We've all heard this story about others, and maybe we've even told it about ourselves. You know, the one about that early stage company with great people and even greater ideas that needed just a third of a million dollars to get the first of many incredible Internet based products out the door. And along came that seasoned vet of the corporate technology wars who was prepared to invest his savings in the company to play mentor and be called an angel, and maybe make some serious money. Well, he invested, but the company never got beyond the early stage. Seems there was some problem having to do with ownership of the underlying software, along with some debts that nobody talked about.

So our kindly angel turned into the devil, suing those once great people and their company for damages for breach of contract, fraudulent misrepresentation, theft, oppression and all sorts of other ghastly things that he, or more likely his lawyer, thought took place. And the lawsuit dragged on and on, with the odd mediator making appearances to try and bring about a settlement. Everyone's energy was slowly sucked out of them, and tons of cash was spent on preparing and reviewing countless documents and interviewing numerous people.

Could this story have turned out differently? Maybe. Instead of launching a lawsuit based upon a bunch of documents signed at the time he handed over his cheque, our investor could have investigated the people and the company a little more thoroughly beforehand. He could have, to use industry jargon, conducted due diligence.

What is due diligence? There are many definitions. While some use the dictionary meanings of "due" and "diligence" and others refer to the convoluted wording found in securities laws, they all involve making careful inquiry before doing something. For anyone purchasing or financing a technology business, exercising due diligence means seeking out information about the business, evaluating that information, and then attempting to verify that information through outside sources before a cheque is delivered. This evaluation and verification is the essence of due diligence.

While due diligence requires time and money to be conducted properly, and often more time and money than many purchasers or investors think is warranted, there are definite benefits to be gained from the process.

Due diligence helps to ensure that the price paid is fair and falls within an acceptable range. It allows a purchaser or investor to rely on information provided by sources independent of the deal, not just provided by the owners of the business alone. It helps to determine whether any dealbreakers exist, and allows for the attempted removal or correction of such dealbreakers early on in the process. And it assists in evaluating the likelihood of future claims being brought against the business by lenders, suppliers, partners, licensees and others.

Instead of having to wait for some time after the deal is closed to discover problems and then sue the owners for breaking the legal agreements exchanged on the closing, a purchaser or investor given advance warning of such problems may be in a position to renegotiate the basic business terms, perhaps by requesting a reduction in the price or payment in installments, or by requiring the release or guarantee of a third party or the posting of collateral.

The overriding goal of due diligence is to ensure that the purchaser's or investor's expectations are realistic and can be met once the deal is closed. In order to accomplish this goal, anything that confirms the assets and liabilities of the technology business being purchased or financed should be the subject of a due diligence investigation.

Yet many purchasers and investors focus on the capability of the technology alone and not on the technology business as a going concern when deciding to cut a cheque. For their due diligence, they obsess over functionality, scalability, compatibility, and all the other things that give the technology a competitive advantage. They test and retest to confirm that the technology not only works but that it works better than every other similar technology on the market.

But such a process isn't proper due diligence for buying or investing in a technology business. Better to call that process a technical audit instead, barely suitable when buying rights to the technology itself or when investing in units of the royalty stream which such technology may generate. Even then, an investigation of who really owns the technology should be undertaken. While some may argue that only a technical audit is necessary when buying or investing in a technology business at the earliest stage of start-up, that argument gets weaker once the business has employees, more than a couple of computers, a premises lease, banking arrangements, and lots of software.

For proper due diligence to be carried out, a number of things should be looked at in addition to investigating how well the technology works. Just how many things should be looked at usually depends upon how much time and money a purchaser or investor is prepared to spend.

A comprehensive review should be undertaken of the corporate and financial records of the technology business, including its financial statements, tax returns, employment records, benefit plans, minute books, marketing and sales materials, and insurance policies. All licenses and permits enabling the business to operate in all jurisdictions where it appears to be operating should be examined.

Many of its contracts should be looked at: financing agreements, security agreements, equipment leases, premises leases, supply agreements, joint venture agreements, shareholders agreements, partnership agreements, non-competition agreements, customer contracts, employment contracts, licensing agreements, distributorship agreements, non-disclosure agreements, and so on. These contracts may contain restrictions relating to assignability, change of control, type of business being carried on, territory of operations, and dealing with competitors. Or they may include clauses covering early termination, rights of first refusal, set off, extended warranties and indemnities, and many other items imposing unexpected liability.

And numerous public records and registries should be searched. These include the records maintained by the provincial personal property security office, local office of the Bank of Canada, Sheriff's office, the Superintendent of Bankruptcy, Revenue Canada, various provincial tax branches, and the Canadian Intellectual Property Office. Fortunately searches of some of these records and registries can now be conducted remotely, either by fax or through "dial-up" or Internet access, without having to actually attend at a government office.

Of all the things mentioned above that ought to be done, three of them deserve special mention when purchasing or investing in a technology business.

A search of the records maintained by the Canadian Intellectual Property Office in Hull for patent, trade mark, copyright and integrated circuit topography registrations may reveal not only who is the owner of the technology used by the business but also who has a lien over it. A review of any employment and consulting contracts entered into by the business, or the absence of any such contracts with its employees and consultants, may reveal that the technology used by the business is actually owned by the employees or the consultants, or by their former employers, not by the business itself. And a careful reading of any assignment and license agreements may indicate that the technology used by the business isn't owned but merely licensed by the business and the right to use it can be easily taken away.

In carrying out comprehensive due diligence, it's important to decide what things should be done first. Ordinarily preliminary title and lien searches on only the most essential assets are conducted before a letter of intent is signed. If some of the records and documents to be reviewed have been assembled in a centralized location for examination by a number of potential purchasers or investors, they may be accessible for review immediately after a confidentiality agreement is signed.

A larger part of the due diligence investigation may take place once the letter of intent is signed, especially if the letter of intent is legally binding and contains a clause providing for the purchaser or investor to be compensated by the business in the event the deal doesn't close. If the letter of intent is non-binding, much of the due diligence may be deferred until the purchase agreement or subscription agreement is executed.

Ordinarily the team assembled by the purchaser or investor to carry out due diligence will work with a checklist of items to be investigated. Each item on the checklist should have a due date and a named individual assigned to its completion. Someone on the team should be selected as the team leader through whom the results of all investigations flow and are recorded. In addition to ensuring that the named individuals complete their assigned items by the applicable due date, the leader should be directly involved in negotiating and drafting of the closing documents, or work closely with those who are.

However, no matter how thorough the team is in its investigations, there are limitations as to what can be accomplished through due diligence. For those interests which are registered, registration may not necessarily be proof of ownership or ensure priority. Other interests may simply not be registered or documented at all. Ascertaining the existence of any unregistered or undocumented liens, restrictions and other interests affecting a business is a challenge. Some may be discovered by searching the Internet, while others may be disclosed only upon personal interviews with those who may have a potential claim against the business, or who perhaps manage some of the business.

But despite this limitation, due diligence must still be done. Since many of us "don't know what we don't know", carrying out due diligence helps us to find out what we don't know and avoid making assumptions based only upon what we do know.

Had the angel investor in our story found out what he didn't know about who owned the underlying software and who was owed money by the business, he might still have invested anyway. He might have decided, once the bad as well as the good news was in, what was really important and what wasn't, and what constituted an acceptable level of risk. At least then his expectations would have been more realistic and possibly met, and the overriding goal of the due diligence process would have been satisfied. And another lawsuit could have been prevented.

Copyright 1998, A. Paul Mahaffy. Reproduction by any means in whole or in part without the prior written consent of the author is strictly prohibited.

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