Due Diligence in Private Debt

Definition & Process Outline

Definition

Independent of context, due diligence (or DD) is the process of thoroughly evaluating a company or organization before making a financial investment in it.

This can include anything from a small business to a large corporation, and the process is undertaken by potential investors or lenders who want to make sure they have a clear understanding of your company's financial health and risk profile.

The process as a whole takes from 4 weeks to a couple of months.

It’s a very long process, and you might want to go into it already prepared so you don’t end up looking like this:

Process Outline

Your company will be thoroughly put to test. You will be required to conjure up virtually every document you’ve used and produced since your company’s inception.

Not only that, but you will often need to justify the nature of these documents to your lending partner. The prospect of having experts combing through your records in search of oversights can bring about more than a few insecurities.

You need to know what is going to be asked of you, to best prepare for what is to come.

Step 1: Investment Memorandum & Presentation

The first step will be signing a non-disclosure agreement to keep any shared information confidential. Then, the investor will provide a list of documents they would like to review and possibly a list of questions for you or other team members to answer.

At the start of the Due diligence process, you will be asked to do a presentation of your business.

Starting with your Investment Memorandum, you’ll proceed to do a presentation of your company.

It will range from a general overview of your business model to more in depths descriptions of each department's structure and standard operations.

During this “interview” of sorts, you’re expected to provide much information. This typically includes a presentation of:

• Your management structure
• An overview of your product/service
• Your corporate statement
• Your market definition & market research
• Your metrics-based models for projected growth
• Your strategic plan to attain this growth and how this loan will help it, i.e. a clear use of funds
• A competitor's analysis
• A presentation of your Sales/Marketing teams as well as their standard operations
• A standard customer contract & deal process
• R&D strategy and structure
• List of major suppliers

There are other elements which you might need to provide in this presentation, depending on which industry you operate in. For example, if you sell e-cigarettes, you will need to provide a list of hazardous substances handled.

If you are a SaaS business, metrics like CAC and churn rates are essential. You live and die by the metrics, and it should therefore lie be the crux of your presentation.

Getting an advisor early will help you know preparing for this first part: what to prioritise according to your sector, how to format the presentation etc…

Step 2: Data Room

Virtually all your back-office will be gathered and provided to the investor. Back in the day, most of these documents would be hard copies. But since we are not in the eighties anymore, it’s now mostly done through a virtual data room like DropBox.

Not a slight against the eighties, though, it seemed fun.

The investor's advisors will review the collected data and create a due diligence report outlining any potential issues or concerns.

Based on this very report, the investor may uncover significant risks or numerous issues with the target company, leading them to decide not to move forward with the deal.

Sometimes, the investor may still be interested in investing but will try to negotiate different terms for the deal based on the findings of the report. They could try to change the warrants or the pricing of the deal.

The DD is a thorough process. For this reason, it will correlate with the negotiation process and the transaction agreements. Sometimes it will even last throughout the signing of the agreement. However, no transaction will happen before the investor is happy with the findings of the report.

Because of this nerve-wracking suspense, it’s important for you, the borrower, to know you have done absolutely everything in your power to facilitate this deal. Leave nothing to chance. Be prepared.

Here’s where our approach starts to become less high-level. Let’s get in the thick of it.

Legal Documentation & KPIs

This article focuses primarily on Private Debt DD processes. That is why this section starts with creditworthiness.

Creditworthiness

The focal point of a private debt DD process from the point of view of the investor is to establish whether the target will be able to repay their loan. This is also called establishing creditworthiness.

The DD report will aim to highlight key features of your company: Your commercial contracts & client status, your assets securitization, your debts and borrowing, your client base and your direct sales. This can be used against the backdrop of your financial statements to make sure your company’s accounting is sound.

There are more documents you will have to provide, but these three categories are essential to establish whether your foundations are solid enough to repay this debt. Note that these features are not exclusive to Private Debt DD processes and will be asked in an equity round as well.

Commercial Contracts

The obvious way to check whether you will be able to repay your loan is to look into your commercial contracts. Investors will look closely at their length, clauses, and the proportion of each of your clients’ contributions to your revenue.

If only one client represents a large part of your revenues and your contract with them terminates before your repayment window, the investor might want to reconsider their offer.

