’s role is to explain what each form of ownership entails as well as outline the positive and negative impact depending upon the client’s goals as an investor or entrepreneur.

Another important consideration when investing or seeking funds relates to what jurisdiction is most favorable for creating the enterprise, especially if the goal is to conduct business in multiple states. If the entity is formed in one state and wants to conduct business in another state, it is required that the entity apply to the foreign jurisdiction for this purpose. One of the more complicated issues of doing business in multiple states is dealing with sales tax issues. Each state has different metrics, which requires the entity to withhold tax in each state in which it is selling products or providing a service. When business will be conducted in multiple states, in many cases, the preferred venue for incorporating is the state of Delaware because it has the most mature body of case law and the decisions are predictable.

The entrepreneur has multiple avenues to pursue in funding the business opportunity. If the business owner is reluctant to give up equity in the venture, he or she may decide that debt financing is most appropriate; however, a lender may be reluctant to grant loans to a business that only has a product or service and does not have a track record of profitability. Some business ventures may pursue grants or a crowdfunding campaign, which is a vehicle for raising capital in order to gather raw materials, conduct research or more fully develop a product.

The investor and entrepreneur must recognize that the business investment needs depend on its legal structure and ability to repay debt, as well as the anticipation of future investment needs. When non-equity capital infusion is the route that is pursued, the owner and lender recognize risk even though the owner may not be giving up any equity in the beginning of the venture. The downside for the lender is that it will not be repaid if the business model does not achieve the intended financial goals.  From the owner’s perspective, the risk is that the business collapses, which would expose the business owner to personal liability of guarantees that were required.

If the entrepreneur cannot secure or chooses not to use debt financing to grow the business, he or she will have to consider equity forms of investment, which include issuing common stock, convertible preferred stock, or convertible notes. All of the above forms of investment involve term sheets, due diligence and the negotiation of transactional documents that are oftentimes complex and time consuming, and could be frustrating for both the investor and entrepreneur. For more information on this issue or other business matters, please contact  PLDO Managing Principal Gary R. Pannone at 401-824-5100 or email gpannone@pldolaw.com.

 

 

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