To map out your revenue streams and have a clearer idea of your business, they will therefore need a copy of these contracts:

• Contracts between you and your customers and clients
• License & distribution contracts and agreements
• Contracts with suppliers.
• Contracts with independent contractors

Any unusual terms or clauses found in these contracts will be weighted in the investor’s decision to maintain the deal with your company, or not.

Let’s assume you are aware of potential odd, unfair, or onerous terms in your commercial contracts. What should you do?

Well, it’s a good idea to consult an advisor who can find a way to communicate this information with your investor in a way that minimizes any negative impact on the deal.

You might feel like you know what the investor wants to hear, but, usually, an advisor will have more acumen in handling this sort of situation.

Change of control provisions in your commercial contracts is another very important factor.

This is a term found in many contracts which states no ownership change should happen before the counterparty gives its consent, in which case the contract will effectively terminate. Your investor will want to identify these provisions, as they play an important part in future funding round.

Customer Database

The relationship you entertain with your top customers is arguably what drives your creditworthiness. Their own financial health is an important part of the equation, as well as other key important factors your investors will want to know more about.

You usually have to provide revenues from your top 10 Clients in the last 2 years (typically), along with some industry-specific performance indicators.

Assets and Securitization

Assets are another crucial part of a company’s value. They influence a company’s production or worth so it’s important for investors to have a clear idea of them. Assets are tangible or intangible.

Tangible assets are machinery, vehicles & hardware. Intangible assets cover anything from intellectual property to branding.

What your lender is interested in is not so much the amount of assets you have than proofs of:

• Whether your company leases their assets or rather owns it
• Whether these assets are securitised: Have they been bonded or pledged to secure any prior debt?
• Licence agreements and permits that prove you’re allowed to use any intangible asset you are currently using, provided you don’t own them.
• Provided you do own intellectual property, your investor will need to know if it’s been registered in your company’s name, or someone else's. (current or former employee for example)

The more assets you currently own the better, in general. Terms and duration of asset leasing contracts are going to influence your investor’s decision, since they directly influence the cost of running your company, and therefore your profit.

You will need to justify your need for some of these leases, or securitizations, and your investor might not see eye-to-eye with it.

Debts & Borrowing

In Private Debt DD, this is an even more focal point. The lending partner is going to want to know:

• Exactly how much you do owe to either banks or other prior lenders
• Exactly how much money you do owe to shareholders

This enables them to come up with informative data like your Debt-to-Equity ratio, which plays a big role in defining your past funding practices, and your risk profile.

To do this, you will need to provide copies of:

• Every loan agreement you’ve contracted.
• Overdraft facility terms with banks
• Any payment default, historic or ongoing, and explanations for circumstances
• Share certificates issued by your company
• Share register, which helps to locate who owns shares

Similar to commercial contracts, loan agreements contain provisions against a change of control. Similar to assets, you will need to show what securities you've used to conclude prior debt deals.

Preparing your figures in advance and promptly reacting to the advisors’ queries is a great plus.

Direct Sales

Your sales are the pump of your business. Accordingly, it will be put under great scrutiny.

• Detailed overview of typical sales cycle (length of sales cycle by size of customer engagement)
• Details on historical conversion rates of your customer’s pipeline
• Structure of your customer’s pipeline
• Proof of your pipeline’s commercial viability on long and short term.
• Historical allocation of marketing spend
• Expected change in marketing team’s structure and strategy

Financial Statements:

Your financial statements are obviously very important. You will generally be required to produce:

• Your income statements
• Your balance sheets
• Your cash flow statement
• Your bank account statements

As a reasonably small company, you might not have the biggest accounting team right now. Help it out by recruiting an advisor early to work closely with them. You can’t cut corners halfway through so preparation is key; but so is communication during the process itself.

Corporate Documents & Legal Litigations

Any Due diligence processes (Private Debt or VC) will contain a thorough review of corporate documents and any past or ongoing legal litigations. This helps them map out areas of potential concerns which could infringe on the repayment process.

Corporate Documents

Corporate documents you need to provide are generally so:

• Shareholders agreement
• List of current directors and past directors
• The company registration certificate
• Minutes of director and shareholder meetings
• Director and shareholder’s resolutions adopted in recent years

Technically, shareholder records mentioned above in the Debts & Borrowing section are also part of these corporate documents.

Legal Litigations

• Details of any past or pending litigation
• Details of any tax audits or tax issues

Employees and Property

Employees

You might think that equity might not always be part of a debt deal. One might think employees' information is less important when the fund does not plan to acquire shares, and thus partial governance of your company. However, Private Debt funds are still willing to know about your employee’s data.

For one, warrants in PD funds sometimes see fit to include an option scheme to their offer, whereby convertible notes can later be transformed into a stake in your company (provided you reach certain requirements and/or milestones.) It then becomes an evident part of your investor’s concern.

Secondly, there are things about your employment methods that can say a lot about your company’s culture and management style.

For example Debt funds in general like ‘lean teams.’ Private Debt funds have little control over how your funds will be used. Still, they’re concerned you will increase your cash burn by compulsively recruiting once you’ve secured your round of funding, thus making it more difficult for you to repay your loan.

There is something about your employment patterns, then, in which your investor has a vested interest.

Typically, you will be asked to produce the following resources:

• List of staff, role/function, salary, which entity they work for and years of service.
• A current organisational chart of the company by department
• Areas of staff recruitment and number of staff to deliver plan
• Employment contracts of key management
• Historical number of employees by year
• Details of any employee share option scheme if applicable
• Management biographies

Be prepared to answer questions about the relevance of certain staff positions and/or employment contracts. We cannot stress enough how important efficient communication about these matters is to the prospect of a successful deal.

Property

Typically, in any funding round, a DD process will require you to show documents about your property, such as lease agreements and other premises-related agreements.

Other

You will need to provide any insurance policies in place.

Rounding up

This cannot be an exhaustive list of documents to provide during a DD. While it constitutes more than half of the documents you will have to produce, there are too many KPIs, documents, permits, leases that are too industry-specific, and product/market-specific for us to cover in this article.

In Fintech, SaaS and other Tech sectors which Private Debt funds like to cover, however, there are key takeaways:

Creditworthiness

Metrics

Administrative soundness

Accounting soundness

That’s it for the list! You can now proudly say:

Why Can DD fail

You now have a general idea of all the things you need to do in order to complete successful Due diligence.

What about the things you need NOT do?

The stakes are too high to indulge in bad practices which will either delay or kill your deal.

Here’s a selection of them:

You Were Not Organised

While some investors might get immediately interested after they’ve seen your KPIs and metrics, you will have to back it up and show that your company has a sound business plan, accounting and administrative structure.

Many small companies start their business in a very creative, funky way: with very few resources, and no trained accountants. Neither time nor manpower to put in administrative tasks… it's all about action!

That results in having a messy back-office

In turn, a messy back office can do two things to ruin your Due Diligence:

• Uncovering bad business practices
• Make you lose the patience of your investor

Poor organisation is often the reason due diligence processes go south. In the best case, your investor will use this information to drastically lower the original deal price. Worst case scenario, the deal dies and with it your funding dream.

The best way to get organised and kick this DD out of the park is to consult someone who has been doing DD processes countless times before.

Efficiency does not bode well with work overload; you don’t want to have too much on your plate as it lets the door open for timely mistakes

You Misled Your Investment Partner

Having a disorganised back office is one thing. Covering up secrets or bad practices on purpose is another.

Whether it's not showing an invalid contract, falsifying signatures, or having your hand in the proverbial cookie jar of your company: thorough due diligence will most certainly find it out.

Save yourself a trip to the court and come clean if you know about any wrongdoing. The best way to deal with problems like this is by trying to fix them within the confines of reason and the law.

Failed Data Room

Failing the data room is one of the most common reasons why DD fail.

It can happen for a plethora of reasons, but what it really comes down to is organisation.

Make sure to always update it in real-time.

Upstream preparation is key in creating a system that’s ergonomically sound. Beta-testing it internally might be a good idea. Have employees give you feedbacks.

Conclusion

Due diligence is a taxing process and requires much preparation. It can take up to a couple of months to reach maturity. Moreover, were they to find any grievances, your investors would have an edge to revise the terms, conditions, and pricing of the deal.

The best way to prevent this from happening is to maximise your chances, by stacking the odds in your favour.

Be smart, be prepared, and get an advisor early, upstream in the preparation process.

If you’ve made it this far, congratulations.

You know have the power of DD.

Still have questions and need expert advice? Talk to one of our advisors!